Rueschenberg: Community Interest in Separate Property Business Re-examined

by Annette Burns on June 28, 2008

The Arizona Court of Appeals, Division I, has updated Arizona law on the issue of a community interest in a separate property business.   In Rueschenberg, filed May 13, 2008, the Court has reviewed and updated Cockrill, outlined findings which are necessary to find a community interest in a separate property business, and confirmed that there is more than one way to do so.   Download Rueschenberg.pdf

This Opinion’s review of the Cockrill, Nace, Roden and Rundle decisions make a detailed review of the Opinion mandatory for all family law attorneys.

The business at issue was undisputably H’s separate property.  The value of the business at the time of marriage was found to be $163,000 based on a capitalization of earnings method. That value was not appealed.

The value of the business as of the marital termination date was found to be $1.44M (with normalized earnings of $360K).   Of this, H’s separate property interest was assigned $550K as a reasonable rate of return on the separate property interest.

Using those figures, the $1.44 current business value minus the $550K assigned to H’s separate property, resulted in a $890K increase during the marriage.  An additional finding was made that 2/3 of the increase was due to community effort as opposed to market or intrinsic forces.

$890K X 2/3 resulted in a $593,000 community interest in the increased value, and Wife was awarded half of that amount as her share of the community increase to the business.  Husband appealed.

It was also undisputed at trial that the community had received virtually 100% of the net distributable earnings of the business during marriage (somewhere between $2.8 and 3.1M)       The trial court did not consider (and was not asked to consider) what the “net distributable earnings” (income less salary and other expenses) were.    A finding by the trial court as to the actual amount of net distributable earnings might have resulted in an offset of excess distributions which were made to the community from the community interest in the business.  But those figures were not requested and were not available.

Husband’s arguments on appeal boiled down to:

  1. It was error to award the community both profits and an increase in the business’ value.
  1. It was error to award the community an interest in the business when the community was adequately compensated during marriage for community effort.
  1. It was error to find that 2/3 of the increase in business value was due to community effort.

Arizona law does not prohibit the distribution of both profits and the increased value of a business to the community.

Husband first argued that Arizona law prohibits the distribution of both profits and increased value of a separate property business.   This was rejected.

Cockrill does not distinguish between “profits” and “increased value” and uses the terms interchangeably.   Allowing the community to share in only profits OR increased value, but not both, would be inconsistent with Cockrill’s mandate to “achieve substantial justice” .   To allow only reasonable compensation would shortchange the community of an interest in one or the other, which was not Cockrill’s intent.

HELD: The Court of Appeals held “when apportioning the increase in value and/or profits from a separately held business, it is not error to apportion both profits (net earnings) and increase in value (whether that is goodwill or a measurable increase in value of some other asset) if the community labor was responsible for a portion of both and if such an apportionment ‘will achieve substantial justice between the parties.’ (citing Cockrill).   Rather . . .  we hold that the trial court must equitably apportion the combined total of the profits (net distributable earnings) and increase in value (whether goodwill or otherwise) of the separate business if the efforts of the community caused a portion of that increase and substantial justice requires it.”

Husband’s argument —— that once the trial court found that the community had been reasonably compensated, the issue of increased value through community effort must fail —— was rejected, citing Nace.

Cockrill allows the trial court to choose an equitable method of determining apportionment of increase in value between community and separate property. With the first method, the court must “determine the reasonable value of the community’s services and allocate that amount to the community, and treat the balance as separate property . . . ”   The second method would “allocate to the separate property a reasonable rate of return on the original capital investment. Any increase above this amount is community property.”

Roden distinguished

But how does the Rueschenberg holding square with Roden, which stated:  “if the community is paid a fair return for its labor, the increase or profits from the separate property remain separate. Only if such return has not been paid, or was not reasonable, would the community have a claim to the growth in value of [the] separate property.”

The Court distinguished Roden.   In Roden, the trial court had used a different method of apportionment  (which, under Cockrill, it was entitled to do).  In Roden, the trial court determined that “the increase in value of [the separate business], which resulted from community efforts, was offset by the amount of compensation – community property – that each party received during the marriage.” (emphasis added)

As pointed out above, the calculation of the excess compensation paid to the community over the years of the Rueschenberg marriage was not requested, and so the trial court could not have made that “offset” finding as was done in Roden.

Why the community could be entitled to both profits and increase in value:  a hypothetical.

The Court of Appeals offered a hypothetical which pointed out that a business employee who contracts to work for a given salary is not also be entitled to an increase in the value of the business, even if that increase in value is directly attributable to the employee’s efforts.    The employee’s contract simply does not give the employee a right to the increase in business value.

One member of a marital community is not, however, an employee who is covered by that contractual salary arrangement.  When one or both spouses contribute to the increase in value of the business, the community is then entitled to a share of that increase, even in addition to the reasonable salary which is paid.

The presumption is that the increase in business value is due to community efforts.  It is the burden of the spouse claiming separate property to show otherwise.

H’s argument that the facts of the case did not support the finding that 2/3 of the increase in value was community effort failed.      It was H’s burden of proof to show that the increase in value was NOT community effort, under Cockrill.

The trial court could therefore start with the presumption that 100% of the growth was community and then temper that with whatever proof H presented of growth for non-community reasons.   While H presented this evidence, the testimony of W’s expert overcame some of that evidence.

H next claimed that the 2/3 of the increase in value found to be due to community effort should have been reduced by the excess of the business profits paid to the community throughout the marriage.

The Court of Appeals agreed in principle with H’s argument, but could not grant H the relief he requested, because “no request was made of the trial court to determine the amount of the net distributable earnings paid to the community. Neither was there a request to determine that the same two-thirds/one-third ratio as to value (goodwill) applied to net earnings.”

In other words, had additional findings been requested of the trial court, some of the community value which was awarded to W might have been offset by the net distributable earnings which had already been distributed to the community.

In Rowe, the separate property stock had been awarded entirely to the H and the trial court had recognized the “overlapping contributions” between the community contributions and the intrinsic nature of the separate property.    That finding was a 75%/ 25% ratio which was followed by a finding that the community had already received more than 75% of the net distributable earnings (through salary and pension contributions).

Had the Rueschenberg court been asked to calculate the net distributable earnings, it might have found that the community had already received more than its 2/3 share of those earnings and in that event, it might have been error to award the community more than that share.

The Court of Appeals was uncertain whether H had actually made the above argument at the trial court level, but gave H the benefit of the doubt and considered the argument.   But, “to prevail on this argument, Husband would be required to show at a minimum that the community received more than its pro rata share of the combined total of net distributable earnings and increase in goodwill.”

Unfortunately for H, he could not show this, because “the trial court was never asked to determine, and did not determine, the amount of net distributable earnings (income less salary and other expenses) generated during marriage. Because of this [lack of information], we are unable to determine the combined total of net distributable earnings and increase in value.”

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