Working capital is vital to the success of all businesses in order to maintain operations and provide for growth. The term “working capital” is an abbreviated version of the more proper financial and accounting term “Net Working Capital”—the amount of liquid assets available to a business and calculated by subtracting current liabilities from current assets. Some financial references define Working Capital as the current assets of a business. The Finance Dictionary defines working capital as the difference between current assets and current liabilities. Regardless of the term, the concept of working capital is that of readily available assets of a business used to sustain, maintain, and grow that business.
The amount of working capital present in a business becomes an important issue for several reasons. It is every business owner’s nightmare to have insufficient working capital. Insufficient working capital can cause a business to fold and cease to exist, in extreme cases. Conversely, most business owners are elated when they have excess working capital. However, there are situations in which excess working capital can cause problems.
Excess working capital can become an issue in three specific circumstances typically found in litigation matters. Excess working capital is defined as the amount of working capital over and above that which is deemed necessary to allow for the maintenance and growth of the business entity. But who determines what is “excess?” In the context of litigation, typically it is the trier of fact—the person or group of people determining the facts of a legal case, usually a judge or jury—who makes that decision.
The three most common litigation situations in which excess working capital is an issue
- Penalty Tax—The accumulated earnings tax under IRC §531 et seq. requires that any corporation formed or availed of, for the purpose of accumulating earnings to avoid making dividend payments or distribution of the earnings to its shareholders, must pay a tax on the accumulation. It is a “penalty tax” in that it is designed to cause an action by the corporation, the payment of dividends; the penalty of not abiding by it is the additional tax. The burden of proof, regarding accumulated working capital not being excessive, is on the corporation.
- The valuation of businesses or business interests in family law and shareholder dispute matters—The accumulation of excess working capital beyond that which is necessary to maintain operations and grow operations adds to the value of the business operation in determining the enterprise value of the entity. This concept stems from real-world behavior in the sale of businesses: Many transaction agreements stipulate that the selling business must maintain a specific amount of working capital in place at the time of transfer of the business to the new owner. When the amount of working capital exceeds the amount stipulated, the distribution of the excess to owners immediately prior to the sale transaction is acceptable and expected. This supports the theory of adding accumulated excess working capital to the operating value of the business or business interest to determine business value. The valuation must justify the excess amount.
- Family law matters—In the context of Family Law, specifically in Florida, the accumulation of working capital must be proven to be reasonable by the business owner in order to avoid the inclusion of pass-through entity income in the calculation to determine alimony and support payments.
So how is the amount of excess working capital determined? Some courts say it’s easy. In reality, however, it is a very subjective concept and very difficult to determine with certainty, simply because it contains subjectivity as to future expenditures. How does one prove that the accumulation of working capital is justified for the business in question? Courts have deemed justification to be present when there exists an amount of working capital to meet the reasonable future or current needs of a business for which funding is required.
In reality, the same justification for accumulating working capital is applicable in arguing the “excess” issue in any of the three litigation situations. When a business entity has documented its plans to expand its plant and equipment to facilitate organic growth, for example, then the accumulation of working capital which may otherwise appear to be excessive is likely deemed not excessive and should not be included in the determination of excess earnings, enterprise value, or income for purposes of alimony and support payment determination.
To answer the question regarding the determination of the amount of working capital required by a business, proof that the accumulation of working capital is necessary requires a thorough analysis of the facts and circumstances of each case. The analysis may be bifurcated:
First, justify the amount of working capital necessary to sustain current operations.
Second, justify the amount of working capital necessary for future growth and/or future business requirements.
In a 1965 Tax Court Case, Bardahl Manufacturing, Inc. v. Commissioner, an analysis was introduced which was then, and subsequently has been, accepted by the courts to measure the working capital requirements of a business relative to its current operations. The specifics of the analysis are beyond the scope of this article, but the concept of the analysis is to estimate the amount of liquid assets needed for a single operating—or business—cycle.
The operating cycle for a manufacturing business is frequently described as the period of time needed to convert cash into raw materials, raw materials into inventory, inventory into accounts receivable, and accounts receivable into cash. Adjustments to the analysis are made for a predominantly service-based business due to the lack of inventory in this type of business. The issue has become not whether the corporation can prove a need for a specific amount of working capital, but one of proving the operating cycle for the specific business under consideration. The portion of the year represented by the operating cycle, expressed as a percentage, is applied to annual operating cash expenditures of the enterprise to determine the working capital required to support current operations. The calculations are accomplished by use of a formula known as the Bardahl Formula, which utilizes historical financial metrics of the business under scrutiny in its application.
Special mention of the credit cycle is necessary as all courts that typically hear the argument of accumulated working capital using the Bardahl analysis tend to shorten the operating cycle by applying the concept that account-payable terms will shorten the operating cycle length as otherwise determined in the Bardahl analysis. The concept of shortening the operating cycle by the credit cycle is flawed in that it assumes that every business is required to make the assumption it will receive the benefit of credit policies indefinitely and operate on the “float” extended by its creditors. There exists no logical reason to presume a prudent businessman would base the operating needs of a business on credit policies over which the business has no control. A business cannot be forced to turn to borrowing to meet its needs. Instead, the decision not to rely on credit, and to fund expansion through internal means only, lies squarely within the purview of corporate management.
To prove the future requirement for the current accumulation of working capital, presentation of evidence via sound business plans is helpful. The discussion surrounding the future business plans by the board of directors, as documented in the corporate minutes, is also helpful. Examples, although not all inclusive, of future plans which require the current accumulation of working capital include:
- plant expansion
- purchase of new machinery
- decision to self-insure
- stock repurchase plans
- new product expansion
- ESOP repurchase liability
- the cost of litigation of potential product or service liability
The tax court and federal circuit courts have been hearing cases involving the accumulation of working capital as it pertains to tax and valuation issues for some time. The triers of fact in these venues are likely more financially savvy than their counterparts who are trying the cases as the issue pertains to business value in the dissenting shareholder action or to the determination of alimony and support in family law. State court venues likely do not have the experience federal courts have.
A 2005 Family Law case (Zold v. Zold) was heard by the Florida Supreme Court before the accumulation of working capital received proper financial analysis and treatment. The actual issue was that of the inclusion or exclusion of pass-through income from an S-corporation as income in the determination of alimony and support payments. Family law courts are accustomed to simply taking the gross income amount from a federal income tax return relative to the earning spouse and considering it as income on which to base alimony and support payments. But, does the S-corporation owner/spouse actually receive the amount of income they report on the income tax return in the form of cash?
In the case, the income-earner spouse argued that no distributions of cash commensurate with the income reported on the individual income tax return from the pass-through entity actually took place because the need to accumulate cash for corporate requirements was present. An unsophisticated analysis of the balance in the corporate cash account versus the corporate earnings relative to the previous three years was performed at the trial court level. The analysis caused the trial court to rule that an improper accumulation of the earnings did occur and that the undistributed taxable income from the S-corporation should be included in the income of the earning-spouse for the determination of alimony and support.
On appeal, the court applied the definitions of a balance sheet and income statement in finding that the trial court’s reliance on a balance sheet to determine an item of income was not proper. Once again, it was a relatively unsophisticated analysis. Yet, the trial court’s inclusion of the undistributed taxable income from the S-corporation as properly includable in the determination of income on which to base alimony and support payments was overturned. The outcome appears to be financially proper. But, the burden of proof was put on the non-corporate owner to evidence the presence of excess working capital.
After reviewing the applicable federal and state statutes regarding the taxation of shareholders of an S-corporation and the state statutes regarding the inclusion of amounts in income for the purpose of determination of alimony and support payments, the Florida Supreme Court analyzed when accumulated working capital should constitute income for the purpose of determining alimony and support payments. The Supreme Court agreed that the circuit court ruled correctly in overturning the decision of the lower court regarding the inclusion of the pass-through income. The issue the Supreme Court had difficulty with was the ruling of the lower court that placed the burden of proof regarding the accumulation of working capital on the non-owner/shareholder spouse.
The Supreme Court recognized that a proper analysis of corporate purpose and requirement for the retention of income (working capital) is the correct analysis to prove the presence of, or lack of, an excessive amount of working capital. The Court determined that the burden of proof is on the shareholder/spouse to show that the accumulation of cash, rather than the distribution of it, is required by the business. In summary, one issue is the focal point in numerous types of litigation: Does the business entity have an excessive accumulation of working capital? The burden of proof regarding the need for the accumulation rests with the business in all scenarios. The question can be answered by the application of the same analysis in all three situations. Using a bifurcated approach, first by establishing the working capital required to maintain the current business operations based upon the business cycle analysis as provided using the Bardahl formula and second, adding to it a justified accumulation for future business plans as supported through contemporaneous documentation for the future, the burden of proof for the accumulation of working capital can be met.