In divorce, Texas law initially presumes that everything owned by either spouse is community property, subject to a just and right division. Community property is divided between the spouses, not necessarily 50/50. Separate property is not divided. One category of separate property is everything owned by a spouse before marriage, and anything that can be traced to an asset owned before marriage. Property acquired during marriage by gift, inheritance, and recovery for bodily injury is also separate. In divorce, Texas law initially presumes that everything owned by either spouse is community property, subject to a just and right division. Community property is divided between the spouses, not necessarily 50/50. Separate property is not divided. One category of separate property is everything owned by a spouse before marriage, and anything that can be traced to an asset owned before marriage. Property acquired during marriage by gift, inheritance, and recovery for bodily injury is also separate.
Income from separate property during marriage is community. For example, a spouse may own rental property before marriage. Natural appreciation in the value of that property remains separate, but rental income is community. If the property is worth $200,000 at the time of marriage, and $250,000 at divorce, the entire $250,000 is separate property. If the property produced rental income during marriage, that is community property.
A business owned before marriage is separate property. Likewise, a business acquired through inheritance, gift, or with compensation for a bodily injury can also be separate. Natural appreciation in the value of the business’ share or stock is also separate. Income from the business during marriage is community property, and can be divided.
A spouse planning a divorce might stop taking income from a separately owned business in a misguided effort to keep it from becoming community property. It is probably already community property retained in the company.
If the company was started during marriage using community funds then it is all community property and this does not apply.
In divorce, determining whether funds in a privately held company should have been taken as earnings can be difficult. The spouse who owns the company will claim it is all separate property. The other might be concerned about ‘retained earnings,’ i.e. money that should have been taken out as community income.
When do reinvested earnings become commingled community property?
1. Are the retained earnings reasonable and required to operate the business?
It is reasonable for a business to retain funds to pay for three to six months of operating expenses. If the business is retaining more than that, a court might find the retained earnings to be excessive, and therefore subject to division in divorce. This varies with industry.
2. Does the business have a history of retaining earnings?
While it’s reasonable for a business to retain earnings and cash for growth and operating expenses, if the company has no history of doing so, recently retained income will be suspicious, and might be divided in divorce. The business’s history is illustrative about whether money is being hidden in anticipation of divorce.
3. Volatility of the Industry
It is reasonable to keep a greater cash cushion in an industry that is susceptible to volatility. All industries experience volatility. Retaining excessive amounts is only appropriate in an industry with exceptional volatility.
4. Small Amount of Customers
If loss of a single customer will significantly affect the company’s revenue, the company will have a history of keeping more cash on hand. This would show that earnings are necessary to operate the business, and not a ruse to hide community income.
5. Does the owning spouse have substantial control of the company’s finances?
This is a major factor. If the owning spouse is a minority stakeholder, and has limited input in asset allocation, a court may consider the retained earnings to be separately owned, and not subject to division. It’s hard to convince business partners to leave their money in a company because one is getting divorced. When the owning spouse is reliant on others to determine whether earnings are paid or retained, the decision to hold cash is likely to be reasonable.
Answering questions about retained earnings causes business disruption. Current and historical business records must be produced for examination by a forensic accountant. Managers, partners, and employees might be subject to deposition. The lawyer for the non-owner spouse will want to know how the company has operated historically, how decisions were made to withdraw cash and whether to retain some. The business will incur expenses producing the records, and will lose productivity while employees are preparing for deposition and being deposed.
Case by Case
Whether retained earnings are community property is a case by case analysis. Given the complexities involved in determining when reinvested earnings become commingled community property, it’s essential to seek help from an experienced divorce attorney.