Inc. Blot - Business Doesn’t Become Community Property Upon Incorporation

Los Angeles Daily Journal, Vol.112, issue #2177, September 14, 1999

When and how does a separate premarital asset become community property? This question has been an interesting, occasionally complex and often fascinating issue in community property law for a substantial period of time. The recent case of In re Marriage of Koester (July 28, 1999) Daily Journal D.A.R. 7695 presents an excellent discussion of issues that arise when separate property changes its “form” during the marriage, but not its essential character. As the court states on page 7696, statute and case law may “easily obscure the basic principle that separate property does not change its character because of a change in form or identity”.

What happened in Koester is relatively simple. Prior to the parties’ marriage in November, 1986, Frederick Koester owned, as a sole proprietorship, Koester Electric. After marriage and before separation the business was incorporated; however, no stock was ever issued. The trial court treated this post-marital incorporation as an acquisition by the community and therefore ruled that the business was a community asset. The court found that Frederick was entitled to a reimbursement right consistent with Family Code §2640 which provides Frederick with a straight dollar reimbursement of his separate property contribution towards the acquisition of the community asset to the extent that he can trace his contribution to a separate property source. The Court of Appeal reversed the trial court and held that Frederick was entitled to a Pereira vs. Pereira (1909) 156 Cal.1, community property interest in Koester Electronics.

The methodology of Pereira and succeeding cases allows for a determination of the community contribution to a separate property business during the marriage and for a return on the investment for Frederick of his separate property capital in the business. Under Family Code §2640 however, the former separate property owner’s right to reimbursement is limited to the value of his separate property asset on the date it is converted to community property.

As applied to Koester Electric, the difference between the two approaches was substantial. The trial court, using a Family Code §2640 reimbursement theory, determined that the value of the business at the time of trial was $622,000. The court determined that the value of the business at the time of incorporation was $337,500. As such, Frederick was entitled to a reimbursement claim of same and was charged with a remaining community asset of $284,000. Had the property been characterized as Frederick’s separate property, and using a Pereira 10% return on investment since marriage, Frederick’s separate property would have been $558,000 and the total community interest would have been $64,000.

The court in Koester provides an interesting discussion of the legislative and judicial history of Family Code §2640. The court points out that §2640 (and it’s predecessor, Civil Code §4800.2) was the legislative response to the case of In re Marriage of Lucas (1980) 27 Cal.App.3d 808. Lucas involved the acquisition of real property during the marriage in joint tenancy where one of the parties contributes separate property to the acquisition of that asset. The California Supreme Court ruled that absent an agreement, the party contributing separate monies would not be reimbursed the separate property contribution upon dissolution of marriage and the division of the community property asset. As the court in Koester points out, “Family Code §2640 arose out of the case of a residence which was purchased with separate property, but the title to the residence was taken in joint tenancy. Thus, as one might expect knowing the origins of the statute, published decisions involving the reimbursement statutes typically arise out of the conveyance or acquisitions of residences.” (See Koester page 7696).

As such, the court in Koester concluded that “Section 2640 was never designed to apply to separate property businesses and is inherently not applicable to businesses, at least when there is no compliance with the rigorous requirements for transmutation set forth in Family Code §852.” (See Koester 7696).

Family Code §852 states as follows:

“A transmutation of real or personal property is not valid unless made in writing by an express declaration that is made, joined in, consented to, or accepted by the spouse whose interest in the property is adversely affected.”

The appellate court in Koester found no transmutation consistent with Family Code §852 since the incorporation of the business changed the form (from sole proprietorship to corporation) but not the character of the business (from separate to community). The mere incorporation of Koester Electric was not an express declaration in writing transferring the business to the community.

The Koester court avoids answering the question of what would have happened had the stock been issued in both husband’s and wife’s names. The court suggests however, that even the issuance of stock may not be sufficient. In footnote 5 the court states that “we divine no absolute rule that Section 2640 could never apply where a separate business was incorporated. However, any such application could only arise when there was an unambiguous express written transmutation under Section 852 of the Family Code. … You don’t just slip into a transmutation by accident.”

The two cases involving stock cited by the Koester court for support of its position do not deal with stock issued in both parties’ names. Kenney vs. Kenney (1950) 97 Cal.App.2d 60, 217 P.2d 151 involves a premarital transaction by Mr. Kenney in an oil partnership which became incorporated approximately two weeks before marriage but did not issue any stock until several weeks after marriage. The Kenney case itself does not indicate whose name was on the stock certificates, but it does suggest that they were issued in Mr. Kenney’s name solely (see page 155). As the Koester court indicates, the fact that the “shares and business interest acquired before marriage but not issued to a spouse until after marriage did not “transmute” them into community property.

The more interesting case cited by Koester is In re Marriage of Barneson (1999) 69 Cal.App.4th 583. That case involved Mr. Barneson, a 65 year old individual with a multi-million dollar stock portfolio and his marriage to a much younger woman of 36. Approximately 15 months after marriage, Mr. Barneson suffered a stroke and within 30 days of the stroke signed a type written letter to his broker combining four stock certificates into one under the name of his then wife.

At the parties’ divorce, the trial court found that the letter and subsequent other proforma document forms signed by Mr. Barneson constituted a valid transmutation under §852 of the Family Code.

The appellate court reversed, finding that Barneson’s mere directions to place the stock in his wife’s name did not necessarily demonstrate a desire to change ownership. The court stated “for example, Barneson may simply have intended to enable Kaiser to easily manage his financial affairs for him after his stroke. … The point is simply that a direction by a spouse to transfer stock into a spouse’s name does not unambiguously indicate the ownership of the stock as being changed…”

In Barneson, the stock was not transferred jointly into both names, but rather from one party to the other.

Interestingly, the Koester court never addresses the impact of Family Code §2581 which states that:

“For the purpose of division of property on dissolution of marriage or legal separation of the parties, property acquired by the parties during marriage in joint form … is presumed to be community property. This presumption is a presumption affecting the burden of proof and may be rebutted by either of the following:

(a) A clear statement in the deed or other documentary evidence of title by which the property is acquired that the property is separate property and not community property.

(b) Proof that the parties have made a written agreement that the property is separate property.”

As such, the Koester court never discusses the not uncommon practice of issuing stock in a small corporation in husband’s and wife’s names. Family Code §2581 clearly states that a jointly held asset would “presumptively” be community property absent a writing to the contrary. Koester, by its continued referenced to Family Code §852 seems to suggest that title on stock certificates may not be sufficient.

Koester may also be read as an attempt to somewhat suggest the limitations of Family Code §2640. By not citing any authority to support its contention that Family Code §2640 was never intended to apply to businesses and only citing the real estate cases under Family Code §2640, the court ignores the application of Family Code §2640 to automobiles, In re Marriage of Neal (1984) 153 Cal.App.3d 117, 200 Cal.Rptr. 341; and boats, In re Marriage of Martinez (1984) 156 Cal.App.3d 20, 202 Cal.Rptr. 646. Despite the strong language in Koester, courts regularly have applied Family Code §2640 to all jointly titled assets.

Finally, Koester may be just the most recent case to protect the party bringing separate property to the community. Read in light of the California Supreme Court case of In re Marriage of Walrath (1998) 17 Cal.App.4th 907, wherein the court allowed Family Code §2640 interests to continue in refinance proceeds from a property to another property, the trend may be clear that separate property in the context of dissolution of marriage may never have been as well protected as currently by the California courts.

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