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.
Courts 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.
If a business, owned by one spouse prior to the date of marriage, increases in value during the marriage, California family law 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/her 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-operator spouse, California family law courts generally apply the Pereira formula. This formula gives the owner-operator 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 as a result of the work, skill and talent of the owner-operator spouse.
If the compensation of the owner-operator spouse and distributions received by the community from the separate property business exceeded the value of the owner-operator 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-operator spouse. In other words, a court may find that the owner-operator 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. It may be applied where the increase in value was not due primarily to the work, skill and talent of the owner-operator 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 family law court, the allocation of the increase in the value of the business during the marriage may be allocated substantially all to the community, all to the separate property of the spouse who owns the business or apportioned.