Introduction to Retained Earnings in Divorce Cases

Retained earnings are a company’s accumulated profits that have been kept in the business (not paid out as salary or dividends).¹ In a divorce involving a business for which a separate property claim is being made, questions may arise as to whether those undistributed profits should be considered as potentially distributable value.

For example, if a spouse could have drawn those earnings but chose to keep them in the company, are such earnings distributable, or simply a corporate asset increasing the business’ value? The answer can impact the financial outcome for both parties.

Analyzing Excess Retained Earnings in Divorce Cases

Valuation analysts can examine whether a company has retained more earnings than necessary (i.e., “excess” retained earnings). If so, those excess assets may be reconsidered and lead to adjustments in the business valuation. Below are certain methodologies used to analyze potential excess retained earnings.

Non-Operating Assets

One methodology to analyze potential excess retained earnings is to identify non-operating assets. These are assets not needed for a company’s day-to-day operations: for example, excess cash reserves, idle investments, or real estate unrelated to the business’ core functions. We separate these because a buyer of the business could remove or liquidate such assets without impairing the company’s operations.

Valuation of Non-Operating Assets

Non-operating assets, such as significant excess cash or marketable securities, are typically valued separately and added to the enterprise value of the operating business.

As noted by Shannon Pratt, this approach is appropriate because these assets can generally be removed from the company without affecting its ongoing earnings capacity.²

In the context of divorce litigation, if a spouse-owned business holds material non-operational cash reserves or liquid investments that are not essential to the company’s day-to-day operations, there may be excess retained earnings. The value of such assets is customarily included in the aggregate business value in addition to the value of the core operations of the business.

Attorneys might request comprehensive financial statements and, where appropriate, obtain corporate bank records. Doing so may uncover non-operating assets, such as unusually high cash reserves or investment accounts, that are recorded on the company’s books. These assets may constitute undistributed value retained within the business and could have meaningful implications in divorce proceedings.

Capital Expenditures and Recent Asset Purchases

Another critical area of analysis is the company’s capital expenditures (CapEx), significant investments in property, equipment, or other long-term assets.

CapEx could be evaluated to determine whether it was essential to maintaining or growing the business, or whether it represents discretionary spending designed to suppress earnings, deplete excess cash prior to divorce, or increase the value of a party’s separate property estate.

Identifying Discretionary Spending

In practical terms, if a business owner makes substantial purchases (such as high-end equipment or vehicles) that deviate from historical spending patterns or are not operationally necessary, it may indicate an attempt to reduce apparent profitability or shield retained earnings. Conversely, such expenditures may be legitimate investments; context and timing are essential.

Attorneys might request detailed ledgers and supporting documentation for any significant asset purchases made in the years preceding the divorce. If an expenditure is not operationally necessary, a valuation expert may classify it as a non-operating use of funds, or even as a disguised distribution to the owner, and adjust the valuation accordingly.

Valuation professionals evaluate the justification for large or unusual purchases by comparing them against historical CapEx trends and normal business requirements. A sudden spike in capital spending of a presumed nonmarital business leading up to, or during, a divorce may raise red flags. For example, if records show that a spouse authorized significant outlays that were inconsistent with the company’s operational history, this could suggest an effort by the spouse to avoid subjecting assets to division.

Normalizing Financial Statements for Non-Essential Spending

When an expenditure is determined to be non-essential, the valuator may “normalize” the financial statements by adding back the expense, thereby increasing a company’s earnings (and generally its value). The asset acquired, if still held by the business, would also be included in the valuation of company assets. This ensures that discretionary or improper spending does not artificially depress the value of the business.

Working Capital Needs Versus Actual Levels

Valuation professionals routinely analyze a company’s working capital (defined as current assets minus current liabilities) to assess whether it is maintaining a necessary level of capital to fund day-to-day operations. The goal is to determine the level of working capital required for normal business activity and to identify whether the company is holding an excess beyond that operational need. Any surplus working capital might be treated as a non-operating asset in the context of divorce.

Assessing Working Capital Requirements

Every business needs a certain amount of cash, inventory, and receivables to run smoothly. However, if a company maintains inventory levels well in excess of industry standards, such as inventory equal to five times the level normally observed within the industry, those additional assets may not be essential for operations. It might instead represent excess value that could be withdrawn without affecting the business’ performance.

This can be addressed by comparing the company’s working capital metrics (such as working capital as a percent of revenue, current ratio, quick ratio, inventory turnover, and accounts receivable days) to industry benchmarks. If similar businesses operate efficiently with lower working capital levels, the excess may be viewed as unnecessary and potentially available for distribution.

In such cases, a determination of the required level of working capital based on the company’s revenue cycle, historical liquidity needs, and peer comparisons may be useful. Any surplus above that calculated requirement might be added to the value of the business or identified as a non-operating asset that could be distributed to the owners.

Owner Compensation

In many privately held companies, particularly those managed by a spouse, owner-operators may pay themselves salaries that deviate significantly from market rates. This practice directly impacts both the company’s reported profitability and its retained earnings, which are central to determining business value.

Reasonable Compensation Analysis

Valuation professionals address this issue through a process known as reasonable compensation analysis. This involves “normalizing” the owner’s compensation to reflect what an unrelated third party would be paid for performing similar duties. This adjustment replaces the actual compensation with a market-based figure for valuation purposes, ensuring that the business’ financial statements accurately reflect its true economic performance.

If an owner undercompensates themselves, the business will report higher profits and, consequently, higher retained earnings. While this may inflate the apparent value of the business, it can also mask the fact that the personal efforts of the spouse have contributed to undistributed assets within the company.

Conversely, if the owner overcompensates themselves, the business’ reported profits and retained earnings will be artificially reduced, potentially lowering the business’ appraised value. In this scenario, earnings may have already been extracted from the company in the form of excessive salary or distributions.

The objective of compensation normalization is to isolate the business’ true economic earnings by adjusting for any anomalies in owner compensation. This ensures that earnings are not artificially manipulated and that the value of the labor contributed to the business during the marriage is properly accounted for.

Examples of Compensation Adjustments

For example, if a spouse pays themselves $50,000 annually when a reasonable market salary for the position is $100,000, the $50,000 differential may represent earnings retained in the business rather than distributed. A valuation expert will typically adjust for this discrepancy, reducing reported earnings for valuation purposes.

Attorneys might scrutinize owner compensation by comparing it to industry benchmarks for similar roles. If the owner-spouse was significantly underpaid, this may support the argument that retained earnings reflect undistributed income.

Conversely, if the owner’s compensation exceeds market rates, the expert may adjust compensation downward, increasing reported earnings and potentially supporting a higher business valuation.

The Role of Valuation Professionals in Divorce Proceedings

The importance of considering reasonable compensation in these situations is recognized in the business valuation field and is reflected in the way experts approach their analyses.

Valuation professionals may provide such compensation adjustments to help ensure that the financial information used in divorce proceedings is as accurate and fair as possible. This approach helps clarify whether retained earnings are the result of genuine business performance or are influenced by how the owner has chosen to pay themselves.

1. Pratt, Shannon P., et al. Valuing a Business: The Analysis and Appraisal of Closely Held Companies.
2. Ibid.