CLASSIFYING THE RETAINED EARNINGS OF A SEPARATE PROPERTY BUSINESS AS MARITAL PROPERTY
2003 National Legal Research Group, Inc.

Overview: Defining the Issues

There are, in general, two different ways in which an old asset can generate new value. First, the old asset may increase in worth, creating new value in the form of appreciation. Second, the old asset may be used to generate a new asset, creating new value in the form of income.

Since appreciation and income are merely two different ways in which an old asset can produce new value, appreciation in separate property and income from separate property should logically be subject to the same rules of classification. While this is a growing trend, it remains a distinct minority rule. The Uniform Marriage and Divorce Act (UMDA) classified all income from separate property as marital property, regardless of cause. This rule has been codified into many equitable distribution statutes, and statutory change proceeds at a slow pace. See generally Brett R. Turner, Equitable Distribution of Property 5.21 (2d ed. 1994 & Supp. 2002) The UMDA was silent on appreciation, and a large majority of states now recognize that the classification of appreciation depends upon its cause. Active appreciation caused by marital funds or marital efforts is marital property; passive appreciation caused by market forces or the efforts of independent third persons remains separate property. Turner, supra, 5.22.

Because different rules of classification apply to income and appreciation, it is important to distinguish accurately between the two. Case law on this subject is inevitably based more upon form than substance, because the underlying distinction between income and appreciation is purely one of form. For the reasons set forth in Turner, supra, 5.21, the better rule is to apply active/passive principles to both income and appreciation. But as long as a majority of states refuse to do this, distinguishing between income and appreciation will continue to be an important issue.

We focus this month on one of the particular trouble areas in distinguishing between income and appreciation: the retained earnings of a business. Ordinarily, "earnings" is merely a synonym for "income." But the definition of marital property includes only income received by a spouse; income received by someone else, or income which is never received by anyone, is never marital property. Retained earnings are clearly income received by the corporation, but are they income received by a divorcing shareholder? Does it matter whether the shareholder controls the company, and whether he or she is drawing a fair and reasonable salary? The issue is further confused by federal tax law, which provides that the retained earnings of certain types of corporations (e.g., S corporations) are taxed to the shareholders individually, even if never actually distributed. What if marital funds are used to pay taxes on retained earnings? Is this somehow a marital contribution to the stock or to the corporation? These are only some of the confusing questions which arise when the court must classify the retained earnings of a business.

General Rule: Retained Earnings Are Not Income

As a general rule, retained earnings are not income because they have not actually been distributed by the corporation to the shareholders. A Missouri court explained:

Generally, retained earnings of a corporation do not constitute marital property. [Citation omitted.] Retained earnings and profits of a corporation are a corporate asset and remain the corporation's property until severed from other corporate assets and distributed as dividends. [Citation omitted.] As retained earnings are a corporate asset, title remains in the corporation; the shareholder does not have legal title. [Citation omitted.] Accordingly, the court's treatment of corporate assets as marital property is in error.

Craig-Garner v. Garner, 77 S.W.3d 34, 38 (Mo. Ct. App. 2002); see also Hoffmann v. Hoffmann, 676 S.W.2d 817, 827 (Mo. 1984) ("[T]he wife could not claim the retained earnings as marital property, because the earnings and profits of a corporation remain its property until severed from other corporate assets and distributed as dividends"); Thomas v. Thomas, 738 S.W.2d 342, 344 (Tex. App. 1987) ("[I]n an ordinary corporation, retained earnings are a corporate asset. They are not marital property").

To similar effect is a Minnesota decision:

We note first that the Siegel-Robert AAA is not "income" under the plain meaning of Minn. Stat. 518.54, subd. 6 (2000), which defines "income" as "any form of periodic payment to an individual." Although the Internal Revenue Code treats AAA earnings as income attributable to individual shareholders for federal tax purposes, there is no evidence in the record before us that an asset-bearing account was set aside by Siegel-Robert for respondent or that any amounts were, or will be, held in such an account or distributed to either party. Retained earnings and profits of a corporation are a corporate asset and remain the corporation's property until severed from other corporate assets and distributed as dividends. [Citation omitted.] Respondent agrees that Siegel-Robert dividends actually paid to the parties were marital property. But because Siegel-Robert never distributed the retained earnings to respondent, the earnings never became respondent's income under Minn. Stat. 518.54.

Robert v. Zygmunt, 652 N.W.2d 537, 543 (Minn. Ct. App. 2002).

This result does not change merely because the business is organized as an S corporation, the shareholders are taxed individually on the retained earnings, and marital funds are used to pay the taxes. The Thomas court explained:

Appellee contends, however, that retained earnings of a Subchapter S corporation should be treated as community property because the community has paid federal income tax on them. This, she argues, justifies the recognition of a community interest in the retained earnings. We disagree.

Subchapter S status does not determine who owns the corporation's earnings. It merely provides an alternate method to tax the corporation's income. A Subchapter S corporation may distribute its income, but, like any other corporation, it is not required to do so. Corporate distributions, regardless of form, are controlled by state law. See Commissioner v. Cohen, 121 F.2d 348 (5th Cir. 1941); Tex. Bus. Corp. Act Ann. arts. 2.38, 2.39, 2.40 (Vernon 1980). The shareholder in a Subchapter S corporation has no greater rights over corporate property than a shareholder in any other corporation.

738 S.W.2d at 344. To similar effect is a case from Louisiana:

Notwithstanding taxation rules promulgated expressly for the purpose of a subchapter S corporation, tax regulations are not the determinant in the characterization of income with respect to Louisiana property laws.

Although Wall McKneely might have possessed the right to transfer the fruits [the retained earnings] to an individual account [in his own name], he had not in fact done so. Title to those fruits remained in the subchapter S corporation. Until those funds were actually disbursed, or distributed, they were not the property, or a fruit, of Mr. McKneely individually.

McKneely v. McKneely, 764 So. 2d 1157, 1160 (La. Ct. App. 2000). The Louisiana concept of "fruits" from separate property is generally analogous to "income" from separate property in other states.

The result reached in the above cases is consistent with the general rule that the use of marital funds to pay taxes on separate property does not create a marital interest. For example, when marital funds are used to make mortgage payments on separate real estate, the resulting marital interest is a function of the amount spent to reduce the principal, not the amount spent for interest, insurance, or taxes. See, e.g., Aunger v. Aunger, 705 So. 2d 957 (Fla. Dist. Ct. App. 1998); Gravenstine v. Gravenstine, 58 Md. App. 158, 472 A.2d 1001 (1984); Trego v. Scott, 125 N.M. 323, 961 P.2d 168 (Ct. App. 1998). See generally Turner, supra, 5.10 n.200. The use of marital funds to pay taxes is not irrelevant; it can be one factor in favor of an unequal division of the marital estate. E.g., Welch v. Welch, 755 So. 2d 6 (Miss. Ct. App. 1999). In addition, especially in community property jurisdictions, the marital estate might be entitled to some form of reimbursement from the separate estate. But marital or community interests generally arise only from contributions to the acquisition of property. Taxes are an expense; they are not part of the purchase price.

Exception: When Retained Earnings Are Income

There are several situations in which courts have departed from the general rule and treated retained earnings as income. In Nardini v. Nardini, 414 N.W.2d 184 (Minn. 1987), the husband operated a small business which sold and serviced firefighting equipment. He bought half of the business for a moderate sum before the marriage, and purchased the remaining 50% during the marriage. The business was really developed, however, by the husband's active efforts during the course of a 31-year marriage. The Minnesota Supreme Court held that almost all of the growth in the company was caused by the husband's active efforts and was therefore marital property. With regard to the corporation's retained earnings, the court held:

[I]n addition to the corporate income distributed to Ralph and Marguerite as salary and [fringe benefits], the corporation had retained earnings of $563,598 (all of which were, of course, earned during the marriage). It seems to us that the nature of income generated through the efforts of the marital partners is not directly changed by its retention as shareholder equity in a wholly owned corporation. Whether the business be carried on as a family corporation or a partnership or a sole proprietorship, income earned during the marriage, whether distributed or undistributed and reinvested in the business, is marital property.

Id. at 195 (emphasis added).

The emphasized passage can be read to suggest that income which would otherwise be marital property is not converted into separate property merely because it is retained. The court's reference to income "generated through the efforts of the marital partners," however, is crucial. If retained earnings are not income, they will often be appreciation in the value of the corporation, and active appreciation in separate property is almost universally marital.

More carefully read, the above passage seems to say only that retained earnings which are not income can still be marital property if they represent active appreciation in the value of the company. This reading was adopted in two subsequent Minnesota Court of Appeals cases. Robert v. Zygmunt, 652 N.W.2d 537 (Minn. Ct. App. 2002); Duffey v. Duffey, 416 N.W.2d 830 (Minn. Ct. App. 1987). Both held that retained earnings were separate property, because the business was operated by independent third parties (a hired CEO in Duffy, other members of the wife's family in Robert) who had sole management control. Robert reached this result even though the wife was a member of the company's board of directors, quite properly finding that nominal attendance at board meetings is no guarantee of actual contribution to the making of management decisions.

The reasoning of these cases was subsequently adopted by the Minnesota Supreme Court. In Gottsacker v. Gottsacker, 664 N.W.2d 848 (Minn. 2003), the husband owned a minority interest in an S corporation run by his family. The trial court and the court of appeals held that the retained earnings were not marital property, and the supreme court affirmed. The court reaffirmed the holding in Nardini that the retained earnings there were marital, but it agreed with Robert and Duffy that the degree of control over the corporation is a key issue:

The determining factor in these decisions from other jurisdictions tends to be the degree of control the shareholder-spouse can exercise over the corporation and, consequently, the degree of control that shareholder-spouse has in determining when to distribute the retained earnings as shareholder dividends. If the shareholder-spouse is the sole shareholder, for example, a court may view the decision not to distribute the corporate earnings reflected in the AAA as an attempt to shield income from the nonshareholder-spouse and therefore may find the AAA to be income. If the shareholder-spouse is one of many shareholders and has little to no control over deciding when or if to make dividend distributions, treating the AAA as marital property credits the shareholder-spouse with income that may, in fact, never be distributed.

Id. at 856. The court concluded:

We conclude that the court of appeals correctly determined that, in this case, the AAA is analogous to retained corporate earnings, the nature of which is best evaluated on a case-by-case basis. This evaluation should follow the tenet that the more control the shareholder-spouse has over the decision to distribute or retain shareholder income, the more likely the court will be to label the AAA income. Here, the district court properly found that Edwards had no such control and we conclude that the court of appeals did not err when it agreed with the district court and concluded that Edwards' AAA was not income.

Id. at 857; see also Swope v. Swope, 122 Idaho 296, 301, 834 P.2d 298, 303 (1992) ("[T]he community has no interest in the retained earnings of a corporation, the stock of which is held as separate property by one of the stockholders, unless the stockholder has sufficient control of the corporation to be able to cause the earnings to be retained").

Another decision treating retained earnings as marital property is Metz v. Keener, 215 Wis. 2d 620, 573 N.W.2d 865 (Ct. App. 1997). There, the court considered the retained earnings of a separate property subchapter S corporation which operated a McDonald's franchise. The wife actively managed the business during the marriage, increasing its annual earnings from $52,000 to $148,000. A significant portion of the earnings was retained by the corporation.

The trial court treated the retained earnings as marital property, and the appellate court affirmed. The court held that the retained earnings were income:

[R]etained earnings represent appreciation in the value of the corporation itself rather than income generated by the corporation. While we understand the distinction which Dorothy is drawing and fully accept that a corporation's retained earnings may serve to increase the value of the stockholder's shares, the property division law of this state clearly views income generated by an exempt asset as separate and distinct from the asset itself.

215 Wis. 2d at 632, 573 N.W.2d at 868. Like Nardini, Metz can be read to suggest that retained earnings are always marital. But there is no question that the wife in Metz ran the business, and ran it very well. Robert and Gottsacker expressly held that Metz does not apply to a situation in which the owning spouse lacks sufficient control to determine whether the earnings would be retained or distributed. While neither case binds the courts of Wisconsin to reach the same result, courts outside of Wisconsin have certainly been reluctant to rely on Metz as authority for including as marital property retained earnings which are beyond the control of a minority shareholder.

A somewhat different basis for treating retained earnings as income was set forth in Heineman v. Heineman, 768 S.W.2d 130 (Mo. Ct. App. 1989). The business at issue there was the wife's separate property incorporated art studio. An antenuptial agreement in Heineman provided that the increase in value of separate property would remain separate. But it left the door open for treating income from separate property as marital. During the marriage, the wife drew no salary from the studio. The trial court held that the studio's retained earnings were an increase in value, and therefore separate property under the agreement. The appellate court reversed, holding that the retained earnings were actually income from separate property:

The trial court held that the retained earnings of the corporation represented an increase in value of the studio. As an increase in the value of premarital property the retained earnings account was, according to the court's finding, nonmarital property.

We hold however that the retained earnings did not represent an increase in value of the premarital studio. The corporation did not exist at the time of the marriage, it came into being after the marriage. The retained earnings account was accumulated from money which otherwise would have been paid to wife as her salary. If the business had remained unincorporated all the profits thereof would have constituted earnings to the wife and would have constituted marital property.

Id. at 137.

Here it is clear that the wife, the sole stockholder of the corporation, for some period of time forewent all compensation for her services, which would have been marital property, and that the retained earnings account of the corporation is directly traceable to that forbearance. It is clear, too, that the earnings of the corporation were attributable in only a minor way to the capital of the corporation. Chiefly the earnings were from wife's valuable services. We hold, then, that the retained earnings account in the amount of $128,063 is marital property.

Id. Thus, not only did the wife control the business, but she deliberately paid herself less than a fair salary in order to accumulate retained earnings. Not only did the wife have the theoretical power to convert marital income into separate property by retaining earnings, but there was good proof that she had done so on the facts. Heineman is probably the single case nationwide in which the justification for treating retained earnings as marital property was most compelling.

Finally, in the early case of J.D.P. v. F.J.H., 399 A.2d 207 (Del. 1979), the court reversed a trial court opinion holding that the retained earnings of a separate property business were never marital. The court stopped short of actually classifying them as marital property:

We do not mean that an increase in retained earnings must always be included when the value of marital property is determined. Certainly not. Rather, our view is that such an increase must not be excluded in every instance.

We recognize that it is far easier to announce this construction of 1513(b) than it is to apply it. But in applying it, the Court must keep in mind that the public policy, mandated in the Act, is to "equitably divide" marital property. That will include a consideration of the values which are at stake, whether the increase in retained earnings resulted from a natural enhancement over which the controlling spouse had little or no control, whether such increase resulted from ordinary and necessary business reasons, whether such increase resulted from an intentional purpose by the controlling spouse to prevent earnings from becoming marital property, the impact of any order on other stockholders, on the corporation and on others with an interest in it; the State and Federal tax consequences of any order on each spouse and the corporation. This listing is illustrative, only, and is not intended to limit the Court as it seeks to do justice under the statute.

Id. at 211. The factors identified in J.D.P. essentially relate to who controlled the business, why the earnings were retained, and whether the earnings were a product of marital efforts. These are the factors generally considered by later cases, although the analysis of the courts has become more specific.

Unanswered Questions. The decisions generally agree that the retained earnings of a separate property corporation are income where the shareholder spouse has sole control over the entire business, and are not income where the shareholder spouse has no control over the business. Left unanswered by the cases is the result in situations between these two extremes.

Two particular situations have not yet arisen in the reported cases. First, it is simplistic to assume that control will either be completely present or completely absent. There are a large number of persons who will have some degree of influence over the decision to retain earnings, but who will not be able to control the decision unilaterally. For example, take the not uncommon situation of a small corporation with two to five principal shareholders, run in a manner similar to a partnership. An individual partner in such a business does not have unilateral control over the decision to retain earnings, but he or she has considerably more influence than the owning spouse in cases like Gottsacker. No fact pattern involving partial control has yet been clearly presented to the courts.

Second, the cases treating retained earnings as income have relied heavily on the mere presence of control. But in none of the cases is there any indication that earnings were retained for a valid reason. If control is present, and no valid reason is suggested and proven, the retained earnings are probably income. It remains to be seen how the courts will respond when the facts really do show a valid reason. There is certainly room to argue that the reason should be considered. Indeed, if the facts show that the retention of earnings was important to the continued survival of the business, it could be argued that the owner really did not have the power to distribute the earnings, as the owner's decision was dictated by outside economic forces. Again, however, no reported case presents this argument.

In both of these situations, it seems that attention must be paid not only to the presence of control, but also to whether and how control was actually exercised on the facts. The purpose for treating retained earnings as income is to prevent the owning spouse from stealing marital property by retaining rather than distributing earnings. When control is actually used to deprive the marital estate of earnings produced by marital efforts Heineman is the classic situation the argument for treatment as income is strong. But where the decision to retain earnings was controlled partly by the desires of other shareholders or partly by economic forces requiring that earnings be retained, it seems questionable to assert that the marital estate is being injured merely because the owner had to some extent the raw ability to injure it. Control which exists in theory is not always exercised in fact, and the owner of a business should not be required to place protection of the marital estate above all other legitimate business concerns. Future cases should not be so quick to assume that the mere presence of control converts retained earnings into income where the decision to retain earnings is clearly reasonable under the facts.

Retained Earnings as Appreciation

Where retained earnings are not income, they are still one element of the value of the company at the time of divorce. If the total value of the company has appreciated during the marriage, the court must classify the amount of appreciation.

In most states, the appreciation will be marital to the extent that it was caused by marital contributions. Because the cases treating retained earnings as appreciation have so far involved shareholders with little or no control over the company, the cases to date have almost uniformly found that the appreciation resulted from passive causes market forces and the contributions of third parties. But existing opinions clearly do distinguish between the two different questions involved: whether the retained earnings are income or appreciation, and whether any retained earnings which constitute appreciation were due to active or passive factors. E.g., Gottsacker; Robert.

One exception is Pennsylvania, where the law contains an unusual provision treating all appreciation in separate property as marital property. Not surprisingly, the court held in Rohrer v. Rohrer, 715 A.2d 463, 465 (Pa. Super. Ct. 1998), that retained earnings are marital property. The court did not need to address whether the earnings were income or appreciation on the facts, for, under Pennsylvania law, both were equally marital.

If the courts hold in the future that the presence of limited control does not convert retained earnings into income, the treatment of retained earnings as active appreciation could become a more significant issue. For example, assume that a spouse is one of ten equal shareholders in a separate property business which retains earnings. The fact that the husband has 10% control over retained earnings should probably not be a sufficient basis to treat retained earnings as income, where the other nine shareholders strongly favor retention of earnings for valid business reasons. But if the husband was responsible for 10% of the overall growth in the company, a court might be justified in treating some of the growth in his stock including but not limited to retained earnings as marital property.

Conclusion

Where the owning spouse has sole control over an entire separate property business, any retained earnings are likely to be treated as income on the theory that the owner had the power to distribute them. There is some possibility of a different result where a strong case exists that retaining the earnings was reasonable on the facts that is, that the owner was clearly not improperly depriving the marital estate of income. If this possibility exists at all, the burden of proof is clearly on the owner.

Where the owner has no significant control over a separate property business, it is highly likely that any retained earnings will not be treated as income. The earnings are an asset of the corporation, and the owning spouse had no power to force their distribution.

Where the owner has some control over the business, but not complete control, it is difficult to predict the likely result. If the owner was actually using his control to limit distribution of the earnings, and cannot prove that a good business reason existed for his conduct, treatment as income may be more likely. If the owning spouse used his control to favor distribution, but was outvoted by other shareholders, effective control would appear to be lacking.

In all situations, if the retained earnings are not income, they can still constitute active appreciation in the value of the business. This theory will create a marital interest to the extent that (1) the overall value of the business appreciated during the marriage by at least as much as the retained earnings (e.g., the retained earnings were not offset by a loss in value of other assets, so that the value of the entire business remained constant during the marriage), and (2) the overall increase in value was caused by contributions of marital funds or marital efforts. As with any issue of active appreciation, this is likely to be a difficult and discretionary question of fact.

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