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Thursday, October 23, 2008

First Department Holds That Value of Husbands Subchapter C Corporation Should Be Reduced For Embedded Taxes

First Department Holds in Case Where Marital Estate is $77,680,333.95 That Value of Husbands Subchapter C Corporation Should Be Reduced By $21,778,708 to Reflect the Federal and State Taxes Embedded in Securities it Owned.

In Wechsler v Wechsler, --- N.Y.S.2d ----, 2008 WL 4635832 (N.Y.A.D. 1 Dept.) the issue of first impression was the extent to which the value of a holding company, Wechsler & Co., Inc. (WCI), a Subchapter C corporation, all the shares of which were owned by the husband, should be reduced to reflect the federal and state taxes embedded in the securities it owned. These securities constituted virtually all of its assets, due to the unrealized appreciation of those securities. As of the date the divorce action was commenced, the valuation date, WCI had ceased trading securities for the accounts of customers and bought and sold securities solely for its own account. The Appellate Division, in an opinion by Justice James M. McGuire, modified the judgment appealed from by the husband. It noted that Supreme Court adopted a "baseline" value of $70,848,107 on the date the action was commenced. That baseline value was determined by the neutral expert before any deduction for embedded taxes and then made adjustments to it that differed in various ways from the adjustments made by the neutral expert. The most significant adjustment was on the issue of the extent of the reduction for embedded taxes. Supreme Court rejected the approach of the Fifth Circuit in Matter of Dunn v Commissioner of Internal Revenue (301 F3d 339 [5th Cir2002] ), the approach embraced by the neutral expert. Pursuant to that approach, consistent with the assumption inherent in the net asset valuation methodology, an actual sale of the corporation's assets is assumed to occur on the valuation date. The value of the corporation is reduced on a dollar-for-dollar basis by the full amount of the tax liability that would arise from the sale of the assets by the hypothetical buyer on the valuation date. Both the neutral expert and the husband's expert testified, and the wife's expert did not dispute, that if the securities were sold as of the date of commencement, the effective tax rate would be 41.74% of the baseline value of $70,848,107. Under the valuation methodology adopted in Dunn, the date-of-commencement value of WCI would be reduced by $29,572,000 (41.74% of $70,848,107). Instead, Supreme Court accepted the approach of the wife's expert and reduced the baseline value of WCI by 11% of $70,848,107 ($7,793,292). That percentage approximated what Supreme Court and the wife's expert denominated the "historical" rate of the annual taxes paid by WCI, a rate determined by comparing the average annual taxes paid by WCI to its average annual gross revenue, i.e., its revenue before all applicable deducttions for its various costs of doing business (including the salaries of its employees). The Court indicated that Supreme Court relied in significant part on the decision of the Tax Court in Matter of Jelke v. Commissioner of Internal Revenue (TC Memo 2005-131 [2005] ), a decision that was reversed by a divided panel of the Eleventh Circuit after the appeal was argued (507 F3d 1317 [2007] ). In Jelke, the Eleventh Circuit adopted the approach of the Fifth Circuit in Dunn and concluded that, on the assumption that a sale of the corporation's assets occurs on the valuation date, the value of the corporation's assets should be reduced by the full amount of the embedded taxes that would be payable as a result of the sale. At trial, Supreme Court was asked to choose between the approach of the Fifth Circuit and an approach different from the one advanced by the Commissioner in Jelke. The latter approach, the one Supreme Court adopted, did not attempt to ascertain the period of time over which the assets of a corporation would be sold by a reasonable buyer and discount the taxes that would be due over that period to present value as of the date of commencement. Rather, it adopts a baseline value of the assets as of the commencement date and reduces that value by an "historical" tax rate of the corporation. Both the neutral expert and the husband's expert vehemently disagreed with the"historical" approach espoused by the wife's expert. The Appellate Division pointed out that the wife offered nothing by way of precedent to support her expert's position. The Appellate Division rejected the approach of the wife's expert because it did not accord with common sense, conflicted with the reasoned testimony of both the neutral expert and the husband's expert and was without precedential support. The approach of the wife's expert assumed that the assets will not be sold as of thevaluation date and that WCI would operate in the future as it had in thepast so that each year it both would sell assets to the same extent it annuallyhad sold assets in the past and would be able to offset income generated by thesale of assets with the same deductions for salaries and other expenses that ithad been able to take in prior years. The assumption that WCI would continue to beable to take the same deductions for salaries was at least brought into questionby proceedings in Tax Court that were pending as of the trial. Furthermore, the assumption that WCI would sell assets in the future to the sameextent that it had sold assets in the past was even more questionable. Moreover, by also assuming that the securities owned by WCI will not depreciatein value over time, the approach of the wife's expert required the husband to bearall the risk of a decline in their value. The Appellate Division held that as between the competing methodologies advanced by the parties at trial Supreme Court should have adopted the one accepted by the Fifth Circuit in Dunn. It concluded that Supreme Court overvalued WCI by $21,778,708 (the difference between the $7,793,292 reduction in value based on the "historical" tax rate methodology and the $29,572,000 reduction that would result under the methodology adopted in Dunn ). This amount differed from the "baseline" value of $70,848,107 because of other valuation adjustments made by Supreme Court. The husband did not dispute all of these adjustments and the discrepancy between the two "baseline" values was of no moment.] That amount should be subtracted from the total value of WCI at the time of the commencement of the action found by Supreme Court ($74,387,630), leaving a total value of $52,608,922.
The Court pointed out that shortly after oral argument, the wife moved to dismiss the appeal on the ground that the husband was a fugitive from this jurisdiction and barred from maintaining the appeal under the fugitive disentitlement doctrine. By an order dated November 27, 2007, it granted the wife's motion and dismissed the appeal with leave to the husband to move to reinstate the appeal on the condition that, within a certain time frame, he post an undertaking of approximately $10 million (45 AD3d 470 [2007] ). The husband posted the undertaking and moved to reinstate the appeal.
The Appellate Division affirmed that part of the judgment of Supreme Court which declined to award permanent maintenance in part because the wife would be "vastly wealthy in her own right." The wife did not perfect her cross appeal, so there was no occasion to decide whether a permanent maintenance award would be appropriate in light of the reduction of the distributive award. The Court noted that Supreme Court awarded the wife over $27 million in assets, reflecting approximately 88% of the other marital assets.
On appeal, the husband argued that, consistent with the approach adopted in Dunn, pursuant to which the hypothetical buyer is assumed to liquidate the assets of the corporation upon acquiring it, an additional reduction in value is warranted to account for the non-tax costs of liquidating the corporation that the buyer would incur. The husband's expert computed those costs by assuming that WCI's assets would be liquidated over a six-month period after the valuation date (the date the action was commenced), an assumption that results in higher non-tax liquidation costs than would be incurred if the assets were liquidated on the date of commencement. Although the parties did not discuss the issue, the assumption by the husband's expert of a six-month liquidation period is not consistent with the assumption, for purposes ofdetermining the extent of the reduction for embedded taxes, that the corporation'sassets are liquidated on the valuation date. Supreme Court held that no such reduction in the value of WCI was appropriate. Supreme Court did not make any specific findings on what the non-tax liquidation costs of WCI would be. Determining whether and the extent to which a reduction in value for non-tax liquidation costs is warranted was complicated further by the parties' contentions about those costs. The Court pointed out that there were other complications that the parties did not discuss. The Court concluded that the value of WCI should not be reduced by any non-tax liquidation costs. It had no rational basis in the record for determining what the amount of the non-tax liquidation costs are, assuming it were to hold that the value of WCI should be reduced by some such costs. It also beleived that the amount of any of the costs it might recognize was small relative to the overall value of the marital property and might not exceed the costs of additional briefing and the possible fact-finding proceeding. It added that its resolution of this issue sets no precedent on the question of whether or the extent to which a reduction in value for non-tax liquidation costs is appropriate in other circumstances. The Appellate Division held that Supreme Court erred in concludingthat the husband’s right pursuant to a subscription agreement to purchase additional shares of the common stock of WCI's predecessor entity at a price of $4,900 per share, a right that when exercised entitled him to 12 additional shares of preferred stockfor each share of common stock, was not his separate property. The subscriptionagreement was entered into prior to the marriage and, as amended prior to themarriage, entitled the husband to purchase 10 additional shares of common stockand thereby acquire 120 shares of preferred. Prior to the marriage, the husbandpurchased pursuant to the subscription agreement 2.65 shares of the common stock,thereby also acquiring 31.8 shares of preferred. Supreme Court concluded, and thewife did not contend otherwise, that these shares and fractional sharesconstitute separate property of the husband. The remaining 7.35 shares of commonstock, and the attendant 88.2 shares of preferred, were paid for and acquiredduring the marriage. Because marital property is defined to include "all propertyacquired by either or both spouses during the marriage" (Domestic Relations Law s236[B][1][c] ), Supreme Court concluded that these shares were marital property.The flaw in Supreme Court's reasoning was that it did not recognize that,especially given the broad meaning of the term property in the Domestic RelationsLaw the husband's right to acquire the 7.35 shares of common stock and 88.2 shares of preferred was itself property that he acquired before the marriage. The husband's right to acquire the shares was tantamount to an "in-the-money option" as the purchase price of the shares was far below their fair market value. Thus, he was entitled to acredit in the amount of the value as of the date of the marriage of his right toacquire the additional shares of stock pursuant to the subscription agreement.The value of the 7.35 shares of common stock and the 88.2 shares of preferred, assuming the right was exercised as of the date of marriage, was approximately $232,800. Consistent with the approach of the neutral expert and the husband's expert in valuing the husband's right as of the date of the marriage to acquire the shares pursuant to the subscription agreement, the value of that right was approximately $196,800 ($232,800 minus the approximately $36,000 purchase price of the 7.35 shares of common stock).
The Appellate Division noted that, in part, because of its conclusion that the wife would be "vastly wealthy in her own right" as a result of the equal distribution of themarital assets, Supreme Court denied the wife's request for permanent maintenance.However, Supreme Court awarded conditional, durational maintenance to the wife,with the husband being obligated both to make monthly payments of $46,666 to thewife, a portion of which was deductible by the husband, and to pay variousexpenses, including the mortgage payments and taxes relating to the home awardedto the wife. Pursuant to the terms of the judgment, this maintenance awardcontinues until the wife receives both the specific assets awarded to her and thefirst payment on account of the distributive award. Relying on it decisions in Gad v. Gad (283 A.D.2d 200 [2001] ) and Pickard v. Pickard (33 AD3d 2002 [2006], appeal dismissed 7 NY3d 897 [2006] ), the husband argued that because Supreme Court did not make a permanent maintenance award he was entitled to a credit against the distributive award in the amount of all the temporary maintenance payments he made. The husband contended that he paid a total of $3,000,987 in temporary maintenance.
The Appellate Division held that the husband's reliance on Gad and Pickering was misplaced and that he was not entitled to any credit for the temporary maintenancepayments he made, regardless of the amount of those payments. The meredetermination by Supreme Court not to award permanent maintenance cannot beequated with a finding that the pendente lite maintenance award was excessive.Supreme Court did not make such a finding either expressly or implicitly. The determination not to award permanent maintenance was based in part on the ground that permanent maintenance was unnecessary given the wife's vastly different economic circumstances as a result of the equal distribution of the marital property. Inaddition, Supreme Court also based this determination on the consequences of thedistribution of the overwhelming preponderance of the liquid marital assets to thewife. As a result, a permanent maintenance award would have required the husbandto tap into the income generated by WCI or liquidate securities it owned eventhough he was awarded this asset. Accordingly, Supreme Court cogently observedthat an award of permanent maintenance would entail an element of "double dipping"by the wife into the principal asset awarded to the husband.
The Appellate Division found that the date-of-commencement value of the marital interest in WCI was $47,131,777.95--$52,608,922 minus the sum of the adjusted, after-tax value of the proceeds of the securities sold prior to the commencement date ($155,691.18), the value of the husband's property interest in WCI as of the date of the marriage ($646,271), the value of the husband's subscription right ($196,800), the value of the common and preferred stock he inherited from hisfather ($3,523,904.80) and the amount of the increase in value of the husband'sequity interest at the time of the inheritance stemming from the controllinginterest in the corporation acquired as a result of the inheritance ($954,477.07).
Supreme Court valued at $30,548,556. the other marital assets, including securities (virtually all of which were in the husband's name), cash accounts, a home and an apartment. After considering the statutory factors Supreme Court determined that the parties should share equally in all of the marital assets. Given itsconclusion that the husband should retain his ownership of WCI, Supreme Court wasconstrained to award to the wife approximately 88% of the other marital assets,collectively valued at $27,135,154. The husband was awarded his Colorado residence(valued at $1.95 million) and, to provide him with "some liquid cash assets,"certain securities Supreme Court had valued at $1,463,422. The result of these discrete awards was a deficiency in the wife's share of the assets of $22,770,623 ($49,905,776, one half of the total value of $99,811,533 that Supreme Court assigned to the marital assets, minus $27,135,154, the value of the specific marital assets awarded to the wife). Accordingly, Supreme Court granted a distributive award to the wife in the amount of the deficiency, and directed that the husband pay the award over a period of 15 years, with annual payments of $1,518,042 payable in quarterly installments of $379,510.50. Supreme Court did not grant pre-judgment or post-judgment interest on the distributive award to the wife, but ruled that interest would accrue in the event and to the extent of a default in any of the required payments.
The Appellate Division held that husband's argument that the securities of WCI (and thus WCI itself) and the other securities he owned or controlled should have been valued as of the date of trial was without merit. While some "courts have concluded that 'active' assets should be valued only as of the date of the commencement of the action,while the valuation date for 'passive' assets may be determined more flexibly,"these "formulations" are but "helpful guideposts" and not "immutable rules of law"(McSparron v. McSparron, 87 N.Y.2d 275, 287-288 [1995] ). Thus, althoughsecurities commonly are "passive assets" that are valued at the date of trial asthey may "change in value suddenly based on market fluctuations" (Grunfeld v.Grunfeld, 94 N.Y.2d 696, 707 [2000] ), they may be active assets when, as here,they are actively managed by the titled spouse. The securities owned by WCI andby the husband required his "specialized knowledge in order to be appropriatelyinvested," Supreme Court stressed that: "The parties, by their actions throughout prior proceedings herein, charted a course of litigation that accepted a [date of commencement] valuation of WCI ... When this trial began defendant agreed, by words and deeds, that the court should utilize a [date-of-commencement] valuation. Thus, when, during discovery, [the wife] demanded up to date financial information about WCI, defendant refused to produce such information arguing that it was irrelevant to a [date-of-commencement] valuation." The Appellate Division declined to disturb Supreme Court's allocation of themarital assets other than the marital component of WCI. Accordingly, it held that adistributive award of $11,705,013 ($38,840,167 minus $27,135,154) was necessary toeffectuate the equal division of the marital property. In accordance with thepayment terms fixed by Supreme Court, the $11,705,013 distributive award waspayable over a period of 15 years, with quarterly payments of $195,083.55.
The Appellate Division noted that a problem arose because the written decision and order direct that the husband transfer to the wife all of the securities owned or controlled by the husband (other than those owned by WCI) and listed in the decision and order along with their date-of-commencement market value. The decision expressly noted that by crediting against the distributive award the full value of the securities as of the date of commencement, "the risks of gains and/or losses since the valuation date [were passed] over to [the wife]." Even assuming that there was some ambiguity in the relevant terms of the judgment on this score, the decision controls (Madison III Assoc. Ltd. Partnership v. Brock, 258 A.D.2d 355 [1999] ). With respect to any of the securities the husband sold while he was free to do soafter the wife's motion for an injunction was denied, the husband argued that hewas required to provide the wife with "the proceeds of re-investment less the costsof the sale, taxes and reinvestment." The wife argued that the husband was required to transfer to her the assets acquired with the sale proceeds. The dispute reduces towhether the husband is entitled to a credit against the distributive award in theamount of the costs he incurred, including taxes he paid, in selling and reinvesting the securities sold. The Appellate Division held that it would be inequitable not to grant the husband such a credit given that he was free to sell the securities during the pendency of the action. Accordingly, it directed a hearing to determine which securities the husband sold, what he did with the proceeds, what costs he incurred and the amount of the resulting credit to which he may be entitled. The judgment of Supreme Court was modified by(1) reducing the base line value of WCI by $29,572,000 pursuant to the approach of the neutral expert and the husband's expert, (2) determining that the husband's right pursuant to asubscription agreement to purchase additional shares of stock in WCI's predecessorwas his separate property and reducing the base line value of WCI by the value ofthat right, $196,800, (3) reducing by $211,403.71 the after-tax value of the proceeds of the securities sold prior to the commencement date of the action but not settled until after that date, (4) determining that the marital interest in WCI was $47,131,777.95, (5) determining that the value of the marital estate was $77,680,333.95, (6) directing the husband to pay the wife a distributive award of $11,705,013, payable in quarterly installments of $195,083.55, and (7) determining that the wife's share of the tax liability of WCI was 44.8%, and otherwise affirmed.