In Part 1, we discussed the general distinction between marital and separate property. Part 2 takes a closer look at the valuation, financial, and forensic issues that can complicate the analysis of marital vs. separate property: tracing assets over time, evaluating commingling or potential transmutation, identifying liabilities, and analyzing changes in value. The relevance and treatment of these issues vary depending on jurisdiction and the applicable legal framework.
Tracing
Tracing is the process of following an asset or funds from an identifiable source through subsequent transfers, transactions or changes. Tracing analyses can provide financial evidence relevant to determining marital vs. separate.
Commingling and Transmutation
The forensic analysis may become more complicated when separate and marital funds are commingled, such as when they are combined in the same account, or when events such as a change in title raise questions about whether property has been transmuted. The definitions and effects of these circumstances vary by jurisdiction. From the forensic accountant’s perspective, a key question is whether the separate and marital components can still be identified and supported by the available financial records, particularly when the timeframe spans many years. A tracing analysis may be limited by unavailable or inaccessible statements, closed accounts, or other gaps in the financial records.
Typically, records relevant to a tracing analysis may include:
Bank and brokerage statements;
Canceled checks and wire transfers;
Closing statements;
Tax returns;
Loan documents and applications; and
Other relevant financial documents.
The financial expert may prepare a chronology of transactions, reconcile transfers between accounts, and identify the source and ultimate use of funds.
Transmutation may present a related issue. Property that began as separate may raise questions about whether its character changed during the marriage through retitling, transfers, or other actions. A financial expert can help identify those changes and review the available evidence. Whether those facts result in a change in the character of the property is a separate determination from the financial analysis.
Liabilities
Liabilities are also an important part of the financial analysis, as the marital estate is not determined by assets alone. Mortgages, lines of credit, business debt, tax obligations, shareholder loans, credit cards, and other liabilities may affect the net value of an asset or the overall marital estate.
The analysis surrounding liabilities may include:
When the liability arose;
What the borrowed funds were used for;
The balances at the relevant valuation date(s); and
Whether the liability is associated with a particular asset.
It is also important to determine whether a liability has already been reflected in the concluded value of another asset, such as a business, so that the liability is not inadvertently counted twice in the marital estate.
Personal and Enterprise Goodwill
For closely held businesses and professional practices, the topic of personal and enterprise goodwill may also be considered as it could impact the division the value to marital and/or separate.
Goodwill generally represents intangible value associated with a business beyond the identifiable tangible and intangible net assets. The analysis of personal vs. enterprise involves consideration of whether that residual value is attributable to the business, an individual, or some combination of the two.
Enterprise goodwill is generally associated with value that can remain with the business and be transferred independently of a particular owner. Personal goodwill, in contrast, is associated more directly with attributes that are unique to and inseparable from an individual. The distinction and allocation may affect the portion of business value included in the marital estate; however, the treatment of personal and enterprise goodwill varies by jurisdiction. We wrote in detail about this topic in a previous article, Personal vs. Enterprise Goodwill: Issues to Consider in Divorce Valuations.
Active and Passive Appreciation
When an asset characterized as separate property increases in value during the marriage, questions may arise not only about the amount of appreciation, but also about which factors caused the increase. Because the treatment of active and passive appreciation varies by jurisdiction, the financial expert should work with counsel to confirm and understand the applicable statutes and case law. Certain states exclude appreciation on separate property, while others may treat some or all of the appreciation during the marriage as marital. While Mercer Capital works nationally and internationally, we defer to counsel for the applicable framework on such complex matters.
If active vs. passive appreciation is relevant in your jurisdiction, active appreciation is generally associated with an increase in value attributable to the efforts or contributions of one or both spouses. Passive appreciation, on the other hand, is generally associated with external factors, such as market or industry conditions or the efforts of individuals other than the spouses. This is a complex analysis requiring specialized knowledge. For a more detailed discussion, see our prior article, article, Active vs. Passive Appreciation of Closely Held Companies.
The same concepts can apply to assets other than businesses. For example, changes in the value of real estate or investment accounts may be a result from personal contributions or improvements, general market appreciation, or a combination of both. Similarly, growth in an investment account may reflect additional contributions, investment returns, or both.
The Expert’s Role
The scope of the financial expert’s analysis will depend on the facts and circumstances of the matter, the jurisdiction, and the assignment. The expert does not provide legal conclusions but instead provides financial analysis to assist counsel and the trier of fact.
Financial, valuation, and forensic considerations often overlap. For example, evaluating a business interest may involve tracing funds invested in or distributed from the business, determining its value, and analyzing the factors that contributed to changes in that value. Similarly, when commingled funds are used to acquire another asset, the analysis may involve tracing the funds through the acquisition and evaluating the asset’s subsequent appreciation.
In Part 3, we will apply these concepts through illustrative examples.