Guarding separate property in a world of community claims

Business owners must be particularly vigilant in maintaining separate property claims, as marital efforts expended on a separate property business may create a community interest. This article analyzes judicial apportionment approaches used to determine the extent of community involvement in business growth. Further, it discusses a way to mitigate community claims and ensure that separate property interests are preserved in the event of divorce.

Parties who own a business interest before marriage but work in that business during marriage may create a community interest in the business from their efforts during marriage. (This assumes there is no premarital agreement providing that the business and profits are separate property.) If the business was created during the marriage, but the value increased due to post-separation efforts, there would be a separate interest from the increased profits since separation. In order to determine the character of the increased profits in the business, there are apportionment formulas that are used depending on whether the capital investment or the spouse's personal activity, ability, and capacity was the chief contributing factor in the realization of income and profits.

The Pereira v. Pereira, 156 Cal. 1 (1909) "approach is to allocate a fair return to the separate property investment and allocate the balance of the increased value to community property as arising from community efforts." In re Marriage of Dekker, 17 Cal.App.4th 842, 850, 852-853 (1993) (this formula yields a greater amount for the community). The Van Camp v. Van Camp, 53 Cal.App. 17 (1921) "approach is to determine the reasonable value of the community's services, allocate that amount to community property and the balance to separate property."  Dekker, supra, 17 Cal.App.4th at 853 (Periera approach was applied to the increased value of company stock from $1,000 to $1 million from husband's marital efforts). The Van Camp approach is usually applied "where community effort is more than minimally involved in managing a separate" property asset, "yet the profits are attributable primarily to" natural enhancement (i.e., market factors) of "the underlying separate asset" which usually yields the greatest amount to the separate property asset. Ibid.

The court chooses the apportionment formula in its discretion that effects "substantial justice between the parties."  Ibid; see also Beam v. Bank of America, 6 Cal.3d 12, 18 (1971); In re Marriage of Brandes, 239 Cal.App.4th 1461, 1466 (2015). In Brandes, supra, the court used a hybrid approach for the apportionment of husband's separate property business, Brandes Investment Partners, by awarding the community an equitable allocation - under the Pereira approach for the early period during which the growth was primarily attributable to his personal efforts, and under the Van Camp approach for the later period during which the growth was primarily attributable to other factors. (Ibid.) In In re Marriage of Brooks, 33 Cal.App.5th 576 (2019), the court used the Van Camp approach for growth in the company stock from others' efforts, not husband's efforts since the husband was a programmer without a key leadership role and was adequately compensated during the marriage.

Based on this case law background and experience, Joseph Crawford's (Hanson Crawford Crum Family Law Group, LLP) tip is to make sure the party working in the separate business is fairly compensated so that during marriage, the community has already been compensated. That way, the community does not receive additional business profits, which preserves the party's separate claims. It is important to keep records of the acquisition of the business, financial records relating to business valuations, offers to purchase, tax returns, and profit and loss statements that may provide evidence of potential separate property claims.

Venture capital and carried interest

One challenge for parties is how and what method to use to apportion community and separate property interests in carried interest of the spouse general partner (GP) in venture capital. Carried interest in venture capital refers to the portion of the profits that the GPs of a venture capital (VC) firm receive as compensation for managing the fund. Typically, this is a percentage of the profits generated by the fund's investments, often around 20%, although it can vary depending on the specific fund agreement. The VC firm invests capital in startups or growing companies. If the investment generates profits through exits like IPOs or acquisitions, the fund returns money to its limited partners (LPs), the primary investors in the fund. Once the LPs receive their original investment back, the GPs receive a share of any remaining profits, i.e., carried interest, a performance-based reward for the GPs' role in managing and growing the funds' investments. Carried interest is typically paid out after the fund reaches a certain threshold of returns to the LPs, ensuring that GPs are incentivized to generate strong returns before earning their share. The VC firm has projections/estimates as to the carried interest over the life of the funds, which life varies but is typically 10 years or more.

There is no specific family law case that addresses the characterization of the carried interests. The most applicable theory to characterize community and separate property interests is the time rule, an apportionment methodology. The issue is what apportionment methodology achieves "substantial justice between the parties" to compensate the community and the efforts of the GP spouse in managing the fund after separation. See In re Marriage of Gowan, 54 Cal.App.4th 80, 88 (1997). One theory is that the carried interest is like a stock option, and the appropriate formula to use is that of In re Marriage of Nelson, 177 Cal. App. 3d 150, 155 (1986). The Nelson formula is as follows: "the numerator was the number of months from the date of grant of each block of options to the date of the couple's separation, while the denominator was the period from the time of each grant to its date of exercisability." Id. That methodology front-loads the community interest based on the vesting schedule in the earlier years of the life of a fund.

Another theory is that the appropriate apportionment method is similar to those applied to pension benefits. The apportionment method is a level time rule so that each year of the fund is weighted the same. Under this theory of the time rule, "the community is allocated a fraction of the [pension] benefits, the numerator representing length of service during marriage but before separation, and the denominator representing the total length of service by the employee spouse." In re Marriage of Belthius, 88 Cal. App. 5th 1, 9-10 (2023). The relation between years of community service to total years of service provides a fair gauge of that portion of retirement benefits "attributable to community effort." In re Marriage of Judd, 68 Cal.App.3d 515, 522-523 (1977). This rule gives "equal weight to each year of service, regardless of whether the divorce occurred early in the employed spouse's career (when salary-based pension contribution deductions might be smaller but would have longer to grow) or closer to retirement (when salary-based pension contribution deductions might be greater but would have less time to grow)." Belthius, supra, 88 Cal. App. 5th at 9-10. Attorneys must apply the facts in each specific case as to how substantial justice is achieved so that the GP spouse is compensated for his post-separation efforts and the community is also compensated. The details of the GP's specific work efforts, the operating agreements, partnership agreements and financial statements will provide these facts.  Attorneys should look carefully at documents and understand their client's role to support the position for what achieves substantial justice.

This is the third of three articles exploring key issues in protecting separate property claims in complex asset marital dissolution cases for estate planners, business managers, financial experts and business owners. The first article, Protecting separate property claims in complex asset cases, appeared on Feb. 27. The second article Tracing separate property in a commingled world, appeared on March 13.