March 01, 2010

Recent Illinois case law highlights the confusion which surrounds the retained earnings of a business under the laws of many states.1 Whether retained earnings should be classified as marital property is an issue of first impression in Illinois. Other states have generally held that retained earnings are non-marital. Those jurisdictions have reached that conclusion based on the evaluation of two primary factors: 1) the nature and extent of the stock holdings, i.e., is a majority of the stock held by a single shareholder spouse with the power to distribute the retained earnings?; and 2) to what extent are retained earnings considered in the value of the corporation?

In such states, business-owning spouses and their attorneys argue that retained earnings merely represent an accounting function. Counter-arguing their position, non-business owning spouses and their counsel contend that retained earnings represent viable distributions which have been unfairly withheld from the marital estate.

Both positions subtly avoid the most basic underlying issue at hand: Does the business possess assets which can be distributed (or sold and then distributed) without impairing the value of the business as a going concern?2

The Nature of Retained Earnings

Retained earnings represent the accumulation of net income over and above distributions. Therefore, retained earnings result from a profitable business distributing less than the full amount of its net income over a given period of time.

Retained earnings do not, however, convey or imply what happened to those earnings. More precisely, it does not relate if any distributable (a.k.a. free) cash flow exists or has existed. Distributable cash flow is defined as cash flow which can be distributed without impairing the operational viability of the business. Ultimately, since only cash, unlike an accounting concept like net income, can be distributed, net income is mostly meaningless when assessing the ability of an entity to distribute cash. Net income primarily deviates from distributable cash flow to equity owners in three significant aspects:

  • Working Capital Requirements. Most growing businesses require investments in working capital which includes accounts receivable, inventory, and other current assets such as prepaid insurance, etc., over and above that of current liabilities. Each incremental level of sales/revenues requires more short-term customer financing (accounts receivable), goods to be stocked (inventory), payments for previous vendor financing of inventory (reductions in accounts payable), etc. Underscoring the significance of working capital requirements is the fact that bankruptcy is often caused by illiquidity instead of insolvency.3
  • Capital Expenditures. Capital expenditures consist of cash payments for long-term assets used in the operations of a business.4 Capital expenditures, in addition to land, are classically categorized as “property, plant, and equipment” (a.k.a. “fixed assets”) which may be respectively illustrated by the purchase of a delivery truck, HVAC system, and drill press. Tax-affected depreciation associated with such current and past purchases frequently mitigates the deviation from net income.
  • Debt Service. While net income is calculated net of any interest expense, net income figures do not relate the cash demands of debt principal payments. Debt repayment structures may include equal cash payments composed of gradually increasing principal payments and decreasing interest amounts (amortization), no principal payments until the end of the term (balloon notes), or various other structures. Regardless, interest payments reflected on income statements may not reflect trends or absolute amounts of cash payments for debt service – which may be substantial.5

To the extent that working capital increases, capital expenditures, and debt reductions require cash payments, distributable cash flow may be significantly below net income.6

Examining theoretical differences between distributable cash flow and net income exposes the problems associated with blindly relying upon changes in retained earnings as a measure of possible distributions which have been unfairly withheld from the marital estate. However, such an examination will not answer whether or not the business possesses assets which can be distributed without impairing the value of the business as a going concern. Such a determination requires an assessment of the balance sheet in conjunction with an understanding of the business’ future cash requirements.

Examination of the Balance Sheet

Distributable, but undistributed, cash flows represent an investment in assets outside of those required for the operations of the business and may appear in two primary forms on the balance sheet: excess working capital and non-operating assets.

Every business possesses an optimal working capital as measured in amount (dollars) and composition.7 The challenge becomes assessing the optimal working capital for a subject company at hand. Is the company attempting to shelter money from the marital estate or is there a legitimate business purpose behind the working capital on the company’s balance sheet? Guidance as to appropriate levels of working capital may derive from the financial institution providing financing as lending covenants may require a certain level of working capital, retained earnings, or level of distributions to the owners.

To the extent excess working capital exists which is unnecessary to support the operations and profit margins of the business, these assets may be distributed without impacting the business. Such excess working capital may manifest itself in unusually large positions in cash or short-term marketable securities. However, such investments may entail legitimate business purposes (especially among risk-adverse owners) who may desire a significant financial reserve to finance future capital expenditures, repay debt (especially if a balloon note exists), or to finance unexpected increases (through working capital investments) or declines (e.g., falling profit margins)
in business.

Alternatively, excess working capital may result from poor accounts receivable, inventory, or other current asset or liability management. However, care must be taken to determine whether or not excess working capital truly exists. Solely relying on industry averages to determine an appropriate level of inventory, for example, may be misleading as some businesses may keep excessively large inventories to prevent stock-outs of merchandise. To the extent this prevention results in increased sales, higher customer satisfaction, etc., and, ultimately, to higher profit margins, inventory levels may not be excessive. Current liabilities may also be mismanaged to the extent they are unnecessarily paid in advance of credit terms. But again, industry averages may or may not govern the determination of whether excessive working capital exists. If industry averages suggest that days outstanding in accounts payable are typically 30 or more, and if a company pays accounts payable in a few days instead of weeks, working capital may not be excessive if, for example, an informal agreement exists for preferential treatment (e.g., quicker delivery times) by a supplier in return for prompt payment.

Even if working capital is excessive and is not required to support the operations and profit margins of the business, the ability to monetize (i.e., sell) working capital must be determined in assessing how much cash may be generated for distribution to the marital estate. Some excessive working capital may result in little or no cash-generating ability relative to stated book values (e.g., obsolete inventory which cannot be sold, uncollectable accounts receivable which has not been appropriately written off, etc.). Alternatively, if short-term marketable securities or other investments are held at cost (possible if the financial statements are not GAAP-compliant), stated book values may understate appreciated and distributable values.

In addition to excessive working capital, some non-operating assets may be sold and the associated funds distributed without impairing operations. Non-operating assets may be defined as assets which do not or are no longer expected to contribute to the operations of the business. Investments in non-operating assets may have originally been made with expectations of future operations. For example, vacant land or new machinery may have been purchased for future capacity needs. If such capacity is no longer expected, the vacant land or new machinery may represent a non-operating asset which can be sold.

In situations where a company is closely held, non-operating assets may exist which lack any operational purpose such as the company-owned condominium or airplane.8 Other non-operating assets, such as investments in long-term bonds and other securities, may simply represent the investment portfolio of the owner embedded within the legal structure of the business.9 Likewise, non-operating assets may include equity investments in unrelated businesses. Such equity investments enable closely held business owners to invest without first distributing funds
and therefore potentially transferring the investment into the marital estate.10

Investments in related businesses (through rental payments or inter-company transactions), much like owner’s compensation and loans from shareholders, may represent opportunities to manipulate distributable cash flow and adequate compensation to the marital estate.

Adequate Compensation to the Marital Estate

The issue of retained earnings typically presents a manifestation of a more fundamental underlying principle: adequate compensation to the marital estate. In this context, adequate compensation raises the issue of control. To the extent an owner may exercise or influence control, the ability may exist to determine to what degree and in what manner the marital estate may or may not be compensated. If no control element exists (e.g., a small investment in a large public company), then adequate compensation, and therefore the issue of retained earnings, likely lacks relevance.

If an element of control exists and compensation to the marital estate has been manipulated, examining the balance sheet for excess working capital or non-operating assets may fail to locate assets which may be distributed. Such a situation may result if owner’s compensation related to the party to the marital estate is higher than that of an arm’s-length (a.k.a. Fair Market Value) level. That is, distributable cash flows to equity have not accumulated on the business’ balance sheet since funds were instead paid to the owner and potentially transmuted into marital property. If excess working capital or non-operating assets exist on the balance sheet, then either the opposite scenario exists (owner’s compensation is lower than an arm’s-length transaction) or related-party transactions transpire at an arm’s-length level.

For these reasons, the existence of excess working capital or non-operating assets may or may not suggest the marital estate has been undercompensated, while the absence of these assets may or may not suggest that the business owner and/or the marital estate has been overcompensated.

Accordingly, an examination of the balance sheet may also warrant an accompanying investigation of the reasonableness of related-party transactions. Owner’s compensation, while representing the most common form of related-party transactions and possibly the easiest to manipulate, can be assessed relative to non-owning employee compensation and market-based data.

Conclusion

Retained earnings are frequently misunderstood as either funds ready for potential distribution or dismissed as a mere accounting equation. Both positions fail to answer the question of whether or not the business possesses assets which can be distributed without impairing the value of the business as a going concern. Such assets are relevant only to the extent an element of control exists as exercised by a party to the marital estate. In such situations, an examination of both the balance sheet and related-party transactions may be necessary to determine whether or not the marital estate has been adequately compensated.

Guest authors:

Christopher P. Casey

James M. Godbout

1 In re Marriage of Joynt, 375 Ill. App. 3d 817 at 821 (2007). In re Marriage of Schmitt, 391 Ill.App.3d 1010 (2d Dist. 2009). In re Marriage of Lundahl, IL App. 1st District, 5th Division, November 2009.

2 For purposes of this article, no distinction will be made between assets which can be distributed in-kind and those which are sold and then distributed.

3 In which insolvency is defined as liabilities in excess of assets.

4 Increases in fixed assets do not necessarily result from capital expenditures paid with cash. To the extent such acquisitions result from debt financing, cash flow, and therefore its related deviation from net income, is unaffected.

5 Typically, in determining working capital requirements, all interest-bearing debt is excluded despite its potential classification as a current liability. However, regardless as to whether or not any interest-bearing debt is treated within the working capital requirement calculation or the debt service determination, the net effect upon cash flow – and therefore the enterprise value of the company – will theoretically be the same.

6 The reverse is also true. Seemingly paradoxically, businesses with slowing or declining growth rates may experience distributable cash flow in excess of net income as working capital is liquidated, capital expenditures are curtailed from historical standards, etc.

7 The composition of working capital refers to the relative amounts of various current assets as well as the components of various current assets (e.g., finished versus raw materials in
inventory, accounts receivable less than or greater than a certain time period, etc.).

8 However, as such assets are not inherently non-operating, their purpose and usage must be examined to properly categorize them as such.

9 To avoid double-counting the value of non-operating assets, any addition of a non-operating asset to enterprise value requires the elimination of the non-operating asset’s related net cash flows from any methodologies utilized in determining enterprise value.

10 Depending on the size (as measured in terms of a percentage of ownership) of the equity interest and the control exercised or influenced, equity investments may be represented on the balance sheet through various means known as the cost, equity, and consolidated methodologies. Each of these various methods conveys information differently on the initial investment, subsequent distributions, and income or losses experienced by the operations of the invested business.