§ 10.02 The Separate Property Business

• Jurisdiction: United States
• Publication year: 2021

§ 10.02 The Separate Property Business

[1]—The Business as Separate Property

⁷⁶ See, e.g.:

Missouri: Bizzell v. Bizzell, 697 S.W.2d 559 (Mo. App. 1985).
Texas: Zisblatt v. Zisblatt, 693 S.W.2d 944 (Tex. Civ. App. 1985).

⁷⁷ See In re Marriage of Wilder, 122 Ill. App.3d 338, 77 Ill. Dec. 824, 461 N.E.2d 447 (1983). See also, In re Marriage of Thacker, 185 Ill. App.3d 465, 133 Ill. Dec. 573, 541 N.E.2d 784 (1989).

A business started by a spouse before marriage in a marital property state is that spouse's separate property.⁷⁶ If the spouse operated the business as a sole proprietor before marriage and then incorporated the business during marriage, the corporation, at least initially, is separate property if the assets of the proprietorship are exchanged for stock.⁷⁷ The stock is separate property because it is purchased with assets earned before marriage. In most marital property states, such purchases retain the character of the consideration given. Therefore, even if a business is started during marriage, if it is capitalized with separate property the business should initially be characterized as separate property.

More complicated business forms require a more detailed analysis. For example, in a North Carolina case, the husband had started a corporation before marriage. During marriage the husband formed a holding company. At the time of divorce, the holding company owned the assets of the company started before marriage as well as other companies. The court correctly noted that the holding company was different from the one started before marriage, and should not be considered totally separate property.⁷⁸

In some instances, a spouse capitalizes a business during marriage with loan proceeds. Courts have not dealt with this consistently. For example, in an Arkansas case the wife acquired shares of stock during marriage in exchange for a promissory note, which she subsequently repaid with her separate funds. The stock was considered marital property.⁷⁹

In contrast, in an Oklahoma case, the husband bought an interest in a company. He made a cash down payment of $50,000 from his separate funds and borrowed the remaining $500,000 of the purchase price. The court treated this ownership interest as 100% his separate property.⁸⁰

In a South Carolina case, the husband had formed businesses during marriage and capitalized them with his separate property. The court held that the businesses were separate.⁸¹

In an Arkansas case, a woman's father formed a business while the woman was married. Stock in the business was issued to the woman in exchange for a promissory note (which was later paid by the woman with her separate property). In her later divorce, she argued that her father had made a gift to her of this "business opportunity," so the shares should be considered her separate property. The court did not accept this argument; the shares were considered marital property.⁸²

A Washington case involved an instance where the husband had, during marriage, purchased stock in his employer with separate funds. The stock was therefore treated as his separate property.⁸³

[2]—The Distinction Between Retained Earnings and Dividends

During marriage, a separate property business can increase in value, and also generate rents and profits. Many states have different rules for characterizing an increase in value of the business,⁸⁴ as opposed to its rents and profits.⁸⁵ It therefore is important to distinguish the two.

Distributions from a partnership, or cash dividends from a corporation, normally are treated as income or "rents and profits."⁸⁶ Interest accruing on a separate property bank account is also considered a rent and profit.⁸⁷ In contrast, a dividend of stock normally is not treated as a rent and profit, since such a distribution has no effect on the spouse's ownership interest in the corporation. After such a distribution, the spouse's pro rata ownership of the company is unchanged.⁸⁸

[a]—The Redemption of the Stock of Other Shareholders During Marriage

A Missouri case considered whether the marital estate should have any claim if the separate property corporation redeems another shareholder's stock during marriage, thereby increasing the spouse's percentage ownership.⁸⁹ The court and a majority of others have concluded that this redemption does not create a marital claim.⁹⁰ Other courts have held that the increase in value of separate shares due to redemption of the stock of other shareholders does create a marital claim.⁹¹

[b]—The Potential Marital Claim for Unpaid Dividends

The form of business organization can affect whether undistributed business profits from a separate property business will be considered rents and profits. Profit earned by a separate property sole proprietorship business during marriage constitute rents and profits of the owning spouse for purposes of divorce law, regardless whether the profits are distributed to the owner.⁹² This rule stems from the business organization theory that a sole proprietorship is not an entity that is separate from the owner. In contrast, in some states, profits earned during marriage but retained by a separate property corporation are not considered rents and profits of the owning spouse.⁹³ The corporation is considered a separate entity, and the profits of the entity are not attributed to the shareholder, except to the extent the profits are paid to the shareholder as a cash dividend.⁹⁴ If the profits are retained by the separate property corporation, under this approach, for marital property purposes, the retained profits are considered an increase in value of the business, not a rent and profit. Courts have disagreed about funds accumulated in a separate property partnership. Some have included such retained earnings in the marital estate⁹⁵ while others have not.⁹⁶

Rents and profits from separate property are not treated consistently by all marital property states. In some states rents and profits are separate property,⁹⁷ while others treat rents and profits as marital property.⁹⁸ Arizona has adopted a general rule that rents and profits are separate property. If the profits stem from the efforts of a spouse, however, the profits will be deemed marital property.⁹⁹

If a state's rule is that rents and profits are marital property while an increase in value during marriage of a separate property corporation is separate property, a shareholder spouse who controls the dividend decision has the power to direct the corporation to retain an unreasonable amount of the corporation's profits. If a spouse does this, what would have been marital property (a cash dividend paid to the owner during marriage) is transformed into separate property (an increase in value due to an increase in retained earnings). For this reason, in such situations (where the owning spouse controls the dividend policy), some divorce courts consider whether the separate property corporation retained an unreasonable percentage of its earnings.¹⁰⁰ If the company did retain an excessive amount of retained earnings, and the owning spouse controlled the dividend decision, the retained earnings can be considered divisible marital property.¹⁰¹ If the spouse does not control the board (and the dividend decision), however, the reasonableness of the dividend policy will not be reviewed by the court, and all the increase in value due to the increase in retained earnings will be the owner's separate property.¹⁰²

A Nebraska court applied a different approach where there was evidence that the company during marriage used a significant amount of funds to improve company facilities. Because these funds would have been marital if paid as dividends, the court affirmed a ruling by a lower court that the increase in value of the shares was marital, even though the spouse owned only 47% of the shares (and, therefore, presumably did not control the business).¹⁰³ If an owning spouse controls a corporation, the argument might also be made that the spouse was intentionally undercompensated and the marital estate was therefore unfairly reduced.¹⁰⁴ If this can be established, there should be a marital claim for the difference between what would have been fair compensation and what the spouse actually received.

If the owner spouse does control the dividend decision, it is somewhat unclear what portion of the retained earnings are marital. Some cases have suggested that the amount of the retained earnings that it would be prudent for the company to retain for legitimate business purposes should remain separate, and any excess should be marital.¹⁰⁵ In most instances, where the working spouse controls the dividend decision, all the retained earnings have been held to be marital property.¹⁰⁶

The owning spouse might choose to use some company profits for purposes other than paying dividends. In an Oklahoma case, a spouse bought an interest in a business during marriage for approximately $550,000. He contributed $50,000 in separate property cash and borrowed $500,000. During the marriage, the husband used some of the profits from the business to pay down the loan. Although dividends from a separate property business are marital property in Oklahoma, a majority of the judges held that the business interest was 100% separate property.¹⁰⁷

The manner in which the court treats rents and profits can create another issue if the business is structured as a sole proprietorship or a partnership. For example, one court held that even though a husband owned a separate property interest in a partnership at the time of marriage, the interest was to be considered marital property because it could not be established that any of the property owned by the partnership at the time of divorce was acquired before marriage.¹⁰⁸ The court therefore assumed that all property of the partnership at the time of divorce represented rents and profits earned during marriage and was marital property. (Such courts do not treat a partnership as a separate...