Bernier v. Bernier

• Decision Date: 14 September 2007
• Docket Number: SJC-09836.
• Citation: 873 N.E.2d 216,449 Mass. 774
• Parties: Judith E. BERNIER v. Stephen A. BERNIER (and a companion case<SMALL><SUP>1</SUP></SMALL>).
• Court: United States State Supreme Judicial Court of Massachusetts Supreme Court

873 N.E.2d 216

449 Mass. 774

Judith E. BERNIER v. Stephen A. BERNIER (and a companion case¹).

SJC-09836.

Supreme Judicial Court of Massachusetts, Dukes.

Argued May 7, 2007.

Decided September 14, 2007.

David L. Kelston (Theodore Tedeschi with him) for Judith E. Bernier.

Paul M. Kane, Boston, for Stephen A. Bernier.

Present: MARSHALL, C.J., GREANEY, IRELAND, SPINA, COWIN, & CORDY, JJ.

MARSHALL, C.J.

This appeal by Judith E. Bernier (wife) from decisions of a judge in the Probate and Family Court incident to her divorce from Stephen A. Bernier (husband) presents us with the novel question whether it is proper to discount the value of an S corporation, see 26 U.S.C. §§ 1361-1379 (2000), by "tax affecting" income at the rate applicable for C corporations, where one spouse will receive ownership of all shares of the S corporation after the divorce and the other will be required to relinquish all ownership in the business. See 26 U.S.C. §§ 311, 312 (2000). Also presented by the wife's appeal are whether the judge erred in discounting the fair market value of the S corporations at issue here by applying "key man" and "marketability" discounts; whether the amount of alimony awarded to the wife was proper; and whether the judge improperly dismissed the wife's equity complaint against the husband alleging misuse of marital assets.

On the issue of tax affecting, we conclude that the judge erred in adopting the valuation of the husband's expert witness that tax affected the fair market value of the parties' S corporations at the "average corporate rate," in the words of the husband's expert, of a C corporation.² As a preliminary matter, where valuation of assets occurs in the context of divorce, and where one of the parties will maintain, and the other be entirely divested of, ownership of a marital asset after divorce, the judge must take particular care to treat the parties not as arm's-length hypothetical buyers and sellers in a theoretical open market, but as fiduciaries entitled to equitable distribution of their marital assets. See G.L. c. 208, § 34.

Further, careful financial analysis tells us that applying the C corporation rate of taxation to an S corporation severely undervalues the fair market value of the S corporation by ignoring the tax benefits of the S corporation structure and failing to compensate the seller for the loss of those benefits. On the other hand, in the circumstances of this divorce action, we agree with a recent decision of the Delaware Court of Chancery that failure entirely to tax affect an S corporation artificially will inflate the value of the S corporation by overstating the rate of return that the retaining shareholder could hope to achieve. See Delaware Open MRI Radiology Assocs. v. Kessler, 898 A.2d 290, 327 (Del.Ct. Ch.2006) (Kessler). Our review of the scant case law and the pertinent literature on the issue leads us to adopt generally the metric employed by the Kessler court, see id. at 328-330, described more fully infra, which most closely achieves the parties' stated intention in this case to divide the value of their S corporations equally, the outcome the judge also sought to achieve. We also conclude that, where the husband testified that he planned to retain control of the S corporations after the divorce, the judge erred in applying key man and marketability discounts, discounts that assume the possible sale of the asset.

On the issue of alimony, we hold that the judge did not err in awarding the wife an amount of alimony sufficient to meet her personal needs, as reflected in her financial statement, exclusive of losses she incurred in owning and operating a horse farm acquired by the parties during the marriage and given to the wife pursuant to the parties' stipulation and the judge's award in the divorce action. See Heins v. Ledis, 422 Mass. 477, 482, 664 N.E.2d 10 (1996) (purpose of alimony is support and maintenance). Finally, we determine that the wife's equity complaint against the husband was not barred by principles of issue preclusion and res judicata and therefore should not have been dismissed. We affirm the portion of the third amended supplemental judgment in the divorce matter concerning alimony, vacate the portion of the third amended supplemental judgment concerning valuation of the parties' S corporations, and remand for further proceedings not inconsistent with this opinion. We vacate the judgment of dismissal in the wife's equity action, which we also remand for further proceedings not inconsistent with this opinion.

1. Background. The parties were married in Massachusetts in 1967. On June 12, 2000, the husband, then fifty-two years old, and the wife, fifty-four years old, filed cross complaints for divorce in the Dukes Division of the Probate and Family Court Department.³ The record indicates, and the judge found, that initially the parties were of modest means. However, in 1986, after they moved from Billerica to Martha's Vineyard, their circumstances improved markedly. The engine of the parties' financial success was two supermarkets that were subsequently owned by two S corporations, of which the husband and wife each owned one-half.⁴ During their marriage, the parties also acquired what the judge termed an "extensive" portfolio of residential, commercial, and undeveloped properties. Among these properties was a thirty-six acre plot of land in West Tisbury, which the parties purchased in 1996, and on which they constructed Rosewood Farm (horse farm), a horse breeding farm under the control and management of their company, Rosewood Farm, Inc.

After they filed for divorce but before trial, the parties voluntarily entered into numerous temporary stipulations governing their financial affairs during the pending proceedings. The stipulations gave the husband sole authority to operate and manage the supermarkets and similar authority for the wife to run the horse farm. Further, the stipulations provided that certain business and personal expenses, and the parties' attorney's fees and costs, be paid from specified joint assets. Additionally, before trial, the parties agreed that all of their assets would be divided equally, and stipulated to the value of most of their assets, approximately $11 million. The parties were unable to reach agreement on two issues: the value of the supermarkets and the amount of alimony due to the wife. On February 27, 2002, a judge in the Probate and Family Court entered a judgment of divorce nisi, bifurcating the trial on the two remaining issues.

Between February and May, 2002, the judge heard eight days of testimony, which centered principally on the value of the supermarkets.⁵ During the trial, each party presented the testimony of an expert witness on valuation: Mark Leicester prepared the wife's valuation, and Joel Horvitz prepared that of the husband.⁶ Leicester and Horvitz were in broad agreement on key points. Specifically, both agreed that the buyer of the supermarket shares would seek an investment that would yield the buyer's required rate of return. They also agreed that the most accurate estimate of the supermarkets' value would be achieved by employing what both parties refer to as the "income" approach, taking the supermarkets' average adjusted income after expenses for a set number of years, divided by the appropriate capitalization rate.⁷

Despite their areas of agreement, however, the two experts arrived at vastly different appraisals of the supermarkets' fair market value. Leicester testified that the fair market value of the supermarkets was $16,391,000. Horvitz set the fair market value at $7,850,000.

The discrepancy in the experts' valuations was due to several factors, primarily Horvitz's application of tax affecting, as well as certain discounts to his calculations of fair market value⁸ and Leicester's omission of those considerations. Specifically, Horvitz tax affected as if the S corporation were a C corporation, at what he termed the "average corporate rate" of thirty-five per cent. But see note 19, infra. He testified that tax affecting the S corporations at the C corporation rate was proper because, among other things, a person contemplating the purchase of an S corporation would factor into his probable rate of return the tax consequences of the purchase. Leicester, on the other hand, did not tax affect the supermarkets' income in his valuation because, as he testified, an S corporation, unlike a C corporation, does not pay taxes at the entity level, and because no sale of the business was contemplated.⁹ Horvitz additionally discounted the fair market value of the supermarkets by applying a ten per cent "key man" discount to the adjusted net income of the supermarkets to account for the undisputed fact that the husband was the most important figure in the operation and management of the supermarkets.¹⁰ He then applied an additional ten per cent discount to account for the "lack of marketability" of the S corporation as a closely held business. Leicester maintained that, because the husband planned to maintain ownership and control of the supermarkets after the divorce, key man and marketability discounts should not apply.

On August 18, 2003, the judge entered a supplemental judgment, finding of facts, rationale, and conclusion of law on the valuation of the supermarkets. The judge rejected Leicester's valuation as "unreliable." Specifically, she faulted Leicester on the grounds that he improperly combined pretax and posttax data in establishing a capitalization rate, improperly applied a rate of growth to his valuation, omitted a marketability discount, and lacked experience valuing S corporations. The judge adopted substantially without change Horvitz's method of applying tax affecting and key man and marketability discounts to the supermarkets, and adopted his conclusion that the fair market value of the supermarkets on the relevant date, see note 5, supra, was $7,850,000....