Apportionment: Calculating Community Interest in Separate Property
[Source: California CPA]
The principle methods of determining a community interest in separate property businesses were established in the cases of Pereira v. Pereira (1909) and Van Camp v. Van Camp (1921).
The doctrines established in these cases have been applied to a variety of assets. Pereira is often applied in cases where the principle engine of growth is the personal efforts of a spouse and Van Camp is usually applied where the engine of growth is either capital appreciation or market factors—or both.
The Pereira approach, which uses a calculation to determine the community property in the business, generally favors the community and the Van Camp approach, which requires no valuation and favors the separate property estate.
In Beam v. Bank of America (1971), the Supreme Court of California declared that, in determining which method to use, the court must use the method that will achieve substantial justice. In other words, there is no bright line rule that determines which method a court should use. Rather, a court should look at each set of facts to determine what would be most equitable.
The Brandes Marriage
Nothing in Van Camp or Pereira precludes a court from using both methods in one case—which is exactly what happened in In Re Marriage of Brandes (2015).
The court applied the Pereira method for the years that the husband’s efforts were the primary factor in the company’s growth. During the last years of the marriage, however, the court found that the growth of the company was chiefly attributable to factors other than the husband’s personal efforts, and so allocation under the Van Camp approach was proper.
Mrs. Brandes argued that there was no basis for the court’s use of a hybrid method and that use of this method did not achieve the “substantial justice” required by Beam. The appellate court, however, disagreed and ruled that all payments in excess of his reasonable compensation were his separate property.
Post-Brandes, trial courts may take a more nuanced view of community appreciation in a separate property business by applying this hybrid approach. It could be argued, for example, that a court could view each year individually, or that a determination could be made at varying phases of the businesses’ growth.
A hybrid approach was proposed by George Norton and Jennifer F. Wald in their 1992 article, “Equitable Apportionment of a Separate Property Business” (Family Law News, State Bar of California Family Law Section Vol. 20, No. 2 (Summer 1997). Norton and Wald suggest that an approach used in a 1945 United States Tax Court case, Todd v. CIR, could be applied in calculating a community property interest in a separate asset.
In Todd, the court apportioned profits between the community and separate estates on an annual basis, considering whether the annual income was due to the community efforts or capital appreciation. Four years after the Todd case, California went after the Todds in an FTB collection case, Todd v. McColgan (1949), and used the same approach to calculate the community and separate property portions of the taxpayers’ incomes for the taxable years at issue in the matter. In discussing this approach with Wald, she said this approach was used in several unreported cases her firm litigated.
The Formulas
The objective of the alternate apportionment formulas is to carve out the community’s fair share of the increase in value of a separate property business. Norton and Wald called the two hybrid methods they used the Capital Labor Apportionment Model (CLAM) and the Capital Labor Natural Enhancement Model (aka Earning Apportionment Model, or EAM). Both methods were extrapolated from the initial Todd case.
In that case, the court determined deficiencies in the income taxes for the calendar years 1940 and 1941 for each of the husbands (petitioners), who were equal partners in a California business. The dispute between the parties concerned the portion of the income attributable to capital and the amount arising from the taxpayers’ management of the business.
The court described the method of calculation used by the commissioner as: “The capital of the business was constantly increasing. Eight percent of the average capital balance in each of these years is held the base of the capital earnings. Salaries for services are found annually for the base of the community earnings. The two are added together and the percentage each base bares to the total constitute the proportions of the total income attributable to capital and to services (Todd v. CIR at p.555).”
This formula was the progenitor of the CLAM formula, where the profits of the separate business are analyzed year-by-year. This approach eliminates the need to choose between Pereira and Van Camp.
Using one approach or the other might ignore the actual contributions to a firm’s growth. It’s akin to the Brandes approach, where different formulas were applied to different periods of the marriage.
CLAM
To apply CLAM, the reasonable compensation of the working spouse(s) must be determined for each year of marriage. To the extent that actual compensation exceeds reasonable compensation, the community is deemed to have made a capital investment in the business. This calculation does not create a vested community interest in the business. It creates a running total of the contribution of labor.
In their above-referenced article, Norton and Wald write, “It is more like an account payable, rather than a vested interest.”
Nevertheless, this running total becomes the basis for calculating the community interest in the business.
Next, a rate of return is applied to the separate property capital for each year. The ratio of the contribution of labor compared to the return on capital is the basis for allocating the annual income between community and separate interests.
Finally, the cumulative allocation of annual income will result in the total separate property and community property investment in the business, which is the ratio used to apportion the business value.
EAM Method
The EAM method is a variation on the Pereira approach. In the Pereira method, the value of the business is determined as of the date of marriage, and the rate of a long-term investment well secured is attributed a rate of return to that asset.
The total of the date of marriage value and the return on the investment are subtracted from the value of the business at the end of marriage. The EAM method simply subtracts an increase in value due to market factors or what Norton/Wald call natural enhancements from the overall community increase in value.
The EAM method could be applied to the day trader who increases the value of the separate assets by actively managing them during marriage. The trader will argue that market factors caused the increase whereas the other spouse will argue that it was due to the skill and efforts of the trader.
A strategy that forces a court to choose between applying Pereira or Van Camp could be risky—it’s an all or nothing bet. The EAM method will credit some of the gain to market factors, but also recognize that the community is entitled to compensation for community efforts.
The Brandes case opens the door for practitioners to analyze the increase in value of separate property businesses in a more creative way. Choosing one approach or the other may not achieve substantial justice. It may be more effective to take an approach that recognizes the many factors that grow a business.
You may select a variation on one of the methods proposed here or a method of your own creation that takes into account the law, economics, and what would be equitable. The menu may only have fish and cigars on it, but now you can order a CLAM.
By Peter M. Walzer, a top family law attorney and partner at Walzer, Melcher LLP
October 2017
