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Is the value derived from the license or the practice? Or both?

Professional License Value in a Divorce

By James N. Mastracchio and Nicholas J. Mastracchio, Jr.

The authors start out by discussing the issue of how the value of professional practices and licenses in divorce cases has been adjudicated in various states. Attention is then directed to recent cases in New York State which may influence the future pattern for other states.

While marriage is not usually perceived as an economic partnership, if a divorce is involved the concept becomes paramount. One of the most difficult issues to resolve is the equitable financial arrangements when one spouse has sacrificed education, career, and standard of living to enhance the earning capacity of the other spouse.

Most states do not recognize enhanced earning capacity as a marital asset. Even in those states, there is recognition that a spouse who sacrifices money and living standards to put the other spouse through an education process or licensing effort cannot then be discarded, and the contribution ignored. One of the most cited cases is Graham v. Graham in Colorado. In this case, the marriage terminated in divorce after six years. During the entire marriage, the husband's main pursuit was his education. The wife worked and provided 70% of the support. No assets were accumulated during the marriage. The trial court determined that the education obtained was jointly owned property. The Court of Appeals reversed and the Supreme Court of Colorado affirmed the decision of the Court of Appeals. They stated:

An education degree, such as an M.B.A., is simply not encompassed even in the broad view of the concept of "property." It does not have an exchange value or any objective transferable value on an open market. It is personal to the holder. It terminates on death of the holder and is not inheritable. It cannot be assigned, sold, transferred, conveyed, or pledged. An advanced degree is a cumulative product of many years of previous education, combined with diligence and hard work. It may not be acquired by mere expenditure of money. It is simply an intellectual achievement that may potentially assist in the future acquisition of property. In our view, it has none of the attributes of property in the usual sense of that term.

The dilemma faced by the court is the inequity to the spouse who has sacrificed for the other spouse. A dissenting judge in this case stated: "The issue here is whether traditional, narrow concepts of what constitutes 'property' render the courts impotent to provide a remedy for an obvious injustice. In cases such as this, equity demands that courts seek extraordinary remedies to prevent extraordinary injustice." The court did provide that the earnings could be considered in alimony determinations.

Many states that do not recognize enhanced earnings capacity provide other avenues to award a distribution to the spouse who provided the support. One of the cases cited is the New Jersey case of Mahoney v. Mahoney. Here the court created a new type of alimony to provide a method of equitability. It stated as

To provide a fair and effective means of compensating a supporting spouse who has suffered a loss or reduction of support, or has incurred a lower standard of living, or has been deprived of a better standard of living in the future, the court now introduces the concept of reimbursement alimony into divorce proceedings. The concept properly accords with the court's belief that regardless of the appropriateness of permanent alimony or the presence or absence of marital property to be equitably distributed, there will be circumstances where a supporting spouse should be reimbursed for the financial contributions he or she made to the spouse's successful professional

Another case often cited by various states is the Iowa case of Francis v. Francis. Here the court recognized that property awards and alimony have been used interchangeably as means of compensating a nonprofessional spouse for the contribution made to the other spouse's advanced degree or professional license. It stated, "insofar as the advanced professional degree created an expectancy of higher future earnings, the degree may and should be taken into account in calculating that future earnings capacity."

This type of reasoning is provided by statue in Michigan, New Mexico, Ohio, and Utah. In most states, however, the approaches have been developed through the courts. Some states provide for reimbursement of expenses while others allow for the consideration of future earnings.

Some states take a more direct approach and consider the enhanced earnings a marital asset. In December 1995, the New York State Court of Appeals decided McSparron v. McSparron, reaffirming its holding that professional licenses acquired during a marriage may be marital assets and subject to distribution in matrimonial actions. This decision by New York's highest court alters the approach to valuing assets in that state's divorce proceedings. While the marital property issue is different in New York, the decision may influence other jurisdictions as well, and the concept could be used to determine value, no matter what the court called it. A history of the development of enhanced earnings in New York and the new decision

O'Brien v. O'Brien

In 1985, the Court of Appeals decided O'Brien v. O'Brien, declaring that professional licenses were capable of possessing value for marital distribution. The court's decision dramatically expanded the definition of marital assets by including the enhanced earnings capacity of a medical degree. The O'Brien decision had a profound effect on CPAs doing valuations and on the court's recent decision in McSparron.

The O'Brien saga began with Dr. Michael O'Brien entering marriage with three and one half years of course work toward a bachelors degree. Over the next nine years, he obtained a medical degree studying in Guadalajara, Mexico and New York. Two months after being licensed to practice medicine, he commenced a divorce action. At trial, Dr. O'Brien argued that the professional license did not satisfy common law concepts of property and represented a "personal attainment in acquiring knowledge." Dr. O'Brien called no witnesses to establish the value of the professional license or to rebut his wife's expert valuation testimony.

Mrs. O'Brien claimed that the professional license was a marital asset subject to distribution and that the license held a quantifiable value. She argued that her contribution to her spouse's career represented an investment in the economic partnership of the marriage and that the product of the parties' joint efforts, the professional license, was in fact property and subject to distribution. She presented expert testimony claiming that the value of the professional license should be computed by calculating the present value of the added earnings capacity that the professional license provides her husband. This was accomplished by comparing the average income of a college graduate and that of a general surgeon. The difference between the average earnings of the two occupations was discounted to present value and the resulting amount was deemed the value of the professional license.

Initially, the lowest court decided in favor of Mrs. O'Brien, holding that the professional license possessed distributable value. The Appellate Division, however, reversed and the case was argued before the Court of Appeals.

Ultimately, the Court of Appeals held that Dr. O'Brien's medical license constituted marital property and was subject to equitable distribution. While the subject property failed traditional property concepts, the court stated that "the spouses have an equitable claim to things of value arising out of the marital relationship," establishing the professional license as an asset capable of distribution to the opposing spouse during a divorce.

Once the court determined that the professional license was distributable, the value of the license came into question. Ultimately, the court accepted Mrs. O'Brien's valuation methodology as applied to her husband's medical license. The court held the value of the medical license was, "the enhanced earning capacity the license affords the holder." The court rejected the notion that a working spouse who supports a student spouse is limited in recovery to a reimbursement of the direct financial contribution. The court reasoned that if direct financial contribution were adopted, it could be applied to any asset and the investment rather than the appreciated value would determine value for any asset. As a result, Mrs. O'Brien was entitled to a percentage of the average additional earnings capacity attributable to the professional license obtained during marriage, even though Dr. O'Brien had only recently embarked on his medical career.

This decision was relatively novel; many states do not recognize the theory that professional licenses can be distributed to a spouse as marital property. The decision started a whole new service offered by CPAs, the valuation of an individual's enhanced earnings capacity.

The Merger Doctrine

Prior to the Court of Appeal's decision in McSparron, valuing a professional license was difficult due to contradictory lower court rulings. New York State courts generally required the use of actual earnings in valuing the worth of an individual provided the person had an established work history. Where a person also held a professional license, certain courts felt the professional license lost an independent identity and merged with the professional practice. For courts applying the "merger" doctrine, the idea that the professional license held an independent and distributable value no longer applied. The lower courts, thus, preempted the application of O'Brien and created controversy over the appropriate value of marital assets.

The merger doctrine was applied most often where a spouse used a professional license to establish and maintain a profession or career. If enough time passed between the licensing date and the matrimonial action, the career and the license merged and the license lost its character as a separate valuable, distributable asset.

One of the first Appellate Division cases to implement the merger doctrine was Marcus v. Marcus. In this case, the Second Department ruled that while the defendant obtained his medical license during the marriage, but over 30 years prior to the divorce action, the only viable marital asset for distribution was the psychiatric "practice as a single asset." The medical practice wholly subsumed the medical license for valuation purposes.

Marcus was the beginning of an avalanche of cases embracing the merger doctrine. With each new case came increasing pressure to recognize the merging of the professional license or college degrees with a career or professional practice. In Vanasco v. Vanasco, the Supreme Court of New York County determined that a CPA license merged into the accounting partnership after eight years and provided no additional value to the marital assets. All courts applying the merger doctrine assigned no value to the professional license for purposes of distributing marital assets. Also, if the "career" was as a nonowner employee, e.g., a CPA working for the IRS, the career had no value, either.

Some lower courts in New York did, however, follow O'Brien where the parties held a professional license for a short period of time before commencing a divorce proceeding. For example, in Shoenfeld v. Shoenfeld, the Appellate Division Second Department ruled that since the husband had practiced medicine for less than two years at the time of the divorce action, the practice had not yet developed to its full potential, and it was inappropriate to find that the license and the practice had merged.

The Reemergence Concept

Various New York State lower courts resurrected O'Brien in limited circumstances by ruling that a merged license might "reemerge" as a separate distributable asset. The reemergence concept applied most often when the licensed spouse changed career paths or utilized a license in a manner inconsistent with his or her profession during marriage. The application of the reemergence concept required the inclusion of both the professional license and the professional practice as marital property. Therefore, each asset was assigned a separate value for distribution.

For example, in Behrens v. Behrens the Second Department determined that a medical license merged with a professional career due to the length of the career and the development of a successful practice. However, because the defendant sold his medical practice shortly before commencement of the litigation and moved to another state where he opened a new practice, his license reemerged as a significant and separate asset to be distributed upon dissolution of the marriage.

Over time, the line between O'Brien, the merger doctrine, and the reemergence concept became blurred causing uncertainty among the lower courts and with those attempting to value marital assets. Difficult issues included the appropriate length of time an individual worked before the license merged with the professional practice and lost independent value. The reemergence concept also created difficulties, especially in those instances where the court was required to identify career paths suitable for a particular license.

The McSparron Decision

The merger issue was finally addressed by the Court of Appeals in McSparron v. McSparron. The court discarded the merger doctrine in favor of a common-sense approach that recognized the ongoing independent vitality a professional license may possess. As a result of the decision, all professional licenses retain status as a distributable asset and never merge into an independent professional career or business. Both the professional career and the professional license retain a value for distribution purposes regardless of the length of time the license is held by either spouse.

While the McSparron court correctly determined that a professional license retains status as a distributable asset, the court remanded the issue of valuing the professional license to the lower court. Unfortunately, the only guidance provided by the Court of Appeals was the statement that the appropriate value of the professional license would meticulously "guard against duplication in the form of maintenance awards that are premised on the earnings derived from the professional licenses." A methodology to properly value a professional license that comports with the Court of Appeals decision in McSparron is presented below.

Valuation Methodologies

When rendering an opinion, the valuation expert must be wary of possible duplication that may occur in assigning values to these two related but independent assets.

Practice Valuation. There are a number of ways to determine the value of a professional practice. Most practices are valued by discounting the present value of future benefits (see Lippitt and Mastracchio, "Developing Capitalization Rates for Valuing a Business," The CPA Journal November 1995, pp. 24-28). Future benefits can be analyzed by applying an excess earnings, earnings capitalization, or discounted cash flow analysis. Each of these methodologies provides the present value of some future benefit that corresponds to the value of a professional practice. The particular technique chosen will depend upon the underlying facts of a given case. For purposes of this discussion, the specific methodology used, e.g., one of the three above, within the valuation framework is of no consequence. All the methods are based upon earnings, or cash flow, after a fair salary for the owner. Using a fair salary is a significant part of determining value regardless of which technique is applied.

The following example uses the earnings capitalization method. It could have just as well have been prepared using one of the other methodologies. Assume that over the last five years a CPA practice had an average net earnings of $40,000 per year, after a fair salary for the owner. The capitalization of earning method determines value by dividing earnings by a capitalization rate. If, for example, the appropriate capitalization rate is 20%, the professional practice would be valued at $200,000 ($40,000/.2).

Earnings, for the valuation process, is the net income of the practice that a purchaser of the practice could expect, i.e., fee income ­ practice expenses ­ fair owner compensation = earnings. Fair owner compensation is the amount that would be paid a nonowner doing the same work. If fair compensation is not factored into the calculation, there is no consideration for the efforts of the practitioner and the practice would be

License Valuation. License valuation is best illustrated by example. Consider a young CPA with no established earnings history and no practice ownership. Applying the O'Brien methodology requires determining the average after-tax earnings of the person with the professional license at the date of the divorce action and comparing those earnings with the earnings of the average person with similar earnings potential at the date of the marriage. According to O'Brien, the earnings are calculated for each year and accumulated until the person reaches age 65 when a present value of the sum is determined.

Assume that the practitioner was married after one year of college and obtained both a degree in accounting and a CPA license during the marriage. Assume further that--

Average salary of a CPA $64,704

Average salary person with one

year of college 34,413

Average projected salary growth 5%

Date of 65th Birthday January 1, 2028

Appropriate discount rate (based upon
long-term treasury rates) 7.9%

The calculation of the CPA license is calculated in Table 1.

Combining the Methodology

If the foregoing valuation methods are utilized, there is no duplication valuing the practice and the license. The license is computed as the differential in earnings between the average person with one year of college and the average salary of the CPA. The value of the practice is essentially the value of the actual earnings compared to the value of those of the average CPA.

The combination of the license and practice values also can be illustrated by example. Assume the earnings of the practice before owner compensation is $104,704, which requires an adjustment for a fair salary. If a fair salary for a CPA is $64,704, the practice earnings after a fair salary would be $40,000. The earnings capitalized at 20% would be $200,000. The license would remain at its value of $375,564 (see Table 1). There is no duplicative process here.

If the earnings capitalization method is not appropriate because the practice is not earning beyond what a typical CPA would make, the practice might be valued by the amount of any tangible assets. If a license was also involved in the valuation, there still would be no duplicative value since theoretically, the CPA could liquidate the practice, receive the value of the assets, and continue to earn what a typical CPA could make.

License Values Based on
Actual Earnings

In McSparron, the court also ruled that, as the marriage progresses, the average earnings of a person with the same license should be discarded and replaced by the earnings of the specific individual. The court states that, "where the licensee has already embarked on his or her career and has acquired a history of actual earnings, the foregoing theoretical valuation method must be discarded in favor of a more pragmatic and individualized analysis based upon the particular licensee's remaining professional earning potential."

The actual earnings of the person may be the same as, above, or below average. The person may or may not own a
practice. Table 2 summarizes the possibilities and considers the potential for

Avoiding Duplicative Values. Only scenario 2 in Table 2 causes a problem. If the enhanced earnings capacity of the individual is his or her actual earnings and the calculation of the practice is based upon actual earnings, the earnings above average are included in both the value of the practice and the value of the license.

For example, if a court ruling requires the license to be valued based upon the actual earnings of $104,704, the license would result in a present value of $927,307 using the same approach as Table 1, substituting $104,704 for the $64,704.

Since both the value of the license and the value of the practice are derived from the actual earnings of $104,704, the separate value of the practice of $200,000 is already included in the $927,307.

It is worth noting that the license is worth more in this second example than the combined practice and license calculation in the first example. Discount rates are the reason for this. A practice is deemed to be a risky investment, and a high interest rate is applied. Licenses require a lower rate because it is presumed that the person can earn an income from the license over a lifetime with relatively no risk. However, this presumption could be deemed to carry more risk, and a higher rate may be justified for the portion of the value above the average. This risk differential, however, was not addressed in McSparron. Another possibility is to use above average earnings for the base earnings in cases where the individual is earning above the average. *

Cases cited:

Marcus v. Marcus 137 AD2d 131 (1988)

McSparron v. McSparron 87NY2d 275, 639 NYS2d 265

Graham v. Graham 194 Colo 429; P.2d 75 (1978)

Mahoney v. Mahoney 91 N.J. 488; 453 A. 2d 527 (1982)

Francis v. Francis 442 N.W. 2d 59 (1989)

O'Brien v. O'Brien 66 NY2d 576, 489 N.Y.S. 2d 743 (1985)

Vanasco v. Vanasco 132 Misc. 2d 227, 503 N.Y.S. 2d 480 (1986)

Shoenfeld v. Shoenfeld 168 AD2d 674, 563 N.Y.S. 2d 500

Behrens v. Brehens 143 AD2d 617, 532 N.Y.S. 2d 893 (1983)

James N. Mastracchio, JD, CPA,
is an attorney in Washington, D.C. Nicholas J. Mastracchio, Jr., PhD, CPA, is an associate professor at the State University of New York at Albany and a consultant on business valuations.

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

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