Keeping Separate Property Separate Without a Prenuptial Agreement

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1 Keeping Separate Property Separate Without a Prenuptial Agreement Popular magazine articles tout premarital contracts as an easy answer to the high cost of divorce. These articles plug everything prenuptial agreements can and cannot do, yet they do not tell us whether prenuptial agreements are a good thing or a bad thing. Rarely, if ever, do these articles tell us about the difficulties encountered in negotiating these agreements. Agreements entered into before marriage go by the interchangeable names of premarital, prenuptial or antenuptial agreements. When signed after marriage, they go by the name of postnuptial agreements. Each is designed to accomplish the same result: to fix the rights of the parties upon divorce or death. Most people believe these agreements are a quick and easy fix to their postmarital problems. However, the person asked to sign the agreement usually believes premarital agreements are designed to deprive them of their marital rights. The mere mention of a prenuptial agreement sometimes leads to the cancellation of wedding plans. In the movie Private Benjamin, the heroine is handed a prenuptial agreement by her French fiancé on the day of the wedding. (Such agreements are so common in France that they are standardized under French law.) She is so affronted and outraged that she cancels the wedding. This phenomenon is sometimes referred to as the Private Benjamin Syndrome. On February 13, 1991, The New York Times ran a tongue-in-cheek article on the effect of Valentine s Day on the restaurant business. The story is told of a fellow at a Valentine s Day dinner at Le Madrid in New York, who asked his fiancee to sign a prenuptial agreement to prove that she was marrying for love, not money. The woman got up, threw her champagne in the man s face and left, said the owner, Pino Luongo. This attitude is a part of the emotional tension that surrounds marriage. In Charles Dickens comedic novel, The Pickwick Papers, the cockney genius, Mr. Weller, gives advice to his son: When you re a married man, Samivel, you ll understand a good many things as you don t understand now; but vether it s worth while goin through so much to learn so little, as the charity-boy said ven he got to the end of the alphabet, is a matter o taste. This bit of advice summed up Dickens attitude towards his own marriage. So much for suspicions about marriage. In many situations, it may be impossible or impractical to negotiate a prenuptial agreement. However, there are ways to protect assets when there is no prenuptial agreement. A SEPARATE PROPERTY SYSTEM The marriage of an elderly songwriter to a much younger woman illustrates what can be accomplished without a prenuptial agreement. At the time of his marriage, the songwriter had not been able to negotiate a satisfactory prenuptial agreement. His accountant set up a system to protect his client s separate property if the marriage did not work out. The system was flawed, as all such systems are. Nevertheless, it gave the songwriter a definite leg up when divorce negotiations began. The accountant created computerized separate property accounts for assets acquired before marriage and set up accounts for the income from these assets. Royalties received from songs written before marriage were placed in these separate property accounts and the separate property designation was carried over to public records whenever possible.

2 The songwriter had substantial ongoing income which he earned as a public performer. He also had income from songs he wrote after marriage. This income, under the accountant s plan, was deposited into community property accounts and was used to pay ongoing marital expenses. As is often the case, marital expenses outran community income. Periodic loans were made form the separate property accounts to the community and were carefully documented. The loans were documented by notes signed by both spouses. Getting the wife s signature on these loans is unusual and shows an extraordinary amount of control. The marriage reached the brink of divorce, but fortunately for the parties. It did not come to that. However, as one of his tools of persuasion, the husband was able to present his wife with a debt of more than $1 million documented by notes she signed. How well this debt would have stood up in divorce is open to question. However, it was persuasive in settling the question of divorce. (The proctological aspects of this kind of relationship are another matter.) Marriages are certainly about love, but there are business relationships to be worked out. Each party s power within the relationship will affect how these business relationships are resolved. A prenuptial agreement between the parties may never be mentioned. Or negotiations toward an agreement may have been attempted and stalled. Here are some practical steps that can be taken to protect separate property in a marriage without a prenuptial agreement. SEPARATE PROPERTY BALANCE SHEET To protect assets where there is no prenuptial agreement, the first step is to inventory and value the separate assets as close to the time of marriage as possible. Each separate property asset and liability should be listed on a balance sheet, dated as close to the date of marriage as possible. The balance sheet should be footnoted carefully fo show the underlying foundation for balance sheet valuations. Assets on the balance sheet should be listed at fair market value. This is difficult and may take a lot of effort, particularly with a going business. Businesses and professional practices generally are conducted on a cash basis method of accounting, which does not record the value of accrual items. Good will is seldom on the balance sheet, since there is little interest in the going concern value of the enterprise. Accrual items, such as accounts receivable, and good will may have to be recorded as balance sheet items. It is wise to obtain a business valuation from a business valuation expert neat the time of the marriage. Where the marriage is preceded by a recent divorce, a business valuation from the divorce may be available. If the valuation is more than a year old, it should be updated. The new valuation should be attached to the balance sheet and footnoted. Where business valuation is impractical, it is prudent to attach income statements and balance sheets for each business entity for the three years of operation preceding the marriage. These financial statements can be used later to determine the value of the entities at the time o marriage. Any other documents that may help in the future to value balance sheet items at the time of marriage should be attached. Real estate, jewelry, coin stamp and other appraisals can be used later to establish values at the time of marriage. Pages from The Wall Street Journal will document the present value of listed stocks if this becomes an issue in the future. SEPARATE BANK ACCOUNTS

3 Income from separate property should be maintained in separate bank accounts. It is better to open new bank accounts than to re-label existing bank accounts. Many community property problems occur when a spouse dies and if the person who created the account is dead, there may be no one available to testify as to why accounts were re-labeled. New bank accounts should be opened for community property. Community property in California is defined as all earned income after marriage. Community property income should never be deposited into separate property accounts, as this will cause a commingling. Assets purchased with commingled funds are presumptively community property. The most burdensome family law litigation arises from the purchase of property out of commingled funds. All community (family) expenses should be paid from the community property account. If any investments are to be made for the community, Payments, including down payments, should be made only from the community account. New investments intended to remain separate property should be paid from the separate property account. Separate property liabilities should be made from separate property accounts. If a new separate property investment is to be made in a going business in which skill and management are to be a factor, the investment should be in the form of a loan to be repaid as soon as possible. Trust deed payments on separate property real estate should be made from a separate property account to avoid an apportionment of the appreciation in the real estate which occurs after marriage. Strict integrity between community and separate account should be maintained. Make every effort to keep deposits straight: put community earnings in community property accounts, separate earnings in separate property accounts. Keep strict computer records. Where errors are discovered, do reversals, both on the computer and in the deposits. MAINTENANCE OF GENERAL LEDGERS A general ledger is an annual summary of activity by account. An account is the accounting terminology used to describe an asset, a liability, a source of income or an expense category. General ledgers for both separate and community property accounts will provide the fundamental record-keeping necessary to maintain the viability of the system. Loans made by the separate property to the community for maintenance of the community lifestyle should be recorded, but should not be regarded as recoverable liabilities of the community. Care should be taken that excess community needs (beyond community income) are met with community obligations to third parties. Borrowing by the community from the separate property is to be discouraged. When it does happen, it should be treated as a oneway street. Loans from the separate property to the community are generally uncollectible, even if they are signed by the wife. However, if such loans are made, they should be documented. There is an off chance that a judge might find these obligations valid. A large loan balance at the end of the marriage has some bargaining power. In California, a transfer of assets from separate to community is presumptively a gift from separate to community. Even if the transfer is in the form of a loan, the court probably will not treat it as a loan, whether or not the wife signs it. REPAYMENT OF NOTES

4 A real danger arises if loans from the community to the separate property are repaid. Such loans ordinarily will not be acknowledged as true loans. Even if the wife signs them, her attorney will argue that good faith and fair dealing between husband and wife require that she have been advised by independent counsel before each transaction in order for such loans to be valid. If the transfers of funds from separate to community are not loans, they are gifts. The funds, having been gifted to the community, remain community. When transferred back to the separate property as are payment of a loan, these funds, being community, taint the separate account; the separate account becomes a commingled account. Any later purchases from the commingled account are likely to be treated as community assets. Trying to repay a loan to the separate from the community may undermine the whole record-keeping system and with it, all separate property. Where it is necessary to continuously fund the community, the best recourse is through outside sources. As always, it is a valid procedure to maintain loan records documented by notes. Have both parties sign the notes and retain these notes, canceling them only when the funds are repaid to the third party. It may be impractical to obtain a spouse s signature on notes to third parties. It will be a rocky marriage if one spouse is continually asked to sign notes. Loans signed by one spouse alone will be honored if the borrowing is well documented and if the funds are used for community purposes. Good record-keeping will protect the parties against charges of commingling. Transactional activity with respect to separate property securities should be segregated for greatest protection. Only clearly separate property infusions of capital should be made into these accounts if they are to be kept separate. Margin trading poses a risk from a lender s intent standpoint; accordingly, it should be avoided. If margin trading is unavoidable, specific steps should be taken to commit the brokerage to a reliance solely on the separate property securities in the account. Reliance on the general credit of the borrower will be interpreted as reliance on the general credit of the community. The opposing attorney representing the community position will have a strong case if documentation is not solid. THIRD PARTY LOANS Successful business people leverage much of their business through outside financing. A loan can be a valuable asset where there is an increase in value of the business or property acquired through financing. Whether the asset acquired through a loan is a community property asset or separate property asset depends on whether the lender relied on community property or separate property for repayment. In community property states, loans based on the general credit of the borrower are community property loans. Since institutional lenders insist on relying primarily on the borrower s income stream or on his general credit, most bank loans are community property loans. The presumption is that the lender relied on community property. The leading case in

5 this area is the California Supreme Court case of Gudelj v. Gudelj, 1 which held that to overcome the presumption, the borrower must prove the lender relied primarily on the borrower s separate property in extending credit. A more recent case, Marriage of Grinius, 2 requires the borrower to show that the lender relied exclusively on separate property to overcome the presumption. The Grinius standard is difficult to prove since the lenders rely on a variety of factors, including income stream, for repayment of their loans. The only pure separate property loans are collateralized loans for which the borrower relies on separate property collateral such as a pawn shop loan or a purchase money loan. In a purchase money loan, the seller rakes back a mortgage for the purchase price, relying entirely on the property as collateral for the loan. When money is borrowed to purchase separate property, care must be taken that in making the loan the lender relies on separate property security. Financial statements, loan documents and credit reports should reflect that the source of repayment is from separate property collateral only, and the collateral should be listed. Documents normally not seen by borrowers, such as credit reports, must reflect the collateral nature of the loan agreement. The borrower should take special pains to examine the documents to be sure any community property source of repayment is excluded. The issue of how the loan was secured may arise years later when no one remembers the collateralized nature of the loan. Bank officers often testify as to what they were trained to do, which is to rely on the income stream for repayment, rather than what actually happened in a particular transaction. It pays to have made a record in the bank file as to the collateralized nature of the loan to guard against faulty memories and rote testimony years later. The borrower should document by letters to the loan officer that the loan is collateralized by separate property and that neither the borrower s general credit nor his income stream is to be the source of repayment. Keep in mind that it is not the state of mind of the person who is making the loan that will be the issue. It is the state of mind of an institutional lender, whose mind is made up by a number of people, most of whom the borrower will never see. REAL PROPERTY A house or other real property owned before marriage remains the owner s separate property after marriage, even though the parties live in it. However, it is difficult to remove a spouse or even a live-in companion from a residence, even though that person has no ownership interest. If a prior existing mortgage debt is paid from community property, the community will develop a small but growing fractional interest in the property. The principal paydown is the numerator: the total equity in the property is the denominator. This fraction is multiplied by the total value of the property. The end result is the community interest in the property. The problem of lender s intent arises when separate property is refinanced during marriage. If the lender relies for repayment on the borrower s income stream or on his general credit, the proceeds of the loan will be community property. If the loan is a pure purchase money loan, the property will remain separate. Payments on a loan should be made from 1 41 Cal. 2d (1953) Cal.App. 3d 1179 (1985).

6 separate property is the separate property character of the property is to be maintained. FOREIGN INVESTORS Off-shore or out-of-state investors may stumble into the quagmire of quasi-community property if they get caught up in a California divorce. In a divorce case, California courts treat all property, wherever located, as if it were community property. Quasi-community property is divided equally between husband and wife, without regard to fault or location of the asset. In a California divorce, property located outside of California or even outside of the United States may be divided equally. Under California Civil Code Section (a), courts are instructed to divide out-ofstate property so that it is not necessary to physically transfer real property. The preferred method is to require one of the spouses to execute a conveyance of foreign real property to the other. Alternatively, the court may grant a money judgement for the value of the interest that he would have received if such conveyances had been executed. The separate property nature of assets should be firmly established by foreign investors if they are to escape from mandatory equal division in a divorce. THE BOTTOM LINE If the goal is to preserve separate property during a marriage, no precautions are too great. There is no guarantee that if all these procedures are followed, the separate property will be protected in whole or part. Beware of the California presumption that property acquired after marriage is community property. When a new company is formed and new assets are acquired, every element of the transaction should be analyzed in light of the principles set forth for keeping separate property separate. Good record keeping, the maintenance of community and separate property bank accounts, and care not to commingle assets are preconditions to keeping separate property separate, with or without a prenuptial agreement.