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The Divorce Court May Apportion the Increase in the Value of a Separate Property Business Using a Compromise Formula

In Todd v. C.I.R., business partners sued the Franchise Tax Commissioner to obtain a refund of taxes assessed against them. The taxpayers had formed a partnership with an initial $1,500 capital contribution.  After determining that the partners had allocated significant portions of their income to their wives, the Tax Commissioner assessed taxes using the following formula: “First the defendant commissioner estimated what would constitute a fair rate of return upon the separate capital investment under the particular circumstances of this case and next estimated what would be a fair salary for the partners for each of the years in question. These figures so obtained were totaled and the percentage of each to the total constituted the proportion of the distributable income attributable to capital and to services.”

The trial court determined that an 8% return on the separate property capital investment was reasonable and allocated the net distributable income between separate income and community income accordingly. The partners appealed.

The Court of Appeal affirmed the trial court’s use of an apportionment method, which was midway between the Pereira approach and the Van Camp approach, holding that cases had to be decided from all of the relevant circumstances. The Court of Appeal found that to account for this, the partners had allocated significant portions of their income to their wives.  The tax authority reallocated a greater share of earnings to the partners, which in turn increased their tax liability and created the contested tax deficiency. To compute the separate property portion of income from the separated property business, the Court of Appeal first estimated a fair rate of return on the separate capital investment. Then, the Court of Appeal estimated a reasonable compensation for the community efforts provided to the business.  The separate property ratio of the income was then determined by taking the reasonable compensation and dividing it by the sum of the reasonable rate of return and the reasonable compensation.  This method is referred to as the Compromise Formula.

Todd v. C.I.R. (9th Cir. 1945) 153 F. 2d 553