The manner in which assets are divided in divorce is partially dependent on the jurisdiction in which the divorce takes place. California, Texas, Arizona, Louisiana, Nevada, New Mexico, Washington and Wisconsin all have what are called “Community Property” laws. The underlying theory of these laws is that a marriage is essentially an equal partnership wherein both spouses make “contributions” and are therefore entitled to share equally in the “profits.” These states typically, but not always, dictate that assets and liabilities are divided equally (50/50). The fact that a state is considered a community property state does not, however, preclude “equitable” distribution of assets and liabilities.
The remaining states utilize a concept called “equitable distribution.” “Equitable” distribution is generally considered to represent “fair” division based on numerous factors such as what each spouse brought to the marriage and what each will need moving forward. Clearly, there is a level of subjectivity involved, and depending on the degree of conflict between the parties, an experienced financial expert can assist in the clarification and resolution of issues. Once the manner in which assets will be divided is settled, there needs to be a measurement of the assets to be divided. Again, while this may seem somewhat obvious, it can be rather complex.
For example, while property acquired prior to the marriage is generally exempt from distribution, any appreciation of that property which results from the efforts of either owner spouse (“active” appreciation), is generally considered marital property. Real estate holdings can easily illustrate this concept. If a spouse owns a piece of vacant land prior to the marriage, does nothing to develop it during the marriage, and the property increases in value by $50,000 from the date of marriage to the date of the divorce complaint, the $50,000 appreciation would generally be exempt from distribution. This is called passive appreciation.
How can assets be preserved as exempt? While the obvious answer may be to have a pre-nuptial agreement signed, the best answer is to plan ahead. Pre-nuptial agreements often do not hold up due to many reasons beyond the scope of this article (undue influence, duress, inadequate legal representation); they can also be costly to enforce. If you’re planning to marry, take inventory of your assets. Make copies of bank, brokerage and retirement accounts that you intend to keep separate. To the extent that you wish to preserve an asset as exempt, you will need to keep it separate and distinct from marital assets. Once co-mingled, clawing back assets becomes significantly more difficult, if not impossible.
A common example is the marital residence, which is normally subject to distribution. If, however, you owned a home prior to the marriage and used the sale proceeds as a downpayment on the marital residence, you may assume that those funds are due back to you first, leaving the remaining value of the home to be divided in equitable distribution. In reality, it’s not that simple. The fact that the funds were used to purchase a marital asset leads to the assumption that there was no INTENT to preserve the exempt status of those funds. On the other hand, if there are substantial assets among the parties, such that allocating the downpayment to the payor spouse doesn’t unduly disadvantage the other spouse, chances are a disproportionate allocation could be achieved.
There are certain assets that simply can’t be kept completely separate. In the case of a retirement account, while the premarital portion remains seprarate, if contributions are made throughout the marriage a portion of the account will be subject to distribution. In this case, depending on the length of the marriage, a financial expert will likely be needed to perform an analysis/tracing of the premarital portion of the account and an allocation of earnings and/or appreciation/depreciation to the exempt and marital portions. This analysis would start with the date of marriage and end at the date of complaint. As a result, maintenance of account statements is critical. If possible, a new account should be opened so as to keep the premarital funds separate.
A business owned by a spouse can present numerous complex issues within the context of a divorce. A spouse may have been gifted his/her interest from a family member, in which case he/she may consider the interest completely exempt regardless of when the gift was made. This may or may not be the case, however, depending on the spouse’s involvement in the business and whether there is any “active” appreciation.
In summary, if entering a marriage with substantial assets, it may be in your best interest to consult with an attorney and/or financial expert to discuss ways in which you may preserve your assets as well as records that should be gathered and maintained in order to support an exempt claim in the event that the marriage ends in divorce.
If you have any questions or would like to discuss this matter further, please contact a member of Withum’s Private Client Services Group at firstname.lastname@example.org.
|Noel Capuano, CPA/CFF, CVA
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.