Jointly Titled Partnership Interests: Marital Property?
© 2004 National Legal Research Group, Inc.
A recent Kentucky Supreme Court decision addresses the proper principles for classifying a jointly titled partnership interest acquired by gift from one spouse's parents. In addition to addressing joint title, the opinion also addresses several interesting issues of tracing. Sexton v. Sexton, 125 S.W.3d 258 (Ky. 2004).
At the time of the marriage, the husband owned an apartment building. During the marriage, the husband's father acquired a new apartment building, and he decided to create a family partnership. To capitalize the partnership, the husband contributed his premarital apartment building, the husband's sister contributed an apartment building she owned, and the husband's father contributed the newly acquired building. The new partnership was called Autumn Park, and it was owned one-sixth by the husband and the wife, one-sixth by the husband's sister and her husband, and two-thirds by the husband's parents.
The main contested issue was the classification of the husband's interest in Autumn Park. The trial court classified the interest as 94% the separate property of the husband. The wife appealed, arguing that the husband's interest was entirely marital property. The Kentucky Court of Appeals affirmed in an unpublished opinion, and the wife appealed to the Kentucky Supreme Court.
A dissenting opinion in the court of appeals would have awarded the wife 50% of the husband's interest in Autumn Park. The dissent initially found that a single partnership interest cannot be held in joint ownership; instead, the joint owners are treated as individual partners of the business. Thus, according to the dissent, the husband and wife were not owners together of a one-sixth interest; instead, the husband and the wife each owned a one-twelfth interest. The dissent then found, without support from any other state, that the law of partnerships trumps the law of equitable distribution, at least in the context of an interspousal partnership, so that the court lacked authority to deprive the wife of her one-twelfth interest.
The dissent's unusual reasoning was rejected by the supreme court. That court held first that a partnership interest can be held by multiple persons in joint ownership. "[W]e find nothing in the [Uniform Partnership Act] to indicate that the legislature intended to preclude two or more persons, including a married couple, from owning a partnership interest as tenants in common if allowed by the partnership agreement or with the consent of the other partners." Sexton, 125 S.W.3d at 264. The court relied upon Wehrheim v. Brent, 894 S.W.2d 227 (Mo. Ct. App. 1995), which held that the Uniform Partnership Act permits ownership of a single partnership interest by married persons as tenants by the entireties.
The supreme court then held directly that the division of partnerships upon divorce is controlled by the law of equitable distribution and not by the law of partnerships. The law of partnerships determines who holds legal title to a partnership and its property. Under the law of equitable distribution, however, "neither record title nor the form in which it is held, e.g., partnership, corporation, or sole proprietorship, is controlling or determinative." Sexton, 125 S.W.3d at 264. To give controlling weight to partnership law would be to abandon the rule that equitable distribution does not depend upon legal title. Thus, "the trial court properly rejected Appellant's argument that partnership law controlled." Id. at 265.
Turning to the law of equitable distribution, the court faced two alternative arguments made by the wife. First, the wife argued that the husband had not traced Autumn Park to a proper nonmarital source. Second, the wife argued that Autumn Park was marital property because it was jointly titled.
Addressing the first issue, the court first noted that, under longstanding Kentucky law, a single asset often has both marital and nonmarital interests. Other dual-classification equitable distribution states almost uniformly agree. Brett R. Turner, Equitable Distribution of Property 5.08 (2d ed. 1994 & Supp. 2003); see, e.g., Harper v. Harper, 294 Md. 54, 448 A.2d 916 (1982); Hoffmann v. Hoffmann, 676 S.W.2d 817 (Mo. 1984). But see Bullock v. Bullock, 699 So. 2d 1205 (Miss. 1997) (any contribution of marital value converts an entire separate asset into entirely marital property). Because a single asset can have multiple interests, the court had to analyze individually each source from which the husband's interest in Autumn Park was acquired.
The major source of the husband's interest in Autumn Park was his premarital apartment building. That building was acquired before the marriage, so its equity value on the date of the marriage was clearly nonmarital. The mortgage on the building was reduced during the marriage by several payments directly to principal, but the husband was able to show that each of these reductions corresponded with the amount of a gift check written to him by his parents. The mortgage was also reduced by regular payments during the marriage, but those payments were made with undistributed rents from the rental property itself. Sexton, 125 S.W.3d at 261. Since the husband did not improve the property during the marriage, the rents were passive income, and passive income from separate property remains separate under Kentucky law. Ky. Rev. Stat. Ann. 403.190(2)(a) (Westlaw 2003); see also Hinerman v. Hinerman, 194 W. Va. 256, 460 S.E.2d 71 (1995) (mortgage was paid with income from property purchased with separate property down payment; no marital interest resulted). To the extent that the premarital apartment building grew in value, there was no evidence suggesting that the growth resulted from marital funds or marital efforts. The premarital apartment building was therefore nonmarital property at the time it was conveyed to Autumn Park.
When Autumn Park was formed, the remaining mortgage balance on Autumn Park was roughly $69,000. To pay that balance off, so that the full unencumbered building could be conveyed to the partnership, the husband's parents loaned him exactly enough to repay the debt. The husband signed a note, which the parents then forgave over the next few years. The husband and his parents testified, and the trial court found, that the parents intended to make a gift and that the device of a forgiven note was used only for tax purposes.
The wife did not contest that the forgiveness of the loan was a gift. Instead, she argued that the husband's parents made a joint gift to both spouses. The supreme court agreed that a joint gift would be marital property and expressly held that the husband bore the burden of proving that the gift was made to him alone. In determining whether the burden was met, the key point was the intent of the donor. "Clearly, the donor's intent is the primary factor in determining whether a transfer of property is a gift, and we likewise hold that the donor's intent is also the primary factor in determining whether a gift is made jointly to spouses or individually to one spouse." Sexton, 125 S.W.3d at 268-69. "The donor's testimony is highly relevant of the donor's intent; however, the intention of the donor may not only be 'expressed in words, actions, or a combination thereof,' but 'may be inferred from the surrounding facts and circumstances, including the relationship of the parties[,]' as well as 'the conduct of the parties[.]'" Id. at 269 (quoting 38 Am. Jur. 2d Gifts 19 (1999)).
On the facts, the husband and his father both testified that the parents did not intend to make a gift to the wife. Moreover, and most importantly, the father wrote a letter to his attorney at the time Autumn Park was formed, stating that he did not intend to benefit the wife and asking whether the wife would be able to claim part of Autumn Park upon divorce if the husband's interest in Autumn Park was titled jointly. This letter was clear evidence, dating back to the time the note was signed and Autumn Park was formed, showing that the husband's father had no intention to benefit the wife. The trial court found an individual gift on the facts, and the supreme court held that that factual determination was not an abuse of discretion.
After its formation, Autumn Park increased significantly in value. The trial court found on the facts, however, that the increase was caused primarily by the efforts of the husband's father, who clearly controlled Autumn Park. The husband worked for Autumn Park and even drew a salary, but his efforts focused on routine operation and did not result in increased value. The supreme court did not discuss the trial court's findings on the issue of appreciation, but, by affirming the trial court's decision, it accepts the trial court's findings.
Finally, the wife argued that some sort of marital interest arose because the parties guaranteed the corporate debt of Autumn Park. The supreme court seemed to agree that a guarantee could be a marital contribution in a proper case, but it agreed with the trial court that the guarantee at hand was not a significant contribution. The parties were liable only if Autumn Park was unable to pay its own debt, but Autumn Park at all points during the marriage had more debts than assets by a comfortable margin. The lender was not in any material way relying upon the personal incomes or credit of the parties as the source for payments on Autumn Park's mortgage. "Under the circumstances, the cosigning of the mortgage note by the parties was de minimis and did not result in an increase in the marital interest in the parties' partnership interest in Autumn Park." Sexton, 125 S.W.3d at 271-72; accord McLeod v. McLeod, 74 N.C. App. 144, 327 S.E.2d 910, 915 cert. denied, 314 N.C. 331, 333 S.E.2d 488 (1985) ("[W]e reject defendant's contention that her signature guaranteeing the corporation's $225,000 debt of itself created a marital interest").
Standard of Proof
In addressing the tracing issues in Sexton, the court very clearly stated that clear and convincing evidence is the proper standard of proof for rebutting the general presumption that all property acquired during the marriage is marital property. 125 S.W.3d at 268 n.31. This is a major holding of law, as the Kentucky equitable distribution statute is silent on the standard of proof needed to rebut the presumption. Ky. Rev. Stat. Ann. 403.190(3).
Sexton's use of the clear and convincing standard contradicts previous Kentucky Court of Appeals cases holding that the proper burden is a preponderance of the evidence. In particular, in Underwood v. Underwood, 836 S.W.2d 439 (Ky. Ct. App. 1992), the court of appeals stated in a long and analytical footnote that a preponderance of the evidence is the proper standard. While the court quoted language from an earlier case applying a clear and convincing evidence standard, the opinion clearly disagrees with that language. "[W]e believe that requiring 'clear and convincing evidence' to rebut the 'marital property' presumption is improper." Id. at 441 n.1. Underwood was overruled on another issue (division of debts) in Neidlinger v. Neidlinger, 52 S.W.3d 513 (Ky. 2001), but Neidlinger did not address the standard of proof regarding the marital property presumption.
The court of appeals followed Underwood and applied a preponderance standard as recently as 2003:
Several cases state that a party asserting a nonmarital interest in property by gift must present "clear and convincing evidence" to rebut the marital property presumption. The court in Underwood v. Underwood, Ky.App., 836 S.W.2d 439 (1992), provided an extensive discussion critical of imposing this higher standard, suggesting that the proper standard should be by a preponderance of the evidence. Although the court in Travis did not specifically decide this issue, its opinion indicates agreement with the analysis in the Underwood case that the preponderance of the evidence standard is the proper standard of proof necessary to rebut the presumption.
Hunter v. Hunter, 2003 WL 21512254, at *6 n.8 (Ky. Ct. App. 2003) (citing Travis v. Travis, 59 S.W.3d 904 (Ky. 2001)). Hunter is not final as of this writing and cannot be cited as precedential authority. But it shows that the question of standard of proof is not as settled as the Sexton opinion tries to suggest.
Interestingly, Sexton cited Underwood as a case applying the clear and convincing standard. 125 S.W.3d at 268 n.31. That citation is hard to reconcile with Underwood's express statement that use of the clear and convincing standard was "improper." 836 S.W.2d at 441 n.1. The only post-Underwood case cited by Sexton in support of the clear and convincing evidence standard is Brosick v. Brosick, 974 S.W.2d 498 (Ky. Ct. App. 1998), which mentioned the standard only in passing and which did not apply the standard on the facts. In other states where the statute is silent on the standard of proof, the courts have adopted the preponderance standard. See Collins v. Collins, 347 Ark. 240, 61 S.W.3d 818 (2001); Sutliff v. Sutliff, 518 Pa. 378, 543 A.2d 534 (1988).
Given the holdings in Hunter and Underwood, the Sexton court was wrong to view the standard of proof as a settled issue. Moreover, there is no indication that the standard of proof was a contested issue of law in Sexton, so the supreme court's statements regarding that issue are technically dicta. Nevertheless, as a practical matter, Sexton probably indicates that the supreme court would be hostile to application of a lesser standard and that Kentucky will continue to apply the clear and convincing evidence standard in future cases.
Transmutation and Joint Title
The court then turned to the second equitable distribution issue: whether the husband's interest in Autumn Park was marital property because it was jointly titled. The wife argued that all separate assets should become marital property when they are titled jointly. The court characterized her argument as follows:
Appellant is asking this Court to adopt the doctrine of transmutation, which has been described as follows:
[Transmutation] occurs when separate property is treated in such a way as to give evidence of an intention that it become marital property. One method of causing transmutation is to purchase property with separate funds but to take title in joint tenancy. This may also be done by placing separate property in the names of both spouses. The rationale underlying [this doctrine] is that dealing with property in [this] way[ ] creates a rebuttable presumption of a gift to the marital estate. This presumption is based also upon the provision in many marital property statutes that property acquired during the marriage is presumed marital. The presumption can be rebutted by evidence of circumstances or communications clearly indicating an intent that the property remain separate.
Sexton, 125 S.W.3d at 270 (bracketed insertions by the court) (quoting 2 Homer H. Clark Jr., The Law of Domestic Relations in the United States 16.2 at 185 (2d ed. 1987)).
After describing the wife's argument in the above terms, the court dismissed it by emphatically rejecting the doctrine of transmutation:
We decline to adopt the doctrine because it is inconsistent "with Kentucky's property division statute, which makes title irrelevant in determining property's character[,]" with the principles of tracing established by Kentucky case law, and with Kentucky's source of funds rule. We would also note that transmutation through joint title would cause spouses not to trust each other. Rather than placing property in their joint names for estate planning purposes, they would be careful that their nonmarital property remains solely in their individual names and does not transmute into marital property. We recognize that nonmarital property can in effect transmute into marital property when a nonmarital claimant fails to adequately trace his or her nonmarital interest and overcome the marital property presumption, but that is simply a failure of proof and not the situation here. Accordingly, we reject Appellant's contention that Appellee's nonmarital interest in the apartment building transmuted into a marital interest solely because the partnership interest was placed in their joint names.
Sexton, 125 S.W.3d at 271 (footnotes omitted) (quoting L. Graham & J. Keller, Kentucky Practice, Domestic Relations Law 15.14 (2d ed. 1997)).
The above two passages are quoted in full because they are the murkiest portion of the Sexton decision. The court was clearly rejecting the notion that jointly titled assets are necessarily and automatically marital property. But this was not a difficult point; the great majority of all dual-classification equitable distribution jurisdictions agree that jointly titled assets can be marital property in at least some cases. The only clear exception is the District of Columbia, De Liedekerke v. De Liedekerke, 635 A.2d 339 (D.C. 1993), and there the matter is controlled by statute.
Equally clearly, however, separate property can generally become marital property when it is transferred by one spouse into joint title if the transferring spouse intended to make a gift to the marital estate. This rule is literally universal; all dual-classification jurisdictions which have considered the issue recognize the possibility of a gift to the marital estate. Turner, supra, 5.18. When other states use the term "transmutation," they generally define the term to mean the conversion of separate property to marital property based upon the donative intent of the owning spouse, and not the automatic conversion of separate property into marital property based upon joint title alone. Sexton drew its definition of transmutation largely from Clark, but Clark's volume was published in 1987, when the law of transmutation was materially less developed nationwide than it is today.
By setting forth and then rejecting an unduly broad version of the doctrine of transmutation, Sexton confused Kentucky law. It is possible to construe the Sexton decision to reject any theory for converting separate property into marital property during the marriage, even one which is factually based upon the donative intent of the transferring spouse. Such a construction would be highly inconsistent with the general emphasis Sexton placed upon donative intent. Nevertheless, because a narrower doctrine based solely upon the donative intent of the transferring spouse is generally called "transmutation" by so many recent opinions, the Sexton opinion can easily be read to reject any theory which allows an interspousal conveyance to convert separate property into marital property.
The court would have done better to acknowledge the general rule that an interspousal conveyance converts separate property to marital property if the owning spouse intended to make a gift to the marital estate. Such an acknowledgement would not have changed the result in Sexton, as the evidence clearly supported the trial court's finding that the husband and his father lacked donative intent. The letter from the husband's father to his attorney, written at the time Autumn Park was formed, is compelling evidence that no one involved with the transaction had any donative intent toward the wife.
Also left unclear by Sexton is the burden of proof in the context of an interspousal transfer. A majority of jurisdictions adopt a presumption, sometimes a very strong one, that interspousal transfers into joint title are made with donative intent. E.g., Robertson v. Robertson, 593 So. 2d 491 (Fla. 1991); In re Marriage of Johns, 311 Ill. App. 3d 699, 724 N.E.2d 1045 (2000); McLeod v. McLeod, 74 N.C. App. 144, 327 S.E.2d 910 (1985); Larman v. Larman, 991 P.2d 536 (Okla. 1999); Whiting v. Whiting, 183 W. Va. 451, 396 S.E.2d 413 (1990). A very respectable minority does not apply a presumption. E.g., Ohio Rev. Code Ann. 3105.171(H) ("[T]he holding of title to property by one spouse individually or by both spouses in a form of co-ownership does not determine whether the property is marital property or separate property"); Va. Code Ann. 20-107.3(A)(3)(g) ("No presumption of gift shall arise [where] property is conveyed into joint ownership"); Wong v. Wong, 87 Haw. 475, 960 P.2d 145 (Ct. App. 1998); In re Hoffman, 493 N.W.2d 84 (Iowa Ct. App. 1993); Grant v. Zich, 300 Md. 256, 477 A.2d 1163 (1984); Pearson v. Pearson, 761 So. 2d 157 (Miss. 2000); In re Marriage of Engen, 289 Mont. 299, 961 P.2d 738 (1998); Schuman v. Schuman, 265 Neb. 459, 658 N.W.2d 30 (2003). The strength of the minority position has been growing in recent years.
Sexton clearly held that a gift from a third party is presumed to be a joint gift unless proven to be separate. But the interspousal situation is different, for there the issue is not whether an existing gift is joint or individual but, rather, whether a gift exists at all. Sexton did not really address the possibility of an interspousal gift to the marital estate, as distinct from a gift to the marital estate by the husband's father. Its policy comments, however particularly the strong statements that legal title is not controlling, the emphasis upon reasonable estate planning, and the observation that a broad theory of transmutation discourages sharing of separate property are often made by decisions rejecting an interspousal gift presumption.
Sexton probably did not involve an interspousal transfer to begin with, because the decision to title Autumn Park jointly was apparently made by the husband's father, rather than by the husband himself. If the experience of other states is any guide, however, the Kentucky appellate courts are likely to see future cases in which one spouse deliberately titled (or asked a third party to title) separate property in the joint names of both parties. When such a case arises, the transferring spouse is likely to argue that any change in character of the property would constitute "transmutation," a doctrine rejected by the Sexton opinion. The author hopes that future courts considering this argument will note that Sexton defined transmutation to mean only the automatic conversion of separate property into marital property by the mere act of taking joint title. A narrower version of the same doctrine, recognizing a change in character where a spouse transfers separate property into joint title with actual intent to make a gift to the marital estate, with or without a presumption of donative intent, is fully consistent with the Sexton opinion.
To the extent that Sexton saw inconsistency between the source of funds rule and the doctrine of transmutation, the court's concern is not fully shared by other states. "[T]he 'source of funds' rule does not abolish the theory of 'transmutation,' which allows a spouse by agreement, either express or implied, or by gift, to transmute an item of non-marital property into marital property." McAllister v. McAllister, 101 S.W.3d 287, 293 (Mo. Ct. App. 2003). "The law is clear, even in source of funds states, that the owner of separate property is free to give it to the marital estate." Turner, supra, 5.24 at 285. Source of funds states are admittedly divided on the joint title gift presumption; for example, as noted above, the presumption has been rejected in Maryland and Virginia, while it is followed in Missouri and North Carolina. But the general notion that property can be given to the marital estate is accepted by all states following the source of funds rule and was accepted by Sexton in the context of a gift from a third party. There is no logical reason why Kentucky law should not recognize the same notion in the context of an interspousal transfer made with actual donative intent toward the marital estate, even though many modern decisions would call that notion a form of "transmutation."
To some extent, this entire issue may be a battle over labels. North Carolina has rejected the doctrine of transmutation by name, adopting something close to the Kentucky definition, yet it recognizes and indeed presumes that an interspousal conveyance into joint title can be a gift to the marital estate. McLeod. The doctrine of express interspousal gift, as recognized by McLeod, covers mostly the same ground as the doctrine which the McAllister court called transmutation. Thus, there seems to be broad agreement among source of funds states that a separate interest found under the source of funds rule can be voluntarily given away by the owning spouse. The main area of disagreement is whether the label "transmutation" refers to an automatic change of character arising from joint title or commingling alone, or whether it refers to a more limited change of character arising from a transfer made with real donative intent toward the marital estate.
In sum, Sexton was correct to reject an automatic rule that separate property becomes marital property whenever it is jointly titled. Nevertheless, future decisions should not read Sexton to reject the possibility that a deliberate interspousal gift of separate property into joint title, made with the actual intent to benefit the marital estate, constitutes marital property. Such intent was not present on the facts of Sexton, but it will be present in other cases. Whether a gift from either the other spouse or a third party is made with real donative intent toward the marital estate, the property so conveyed should be classified as marital.
Joint Titling Category