CASE SUMMARY: Bernier v. Bernier, 11-P-394

Monday, July 30, 2012

Bernier v. Bernier, 11-P-394

This was the second time the Bernier matter went up on appeal.  The major remaining issue at this juncture are the proper tax affecting to be implemented in determining the value of the parties’ business which consists of super markets located on Martha’s Vineyard.  The business had elected S Corporation status during the marriage.

During the first trial, Husband offered testimony of his expert who tax affected the company as if it were a C Corporation resulting in a value of $7,850,000.  Wife offered testimony of her expert who did not tax affect at all resulting in a value of $16,391,000.  The trial judge adopted the value of Husband’s expert after the first trial.  Wife appealed.

The Supreme Judicial Court reversed and remanded the matter for further consideration finding that the judge had “erred in adopting Husband’s expert’s valuation at the presumed “average corporate rate” of a C corporation.  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.”  The court reasoned that “such a result was particularly misplaced in this case in view of the uncontroverted evidence that the supermarkets would continue to operate as S corporations after the parties’ divorce; that they would continue to be owned by one of the existing shareholders; and that the supermarkets were profitable and would continue their historic practice of making cash distributions.  On the other hand, in the circumstances of this divorce case, 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.”  [internal citations omitted].  The SJC adopted generally the metric employed by the Kessler court in Delaware Open MRI Radiology Assocs. v. Kessler, 898 A.2d 209, 328-330 (Del. Ct. Ch. 2006).

In Kessler, the Delaware court proposed an approach which would capture the tax benefit to the buyer of S corporation shares of receiving cash dividends that are not subject to dividend taxes.  In order to calculate the effect of taxes on the buyers and sellers in Kessler, the judge asked if the S corporation were a C corporation, at what hypothetical tax rate could it be taxed and still leave to shareholders the same amount in their pockets as they would have if they held shares in an S corporation.  After making calculations, the Kessler court imputed a pre-dividend corporate tax rate of 29.4 percent to the S corporation.

The SJC recognized that Kessler had not been decided when the trial court issued the first judgment in Bernier I.  Nevertheless, they concluded that the “metric employed by the Kessler court provides a fairer mechanism for accounting for the tax consequences of the transfer of ownership of the supermarkets from one spouse to the other in the circumstances of record.”

On remand both parties presented testimony of new experts.  Husband hired a tax expert and Wife hired a new valuation expert.  The problem encountered was the tax rates.  The parties in Bernier agreed to value the business as of 2000.  Kessler used the tax rates in 2004 at which time the applicable Federal dividend tax rate was 15%.  In 2000, the applicable Federal dividend tax rate was 40%. 

Wife’s expert applied the 40% dividend tax rate which resulted in a zero percent tax affecting because the personal dividend tax rate in 2000 was the same as the applicable personal income tax rate of 40%.  This resulted in a value of $14,000,000. 

Husband’s expert stated that the S corporation income flowing out to the shareholders was subject to Federal and State ordinary income tax.  In 2000 the applicable Federal tax rate was 39.6% and the applicable MA tax was 5.85%.  This resulted in a 46% tax for a value of $9,349,193. 

After trial, the judge found that both parties had taken unreasonable positions.  She rejected both new values.  Specifically, the judge found that Wife’s approach to use a zero percent tax rate overlooked the SJC’s “clear mandate” that “not tax affecting the valuation was unfair.”  She found that Husband’s approach ignored the court’s decision in Bernier I that, in her view, any tax rate above 35% would undervalue the business.

Having rejected the opinions of both parties’ experts, the judge chose to adopt the same tax rate used in Kessler of 29.4%.  This resulted in a valuation of $11,366.129.  As a result, the judge ordered Husband to buy out Wife’s half of the newly stated value (Husband had previously elected to buy out Wife’s share in the business and paid her one-half of the previous value).  Husband was also ordered to pay additional legal fees to equalize certain fees paid by the markets pursuant to prior stipulations.  Both parties appealed.

This court rejected both the trial court’s and the Husband’s positions in favor of Wife’s approach.  The SJC generally adopted the Kessler metric which was not to say that it was appropriate to extrapolate the exact tax rate employed by Kessler where the parties specifically agreed to a valuation date in 2000 when a different tax rate was in place.  The court held “There is a distinction to be drawn between failing to tax affect at all the earnings of the supermarkets because an S corporation does not pay Federal taxes at the entry level (a basis for the approach taken by the wife’s first expert in Bernier I), and utilizing a zero percent tax affecting rate arrived at through application of “all applicable rates, as the SJC ordered in Bernier I.”  The Kessler court asked the question “at what hypothetical tax rate could it be taxed and still leave to shareholders the same amount in their pockets as they would have if they held shares in an S corporation.  In this situation, because the dividend tax rate in effect in 2000 was 40%, a tax affecting rate of zero was necessary to achieve that result.” 

The judgment was vacated and remanded back to the trial judge again. 

Wife also sought interest on the judgment which the trial court implicitly denied by not addressing it.  The interest issue was also vacated and remanded back to the trial court for consideration in light of the valuation issue and to address the uncertainties with respect to the time frame in which Wife seeks interest.

There was a companion Equity action which was tried separately and appealed.  The appeals were consolidated.  As to the equity action, the net income of the supermarkets was equalized through the end of 2000, leaving unequalized income of about $3.6 million yearly for the period from January 1, 2001 to February 2, 2004 during which time Wife continued to be a 50% shareholder.  The issue in the equity action was the equalization of the net income of the markets during the period in question.  After trial the court ordered Husband to pay $762,375.30.  The decision was based on the Husband’s having paid taxes on the money individually beginning in 2002.  Wife argued that her half should have been considered and taxed at her income tax rate during that time rather than at the rate actually paid by the Husband.  The trial court and the Appeals court rejected Wife’s claim.  The judgment in the equity action was affirmed.