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A US court considers the goodwill value of a partner's equity in a large law firm even when that equity cannot be sold

August 12, 2017

In a matrimonial case, an appellate court considers the decision of a lower court in relation to the goodwill value in a large law firm. Excerpts below. Please note that each paragraph is a separate excerpt and there may be text in-between that has not been included.

 

For the full text, see  http://caselaw.findlaw.com/nj-superior-court-appellate-division/1870170.html 

 

It is a settled legal question that intangible goodwill may attach to an attorney's interest in a professional practice. Dugan v. Dugan, 92 N.J. 423, 433 (1983). If found, the value of goodwill is subject to the equitable distribution claims of the non-titled spouse. Ibid. However, the determination of the amount ascribed to goodwill is a complex question of fact.

 

As Dugan instructs, the start of the examination of goodwill considers whether excess earnings exist. Dugan, supra, 92 N.J. at 439–40. This was a highly contested issue on which the experts used slightly different resources and offered greatly disparate opinions. Factual findings regarding this pivotal question were not provided.

 

In Stern v. Stern, 66 N.J. 340 (1975), the Court examined the defendant's challenges to ordered equitable distribution of his partnership interest in a “very successful, well-known and highly respected law firm.” Id. at 344. In part, the defendant contested “the propriety of considering his earning capacity as being a separately identified and distinct item of property.” Ibid. The Court agreed, stating:

 

Generally speaking, the monetary worth of this type of professional partnership will consist of the total value of the partners' capital accounts, accounts receivable, the value of work in progress, any appreciation in the true worth of tangible personalty over and above book value, together with good will, should there in fact be any;  the total so arrived at to be diminished by the amount of accounts payable as well as any other liabilities not reflected on the partnership books. Once it is established that the books of the firm are well kept and that the value of partners' interests are in fact periodically and carefully reviewed, then the presumption to which we have referred should be subject to effective attack only upon the submission of clear and convincing proofs.

 

The good[ ]will of a law firm, for ethical reasons, may not be sold or transferred for a valuable consideration. N.J. Advisory Committee on Professional Ethics, Op. 48, 87 N.J.L.J. 459 (1964);  Opinion 80, 88 N.J.L.J. 460 (1965). It may, however, in a given case, be possible to prove that it does exist and is a real element of economic worth. Concededly, determining its value presents difficulties. Rev. Rul. 609, 1968–2 Cum. Bull. 327.

 

Years later, in Dugan, the Court undertook review of whether goodwill was part of the value of the plaintiff's, a solo practitioner, law practice, “if so, whether it constitutes property subject to equitable distribution;  and, if so, how it is to be evaluated.” Dugan, supra, 92 N.J. at 428. Noting intangible goodwill is “essentially reputation that will probably generate future business,” the Court suggested goodwill encompasses the “advantages of an established business that contribute to its profitability,” such as a good name, capable staff, and a reputation for superior services. Id. at 429–30. Further, “[g]oodwill can be translated into prospective earnings.” Id. at 431. Emphasizing “future earning capacity, per se, is not goodwill,” the Court held, “[W]hen that future earning capacity has been enhanced because reputation leads to probable future patronage from existing and potential clients, goodwill may exist and have value. When that occurs the resulting goodwill is property subject to equitable distribution.” Id. at 433;  see also Levy v. Levy, 164 N.J. Super. 542, 554 (Ch. Div. 1978) (“What is being measured is in reality the capacity of repeat patronage and of a certain immunity to competition to produce earnings beyond the average for that kind of business.”). The Court explained:

 

After divorce, the law practice will continue to benefit from that goodwill as it had during the marriage. Much of the economic value produced during an attorney's marriage will inhere in the goodwill of the law practice. It would be inequitable to ignore the contribution of the non-attorney spouse to the development of that economic resource. An individual practitioner's inability to sell a law practice does not eliminate existence of goodwill and its value as an asset to be considered in equitable distribution. Obviously, equitable distribution does not require conveyance or transfer of any particular asset. The other spouse, in this case the wife, is entitled to have that asset considered as any other property acquired during the marriage partnership.

 

“For purposes of valuing the goodwill of a law practice, the true enhancement to be evaluated is the likelihood of repeat patronage and a certain degree of immunity from competition.” Ibid. Careful consideration in assigning value to goodwill in a divorce action is required because the attorney-spouse is essentially “forced to pay the ex-spouse ‘tangible’ dollars for an intangible asset.” Id. at 435.

 

Dugan articulated “one appropriate method to determine the value of goodwill of a law practice.” Id. at 139. This computation is “accomplished by fixing the amount by which the attorney's earnings exceed that which would have been earned as an employee by a person with similar qualifications of education, experience and capability.” Ibid.;  see also Levy, supra, 164 N.J. Super. at 547 (“Where the business is a service organization then the question of excess [net earnings] requires comparison of the net earnings with the reasonable value of the personal services which produced them.”). The methodology followed requires a trial court to first, ascertain what an attorney of comparable experience, expertise, education and age would be earning as an employee in the same general locale. The effort that the practitioner expends on his law practice should not be overlooked when comparing his income to that of the hypothetical employee. A sole practitioner who, for example, works a regular sixty-hour week may have a significantly greater income than an employee who regularly works a forty-hour week, and the income may be due to greater productivity rather than the realization of income on the sole practitioner's goodwill. Next, the attorney's net income before federal and state income taxes for a period of years, preferably five, should be determined and averaged. The actual average should then be compared with the employee norm. If the attorney's actual average realistically exceeds the total of (1) the employee norm and (2) a return on the investment in the physical assets, the excess would be the basis for evaluating goodwill.

 

The excess is subject to a capitalization factor [which is] the number of years of excess earnings a purchaser would be willing to pay for in advance in order to acquire the goodwill. The precise capitalization factor would depend on [a variety of factors including] [t]he age of a lawyer ․ because ․ goodwill would probably terminate upon death․ Subject to such adjustments, ․ a figure close to the true worth of the law practice's goodwill may be obtained.

 

see also http://www.jdsupra.com/legalnews/you-can-t-disregard-the-partnership-70877/

 

 

 

 

 

 

 

 

 

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