Initial Characterization of Business
If a business is acquired prior to the date of the marriage it will be characterized as the owner’s separate property.
If a business is acquired during the marriage it will generally be characterized as community property.
Allocation/Apportionment/Reimbursement Re: Separate Property Business
If a business is characterized as community property, the business will be awarded to one of the parties, to the parties jointly or sold. Generally it is awarded to the operating spouse.
If the value of a separate property business increases in value during the marriage and the increased result from the natural enhancement of the asset, the increase will be characterized as separate property (Estate of Ney). However, if the increase results primary from the work, effort, and industry of the owner-operator spouse, the community may be entitled to receive reimbursement of a portion of that increase (Cozzi v. Cozzi). The right, if it exists, is not an ownership interest in the business - it is a right to reimbursement (Patrick v. Alacor Corp. (Patrick I) and Patrick v. Alacer Corp. (Patrick II)).
If the community is entitled to a right of reimbursement, the amount of the reimbursement will be determined in such a manner so as to achieve substantial justice. The divorce court will generally use the Pereira approach or the Van Camp approach. However, the divorce court may apply Pereira in certain years and Van Camp in other years. The divorce court may also utilize a different equitable approach.
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.
The divorce court may use the Pereira approach in some years and the Van Camp approach in other years. (IRMO Brandes).
Pereira + Van Camp = Brandes
The court could split the difference between the Pereira and the Van Camp approach (Todd v. C.I.R.).
In calculating the allocation/apportionment/reimbursement amount, divorce 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.
Right to Reimbursement?
Depending upon which formula a 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 a business, owned by one spouse prior to the date of marriage, increases in value during the marriage, California divorce courts may allocate the increase in the value between that spouse’s separate property and community property, using one of several different formulas. The theory that gives rise to this potential allocation is based upon statutory law that provides that while a party’s earnings during the marriage are community property, the earnings of a separate property asset are separate property. If a spouse contributes substantial effort (community property) to his business (separate property) the community must be reasonably compensated. If the business does not increase in value during the marriage, there is no value to allocate. Any allocation is in the form of a reimbursement, not in the form of an ownership interest in the business itself.
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 ownerspouse’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. 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. (IRMO Van Camp).
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.