A divorce may involve no or minimal community property. Cases of this type may be resolved very quickly, inexpensively and may or may not need the services of a divorce lawyer. Other times a divorce may involve extremely complex issues that all but require the involvement of a divorce lawyer and other experts. Cases of this type often resemble business litigation between partners. However, complexity does not necessarily mean that the matter will involve a trial. Many complex matters are resolved amiably without the involvement of a judge or a trial.
The complexity of a divorce may relate to many different issues.
Community Versus Separate Property
Although defining community property and separate property seems very straight forward, often the issue is extraordinarily complex. California is a community property state. Separate property is defined in California as an asset owned prior to the date of marriage, acquired after the date of separation, or acquired after the date of marriage and prior to the date of separation by way of inheritance or gift as it is defined by the California Family Law Code. Community property is defined as an asset acquired after the date of marriage and prior to the date of separation unless acquired by way of inheritance or gift as it is defined by California law. Income, rents, and dividends generated by separate property are separate property.
Tax issues cannot be ignored. Often tax issues are not identified until it is too late to avoid the consequences, manage them, or structure around them. Tax is yet another area of sophistication that must be addressed in divorce. Tax plays a role in many, if not most, divorce cases. Divorces involve income and assets that frequently have tax related issues.
Tax issues may impact the actual values of many asset categories and they may impact decisions relative to whether an asset is desirable to a party. The tax issues related to the following issues and assets should be analyzed early in the divorce.
Tax rules and regulations must be strictly adhered to in order to avoid additional tax, penalties, and interest. The Internal Revenue Code (IRC) is somewhat like a minefield in enemy territory with the distinction being that the IRC provides a map detailing the exact location of the explosives. Unless you are familiar with the IRC and its traps you run the risk of unexpected and costly surprises.
Tax and the Valuation of Assets
Divorces cases are consistent in holding that embedded capital gains tax relative to an asset are not deducted from the fair market value of the asset in a divorce. The deduction of the tax from the value of an asset in a divorce is limited to situations where the tax is immediate, specific, and arising out of the divorce itself. If an asset is being awarded to a party in a divorce and that asset is not being sold pursuant to the divorce judgment there is no deduction from fair market value relative to the tax. Speculative future tax consequences are irrelevant to the valuation of assets if the value is determined by the divorce court in a trial. The one exception is tax related to stock options and this exception relates to the fact that stock options have no intrinsic value unless and until they are exercised as opposed to other assets whose value is not dependent on a sale. There is also an issue as to whether the divorce court should tax impact earnings in the valuation of a business.
Characterization and Allocation of Retirement Plans
California divorce courts characterize and value retirement plans in a divorce based upon these and other factors depending on the details of each specific plan:
- type of plan
- increase in plan value during the marriage
- contributions to the plan during the marriage
- specific contractual terms of the plan
- performance of plan assets
- age of the employee
- years of employment before and after the marriage
- first possible retirement date
- survivorship options
California divorce courts generally allocate retirement plan benefits between separate property and community property according to when the benefits were earned. Benefits "earned" during the marriage (after the date of marriage and before the date of separation) are generally characterized by divorce courts as community property. Benefits "earned" before the date of marriage or after the date of separation are generally characterized as separate property.
Defined Benefit Plans
Defined Benefit Plans are plans that generally provide for specific benefits, commencing at a specific age or date that are payable for a defined period of time (e.g. $6,000 per month, commencing at age 55, and payable until death). This type of plan is valued by an actuary who calculates the present value of the future stream of payments using various assumptions and tables. The assets of the plan are not relevant to the value of the community interest in the plan.
Non-Military Defined Benefit Plans are generally allocated by divorce courts between community property and separate property using what is commonly described as the “time rule.”
A traditional pension plan is a Defined Benefit Plan. The terms of a Defined Benefit Plan define the "benefit."
Military pensions are allocated by the divorce court using the frozen benefit method. The community interest is fixed as of the date of the court order and is calculated as if the service member had retired on that day.
Defined Contribution Plan
A Defined Contribution Plan is a plan that allows for a specific dollar contribution to be made into the plan annually. The plan functions somewhat like a savings account. Examples of these plans would include 401(k), IRA, SEP IRA, profit sharing plan, etc. The value of these plans is reflected on the employee's current plan statement. An actuary is not used for the valuation. The money contributed into these accounts, after the date of the marriage and before the date of separation (and the earnings and losses on those contributions until division) is generally characterized as community property. Gains or losses on community (or separate) assets in a plan, generally take on the character of the underlying assets, regardless of when the gains or losses occur.
The terms of a Defined Contribution Plan define the "contributions" that can be made into the plan.
Stock options, restricted stock, stock appreciation rights (SARs), profits units, phantom stock, and restricted stock units (RSUs) may be granted to employees as a part of a compensation package. Generally, they are all treated the same way by divorce courts. These types of assets have a risk of forfeiture and are not taxable until they vest.
Once they vest, the employee has a contractual right to their ownership. Vesting may occur proportionally over several years (e.g. four or five years) which is referred to as tiered or “graded vesting” or the vesting may all occur after a specific number of years which is referred to as “cliff vesting.”
Characterization and Allocation of Stock Options
In a California divorce, stock options and similar assets granted during the marriage and/or partially vested during the marriage may have a community property component. Stock options that are earned partially during the marriage are allocated between community property and separate property by the divorce court. The foundation for the allocation is the divorce law that provides that “earnings” during the marriage are community property. If a spouse is compensated during the marriage, in part, with a grant of stock options that partially vest during the marriage, the stock options will most likely be partially community property. If a spouse’s employment during the marriage results in partial vesting of stock options granted before the date of the marriage, the options will also most likely have a community property component. The number of options allocated between separate property and community property can vary depending upon which formula is used by the divocourt.
Characterization and Allocation of Equity in Real Property
California family law courts allocate the increase in equity in real property during the marriage to the community and/or the separate property of the parties based on a number of factors:
- date of acquisition
- source of funds used for acquisition, improvements, and/or principal payments on a loan
- increase in value
Community Acquires an Interest in a House Owned by One Spouse
California divorce law dictates that the community may acquire an interest in real property if community funds are used to improve or make principal payments on a mortgage secured by a residence owned solely by one spouse. (IRMO Moore/IRMO Marsden)
The amount of equity that exists on the date the owner-spouse places the other spouse’s name on title to his or her separate real property will generally remain his or her separate property (without any appreciation or interest) unless a specific waiver is made, in writing, of his/her right to reimbursement. (Family Code Section 2640)
Separate Money Used Re: Joint House
If a party uses his or her separate funds to acquire real property in joint names, or pay down the loan on jointly owned real property, he or she may be reimbursed if that party can trace the separate funds back to a separate property account. Reimbursement of separate funds used to improve real property in joint names is limited to the increase in value resulting from the contribution.
If an asset is purchased with funds obtained through the refinance of a jointly owned house that was originally the separate property of one spouse, upon divorce that spouse may be reimbursed the equity that existed on the day the house was transmuted into joint names. The spouse who originally owned the first house as separate property may trace his/her equity in the first into the second house. (IRMO Walrath)
Tracing may be used to uncommingle bank or brokerage accounts. It may also be used to trace separate funds used to purchase an asset that is titled in joint names. Tracing is also used relative to certain reimbursements to the separate property of one spouse or to the community.
There are two types of tracing:
- Direct Tracing Method (mechanical tracing)
- Family Expense (Recapitulation) Method
Tracing can be used to benefit either the separate property of one spouse or the community. Tracing can be very expensive and a party generally will not know if the tracing will be successful until after it is complete.
The Direct Tracing Method is the favored method of tracing. Direct tracing requires the step by step tracing of funds from a separate bank account or source into the identified transaction. The funds must be shown to have been present in the bank account on the date when the transaction occurred. There may be additional factors that come into play for the tracing to be successful. If separate funds were transferred into a community account prior to the subject transaction, each transaction occurring between the deposit and the subject transaction must be documented. Specific detailed tracing requirements must be met.
The documents must show the existence of the $100,000 in husband’s separate account, the transfer of the funds into the joint account, and the transfer of the funds from the joint account into the escrow. On the date the $100,000 was transferred out of the joint account into the escrow, there must have been at least $100,000 in the account, and the amount of separate funds must not have dropped below $100,000 between the date the husband made the transfer into the joint account, and the date of the transfer of the funds into the escrow. If the husband’s separate funds had dropped below the $100,000 level, the maximum amount that the husband could have traced would have been the remaining portion of the $100,000.
Family Expense (Recapitulation) Tracing
The second method of tracing is referred to as the Family Expense or Recapitulation method. This method may be used when the necessary records do not exist to complete a direct tracing.
The divorce court may conclude that the asset purchased was purchased with separate funds, if the separatizing party can prove that at the time of transaction, there were no community funds available to make the purchase. This may be proven to the divorce court by demonstrating that all of the community expenses at the time of the transaction or simply that there were no community funds.
Community expenses paid with funds contained in a commingled (containing community and separate funds) account are presumed to be paid with community funds contained in the account as opposed to one spouse’s separate funds. This is referred to as the “community expense presumption.”
Mixed Bank Account
If a joint bank account contains community funds and the separate funds of one spouse (commingled funds), tracing may still be possible. Commingling by itself is not fatal to a separate property claim. For example, if the joint account had a balance of $300,000; $200,000 of which is the separate property of one spouse, $100,000 of which is community, and $100,000 is withdrawn to pay community expenses, the remaining funds in the account may be the separate funds of the spouse who contributed the $200,000 into the account. (It may be helpful to view the separate funds as the heavier funds that sink to the bottom of a glass and the community funds as the lighter funds that rise to the top of the glass and are thus first available to be used to pay community expenses.)
Evidence, Presumptions, and Privileges
Family law is made more complex because any divorce trial involves the evidence code and the Code of Civil Procedures.
A trial in a divorce case is not dissimilar to a trial in other civil litigation. The California Code of Civil Procedure and the Evidence Code must be followed. Trials may be very complex proceedings that are often lost due to a lack of understanding of procedural rules or the rules of evidence.
Many of the complex areas in divorce require the services of experts.
In divorces, the attorney establishes the strategy and executes the plan, but experts often play a critical role in the success of the case. Retaining the right expert is extremely important. As with lawyers, all experts are not created equal. An incompetent or unqualified expert can destroy a case.
Divorce is far more complex than is generally understood. It is litigation not unlike business litigation. The Evidence Code and the California Code of Civil Procedure apply in divorces as they do in other types of litigation. A divorce is, to a large degree, the division of partnership assets. The same fiduciary duties exist between parties both before and after separation, as exist in corporate transactions. If civil cases don’t settle, they proceed to trial. The same is true of divorces.
Fiduciary duties require each party to act with the utmost good faith toward the other in the disclosure of all relevant material facts and information regarding both community and separate property assets and debts. There may be harsh penalties for breaching these duties.
Parties to a divorce should be prepared to make full and immediate financial disclosures to their spouses as required by their fiduciary duties to one another. The fiduciary duties require each party to act with the utmost good faith toward the other. Both spouses to a marriage are bound by fiduciary duties to one another during marriage until the divorce has been finalized and the property is divided. Sections 721(b), 1100(e), and 2100(e) of the California Family Code set forth the rules and requirements.
"Magic Words Are Not Required"
Relatively recent California Court of Appeal cases, such as In re Marriage of Feldman (2007) 153 Cal.App.4th 1470, highlight how seriously the divorce courts take non-disclosure issues. Parties no longer have to request the specific documents, ask the exact questions, or use any “magic words” in order to obtain key information. Until the property has been finally divided between the parties, spouses are obligated to make full and accurate disclosures to one another regarding the existence, characterization, and value of community property assets and debts. Failure to do so opens the door for a divorce court to penalize a non-compliant spouse with 100% of the value of a non-disclosed asset in addition to sanctions (which, in the Feldman case, totaled $390,000). Divorce courts may make this type of order when it deems it is necessary to motivate compliance with fiduciary duties and disclosure requirements. The size or dollar value of the undisclosed asset may not matter; what does matter is that both parties stand on a level playing field.
The State Bar of California recognizes divorce as a specialized practice area. Representing clients in divorces that involve the valuation of business interests is an even more specialized area. Handling these matters requires a working knowledge of family law valuation principles, taxation, compensation issues, accounting principles, general foundational business knowledge, and the complex and conflicting divorce valuation statutes, relevant case law, and divorce litigation practicalities.
Representing a party in a divorce involving a business interest requires the retention of a valuation expert in divorce business valuation. Valuation experts can be invaluable in the divorce negotiation process and in reaching a settlement in that experts often collaborate to reconcile the differences in their findings and opinions. In fact, in many cases the divorce court will order the accountants to meet and confer long before the trial to attempt to resolve their differences.
Date of Valuation
Businesses are generally valued on the date closest to trial that is reasonably practical. However, if the value of the business has changed between the date of separation and the date of trial, the valuation date may be set on an alternate date including the date of separation depending on the reasons for the change in value.
If the valuation date is on the date of separation, the community may receive a return on the value of the business between the date of separation and the trial date. (IRMO Watts)
If the valuation date is on the date of trial, the increase in value after the date of separation may be allocated between the operating-spouse and the community depending on the circumstances. (IRMO Imperato)
Measure of Value
A business may be valued at fair market value or at the value of the business as an investment to the operator-spouse. This measure is referred to as investment value or marital value. In certain situations the court may use other measures of value like liquidation value.
Methods of Valuation
A court has wide discretion in selecting a valuation method so long as the method achieves substantial justice. The method may not take into consideration future speculative events or the owner-operators future work or services. In general, there are three broad valuation approaches:
- Income Approach
- Market Approach
- Asset-Based Approach
Within these three broad approaches there are different methods.
In arriving at a goodwill value, the following factors are considered: compensation of operating-spouse, reasonable compensation, rate of return on tangible assets and multiplier/capitalization rate.
The total compensation of an operating-spouse must be determined in valuation process. Compensation includes salary, bonus, personal expenses (perks) and potentially undistributed earnings depending on the working capital needs of the business. It may also include deferred compensation and/or contributions to a retirement plan.
There are issues relative to which period of time should be used to measure compensation, whether to use an average and what type of average to use.
"Reasonable" compensation is a critical part of the analysis which requires the determination as to whether to use the "average salaried person" standard or the "similarly situated peer" standard.
Allocation of the Increase in the Value of a Separate Property Business During the Marriage
When one spouse owns a business before marriage that increases in value during the marriage, a question arises as to whether the community is entitled to any reimbursement relative to a portion of that increased value.
Divorce court may answer this question using the Pereira formula, the Van Camp formula, a combination of the two formulas or an application of each formula during different periods of the marriage.
Equitable Allocation Approach
Using the Van Camp approach if the owner-operator's spouse was paid adequate and reasonable compensation during the marriage, there will be no reimbursement to the community. If the owner-operator spouse was under-compensated but the business distributions used for community expenses or the purchase of community assets exceeded the amount of the under-compensation, the community will not be entitled to any reimbursement.
Using the Pereira approach, the owner of the separate property business receives an investment return on the value of his business as it existed on the date of marriage and the remaining portion of the increase in value is reimbursed to the community.
If the court uses the Pereira approach in some years and the Van Camp approach in other years, the approach would follow the approach used in IRMO Brandes.
Pereira + Van Camp = Brandes
In calculating the allocation / apportionment / reimbursement amount, courts look to a number of factors depending on the approach used: valuation on date of marriage, valuation on date of separation, other valuation dates as applicable, actual earnings, personal expenses (perquisites), undistributed income, reasonable compensation, rate of return on separate property value and compound versus simple interest.
Does the community have a right to reimbursement from a separate property business owned by one spouse if the business increases in value during marriage? Maybe!
Right to Reimbursement?
Depending upon which formula a divorce court selects, the increase in value of a separate property business during the marriage could be entirely the separate property of the owner-spouse, all community property or part separate and part community.
If the increase in value is due primarily to the efforts of the owner-spouse, California divorce courts generally apply the Pereira formula. This formula gives the owner-spouse a reasonable rate of return on the value of the separate property business, as it existed on the date of marriage. The remainder of the increase in value is allocated to the community in the form of a reimbursement.
This formula is often applied to personal service businesses, professional practices and businesses that increased in value primarily as a result of the work, skill and talent of the operating-spouse (IRMO Pereira).
Van Camp Formula
If the compensation of the owner-spouse and distributions received by the community from the separate property business exceeded the value of the owner-spouse’s contributions to the business (reasonable compensation), then the community has been made whole and it has no right to reimbursement relative to the increase in value of the separate property business under the Van Camp formula.
This approach analyzes whether the community was reasonably and adequately compensated for the work, effort and skill contributed to his or her separate property business. If the compensation was not reasonable and adequate, the community may be awarded a sum equal to the amount of under-compensation. Additionally, the divorce court may consider any distributions made by the separate property business to the community during the marriage as either reducing the amount owed to the community for under-compensation or in the determination of whether the community was reasonably and adequately compensated for the work, skill and effort of the owner-spouse. In other words, a divorce court may find that the owner-spouse’s compensation was a combination of his or her compensation and the distributions received by the community.
Van Camp is often applied to capital intensive businesses by divorce courts. It may be applied where the increase in value was not due primarily to the work, skill and talent of the operating-spouse. The divorce court will look to whether the increase in value was due, in part, to the industry, existing momentum, unique competitive advantages, patents, a monopoly, legislation, a world class management team or other market factors.
Depending upon the facts of the case and the formula applied by the divorce court, the allocation of the increase in the value of the business during the marriage may be allocated all to the community, all to the separate property of the spouse who owns the business, or apportioned.
- Allocation of Equity in Real Property
- Allocation of the Increase in the Value of a Separate Property Business During the Marriage
- Allocation of Retirement Plans
- Allocation of Stock Options
- Basic Tracing
- Date of Separation
- Evidence, Presumptions, and Privileges
- Family Law Overview
- Fiduciary Duties
- Temporary Restraining Orders