How to Keep the Separate Property Business Separate

May 9, 2019
By Clifford Petroske

Naturally, when it comes time to split stuff up in a divorce, we want to at least keep what we had before the marriage.  For the monied spouse, it’s one thing to have to give up a large percentage of assets he/she acquired during the marriage to the other spouse, whose contributions are often, at best, indirect, but its quite another to have to split up separate property — something acquired prior to the marriage or by gift, inheritance, or personal injury award — that is generally retained by the owning or “titled spouse.”  We like to think that separate property remains entirely separate, and the titled spouse gets to keep it all. However, distributing part of the value of a separate property asset can happen when it grows in value and some part of that growth was due to the direct and/or indirect efforts of the spouses. The appreciation of the separate asset is, to that extent — and only to that extent — marital property and should be divided between the parties.  The part of the appreciation or growth in value of a separate property asset that is the result of passive market forces should – if things are done right — also remain separate property.  Unfortunately, intangible assets like business interests cannot be easily partitioned between the separate property portion (both acquisition date value and market-based appreciation), and the marital property appreciation caused by efforts of the spouses.  For the titled-spouse to retain as his separate property both it’s value on the date of acquisition, as well as the portion of the total value that is appreciation caused by passive market forces, he/she must provide expert testimony proving to the Court the extent to which passive market forces were at work in causing the value to increase.  

At times, this burden is fairly easily met and no expert testimony is needed.  These are cases where it is fairly obvious that the titled spouse did not do anything that would cause an increase in value of the separate property asset.  In other words, it may appear — just by looking at it — that the titled-spouse’s ownership interest appreciation was entirely passive and, as a result, is entirely separate property.  In the seminal cases Price v. Price, 69 NY2d 8, and Hartog v. Hartog, 85 NY2d 36, the New York Court of Appeals wrestled with the question of how much direct effort by the titled spouse is required to tip the balance from entirely passive appreciation, where the increase in value is not at all marital property, to active appreciation where the increase in value is marital property, at least to some extent.

Initially in Price, decided in 1986, the Court concerned itself with another question altogether — whether the non-titled wife’s indirect efforts (i.e., raising children, homemaker, host/hostess, etc.) were sufficient to entitle her to receive something from the increase in value of her husband’s separate property business.  After deciding that indirect efforts were sufficient, it then made the observation that “where the appreciation is not due, in any part, to the efforts of the titled spouse but to the efforts of others or to unrelated factors including inflation or other market forces, as in the case of a mutual fund, an investment in unimproved land, or in a work of art, the appreciation remains separate property, and the non-titled spouse has no claim to a share of the appreciation.”   

For example, in the context of business ownership, if the titled spouse’s interest is simply the ownership of stock so that the increase in value during the marriage is the result of “the efforts of others,” then the increase in value of the separate property business would also be separate.  But what about cases that are not so obvious, where the Husband’s or titled spouse’s involvement in the business is more – but not much more — than merely owning stock in the company? What if the business-owning spouse, in addition to owning stock, was a corporate officer on paper only, did nothing to operate the business, but occasionally conferred with management on business decisions?  Would that be enough to swing the pendulum the other way, and make the appreciation marital property, at least to some extent?

As it turns out, that would be enough, according the Court of Appeals in Hartog, where those were the exact facts concerning the Husband’s involvement in two pre-marital businesses that increased in value during the parties’ marriage.  

As the Court said in Hartog, “when a non-titled spouse’s claim to appreciation in the other spouse’s separate property is predicated solely on the non-titled spouse’s indirect contributions, some nexus between the titled spouse’s active efforts and the appreciation in the separate asset is required.”  That makes sense – clearly there must be some “nexus” or causal connection between effort and increase in value, but unfortunately the Court did not provide much insight into how to determine if that nexus exists.  All it did was conclude that, in the particular case before it, the Husband’s practice of occasionally talking to his brother, who actually operated the two businesses in question, about business decisions (in addition to be an officer of those businesses on paper) was enough.  There was no discussion in the Court of Appeals decision, or in the prior decision at the intermediate level Appellate Division, of how often those discussions occurred, or how important those business decisions were. The takeaway, unfortunately, is that if you’re lucky enough to have similar facts to those in Hartog, or facts similar to those in later-decided intermediate level appellate court cases, then it’s easy to tell if there is a causal connection between efforts by the titled spouse, and increase in value of the separate property business interest.  But if it’s a close case and you don’t have facts that conveniently fit a precedent case, it’s not so easy. An appeal to common sense wouldn’t hurt, and the skill of counsel in this regard cannot be underestimated.

Should a nexus between the titled spouse’s level of involvement in the business and the business’ appreciation in value be established, the next task is determining how much of the appreciation is due to passive market forces, as opposed to the efforts of the business owner.  Under Hartog, the burden of proving this distinction falls on the titled spouse.  Should the titled spouse fail to do so, all of the appreciation will be presumed to be the result of his/her active efforts, and will therefore be marital property.

Incredible as it may seem, in actual practice the titled spouse usually does nothing to protect the portion of the appreciation of his or her separate property business interest that results from passive market forces.  In the usual case, the Court will only appoint a neutral forensic accountant to value the appreciation of the business, and no distinction is made between a case in which the titled spouse owned the business prior to the marriage (or otherwise came to own his/her ownership interest as separate property), and a case in which the titled spouse started the business during the marriage.  This is not an issue when the business interest is entirely marital property– there is no need to show how much of the value is the result of passive market forces, since all of the value (both passively derived and actively obtained) is marital. However, when the business interest is in some part the separate pre-marital property of the titled spouse, a forensic accountant cannot determine the portion of the value that is the result of passive market forces.  In the usual income approach (capitalization of earnings or excess earnings methods), the accountant determines the true income attributable to the owner, capitalizes excess earnings, and then adds in the value of net tangible assets. The underlying economic forces at play that have created the business’ income and assets are generally not considered.

Done properly, after the forensic accountant has determined how much the value of a separate property business interest has increased during the marriage, a second expert — an economist — is needed to determine how much of that appreciation was caused by identifiable and quantifiable market conditions.  Those market conditions comprise the passive portion of the appreciation, and remain the separate property of the business-owning spouse.

The job of the economist is to figure out, from market data, what economic and market factors are likely to have passively influenced business performance.  However, each type of business presents different economic and market factors that are likely to have influenced business performance, in differing amounts and in differing directions.  For example, in the retail sector a very significant relationship exists between the changes in sales of jewelry and the level of changes in disposable income and unemployment levels. Data indicates that a 1.0% increase in disposable income leads to a 0.6882% increase in jewelry sales, while a 1.0% increase in unemployment reduces jewelry sales by almost 4%.   Not all retail businesses behave the same. For shoe stores, the key economic factors are population levels, debt service as a percentage of disposable income, as well as the unemployment level. A 1% increase in population leads to a 2.6% increase in shoe sales, and an increase of 1% of in debt service as a percentage of disposable personal income leads to an 8.4% increase in shoe sales.   Interestingly, the effect of unemployment level on sales is significant, but not as pronounced as with jewelry sales. For footwear, a 1% increase in the level of unemployment reduces sales by almost 2.4%. (see, “Silver in Gray Divorces,” Ashok Abbot, PhD.).

There is no denying that the added cost of an economist may discourage some business-owning spouses from pursuing a valuation of the passive appreciation of their businesses.  However, consultation at the outset of the case with an experienced divorce attorney can help determine if the investment is likely to be beneficial.