Determining How Much of a Business is Community Property
Updated: Oct 12, 2021
California is a community property state. This means that during a divorce, all marital assets are divided between the spouses evenly. Asset distribution is a 50/50 proposition. It is essential to know that only marital assets are divided. It is possible to have separate assets even from periods during the marriage, and these assets are not divided. For example, suppose one spouse owns property before the wedding or inherits property, remaining separate from other marital assets. In those cases, that property is considered separate and is not divided during a divorce.
If a spouse owns a business before the marriage, what is separate and marital property becomes difficult.
Whether a business is considered separate or marital property can be taken care of with a pre or post-nuptial agreement. For the contract to be honored during a divorce, both spouses have to enter into the agreement of their own free will with no sign of threat or coercion. The agreement must also be fair to both sides. A one-sided deal can be set aside by the court as excessive. Both parties also need to have their attorney advising/representing them in the preparation and execution of the agreement.
The first question asked is whether the business was started before or during the marriage. If the business was formed during the marriage, then in most cases, the company will be considered a marital asset to be divided during a divorce.
For businesses that had been started before marriage, marital property and separate property depend on the business itself. Thus, the main question becomes, did the company grow due to the talent, experience, and sweat equity of the spouse running the business, or did the business progress due to market forces with little to no dependence on the experience or sweat equity of the spouse?
Depending on the answer to this question, the courts will attribute the appropriate analysis to the business to determine what amount should be considered community property and what should be considered separate property.
These two analyses are known by Pereira or Van Camp (the shortened name of the cases that set forth the respective analyses.)
In the first example (Pereira), a business started before the marriage, and the company has explicitly grown due to the spouse’s talent and input.
The Pereira analysis takes the value of the business at the time of the marriage and allows for an increase of value for every year of the marriage. To determine the growth in value, the court will calculate a reasonable rate of return multiplied by the number of years of marriage. That amount is allocated to the spouse as separate property. Anything above that amount is distributed as community property.
The Van Camp analysis is used when a business grows due to market forces rather than the talents of the spouse running the company. For example, Van Camp is used when a business has increased due to technology, investment in research and development, or market trends.
Under the Van Camp analysis, the court will determine a fair market salary (known as reasonable compensation) for the spouse, even if the spouse didn’t take a salary to that level. Anything above the fair market salary is determined to be separate property and is not subject to distribution. However, if the entirely reasonable compensation was not paid during the marriage, that remaining amount is distributed as community property.
When is each analysis used?
Pereira is generally used for professional services such as doctors, lawyers, small retail establishments, or accountants. There is little to differentiate one company from another in these businesses except for how successful the owner is at growing the business. When it comes down to it, most accountants offer similar services. One accountant might be far more successful than another due to talent, education, certifications, or business networking, while another may scrape by. This sort of business grows in direct proportion to the effort put into the business.
Van Camp is used when business growth is based on anything other than the skills of the owner. For example, manufacturing, technology, or internet-based operations will grow based on market trends, new technology, or other market forces outside of any individual’s control.
Pereira and Van Camp have been the examples used in divorce cases involving a business for over 100 years. The original Van Camp vs. Van Camp case was a divorce case in 1921. Pereira vs. Pereira was from 1909.
In 1914, Frank Van Camp started a seafood company which became an immediate commercial success. As the full-time manager of the company, he received a salary. However, it had been determined that everything above the compensation he received was separate property.
In 1900, Mr. Pereira was running a business with an initial investment of $15,500. He continued to work on and grow the company keeping the initial investment in the business. The court initially ruled that all profit above the initial investment should be considered community property. Mr. Pereira appealed the ruling as it did not consider the increase in value of the initial investment. The appeals court agreed with Mr. Pereira and remanded the case to recalculate the appropriate value of the business. Mrs. Pereira petitioned the court of appeals to amend the judgment by taking the initial investment and adding a 7% increase as the return on the investment. The Court of Appeals granted the request.
To this day, these two cases remain the precedents used when determining how much of business is allocated as separate property and how much is considered community property.