• tangible assets
• intangible assets (name, reputation, quality of personnel)

Steps in "excess earnings" method. Under the excess earnings method, the market value of net tangible assets is multiplied by a rate of return appropriate to these assets to calculate earnings attributable to tangible assets. Then this earnings figure is deducted from total earnings to calculate an earnings figure attributable to intangible assets. Then these "intangible" earnings are divided by a capitalization rate for intangibles to calculate an estimated value for the intangibles. Valuators sometimes use this method to estimate "goodwill."

This method, described in Rev Ruling 68-609, is said to be conceptually easier for lay persons to understand and is frequently used by courts in equitable distribution cases. The IRS, however, has said it should be used only as a last resort when other better methods are unavailable.

What rates of return? According to Revenue Ruling 68-609, the reasonable return and the rate of capitalizing excess earnings depend on the nature of the business, how stable or hazardous it is, and other factors. Low rates of return (8% on tangibles and 15% capitalization rate) should be used for small risk businesses with stable and regular earnings; the 10% rate of return and 20% capitalization for high risk business. See Revenue Ruling 65-192, 1965-2 C.B. 259 and Revenue Ruling 65-193, 1965-2 C.B. 370.

Example

Alina divorces Bert, who claims half the value of Alina's medical practice. She claims that he is not entitled to the future earnings of the practice, which will be due to her own efforts. What is the value of the medical practice that Bert is entitled to share?

Assume that over the last 5 years:

• the tangible business assets have averaged $200,000
• net earnings have averaged $350,000 per year
• annual draws by Alina have been $300,000 per year

Assume that the tangible business assets (office space, supplies, equipment) a fair return of 10% and assume that goodwill is capitalized at a rate of 20%.

Notice that this assumes Bert is not entitled to a capitalization of earnings in an equitable distribution, since future earnings are not considered a marital asset -- Alina will earn them after their separation. The "excess earnings" method allows for the valuation of intangible assets.

Critique. It's hard to believe that this is more understandable than capitalizing earnings! What do you think?

Example

For an example of the "excess returns method applied in an equitable distribution, see Smith v. Smith, The court valued the Charlotte Motor Speedway by adding --

• the net value of the facilities (based on appraisal)
• the capitalized excess earnings realized by current operations
• the company's book value, excluding the appraised value of its facilities

As the court explained, excess earnings are "the net income from operations in excess of a normal return on value from a net lease of the real property owned by Charlotte Motor Speedway, Inc. (CMS), or, stated differently, the amount by which expected net income from operations would exceed the expected rental income."

See also Barth H. Goldberg, Valuation of Divorce Assets, §; 6.6 (1984); 2 John P. McCahey, Valuation and Distribution of Marital Property, §; 22.08(2) (1993).

Student paper

For a discussion of goodwill valuation methodology in the context of an equitable distribution of a dental practice, see Caroline Finch, Measuring Goodwill in a Dental Practice in the Context of Equitable Distribution.