Answers to Winter 2010
California Bar Exam Questions

The Writing Edge

Winter 2010 Bar Question 6

Community Property

Herb and Wendy, residents of California, married in 2001. Herb worked as an accountant. Wendy was an avid coin collector who hoped someday to turn her hobby into a profitable business. Prior to marriage, they had entered into a prenuptial agreement providing that each spouse’s wages would be his or her separate property.

On Wendy’s birthday in 2002, Herb gave Wendy a drawing by a famous artist. Herb paid for the drawing with $15,000 that his parents had given him. Wendy hung the drawing in their bedroom.

In 2003, Wendy opened CoinCo, a shop specializing in rare coins. She capitalized the business with a $10,000 inheritance that she had received when her grandfather died. Wendy worked at the shop alone every day. Customers appreciated her enthusiasm about coin collecting and her ability to obtain special coins at reasonable prices. Over time, Wendy learned that she had acquired a number of highly valuable coins. There was also a renewed interest in coin collecting due to the discovery of several boxes of old coins found buried in the area.

Although Wendy’s services at the shop were worth $40,000 per year, she took an annual salary of $25,000. She also paid $5,000 in household expenses from the business earnings each year.

In 2008, Herb and Wendy separated, and Wendy filed for dissolution of marriage. At that time, CoinCo was worth $150,000, and the drawing was worth $30,000.

In 2009, before trial of the dissolution proceeding, Wendy was disabled by a serious illness and had to be hospitalized. She closed CoinCo while she was in the hospital, and the value of the business fell to $100,000 by the time of trial. Her hospital bill was not covered by health insurance.

In the dissolution proceeding, Wendy claims that the prenuptial agreement is valid and Herb claims that it is not.

What are Herb’s and Wendy’s respective rights and liabilities in:

1. The drawing? Discuss.

2. CoinCo? Discuss.

3. The hospital bill? Discuss.

Answer according to California law.

All questions © 2010 California State Bar Exam. All rights reserved

Community Property
Question 6, Winter 2010

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Community Property
Question 6, Winter 2010

Prenuptial agreement. A prenuptial agreement to changes the character of certain assets from their treatment under community property law. Prenups are valid so long as they are in writing, are entered into before marriage and are not
procured by duress or coercion. Here, H and W agreed before they married to treat their wages as separate property. There is no evidence of duress or coercion. So long as the agreement is in writing it is valid.

However, the foundational principle of community property is a duty of support. This includes treating all property acquired during marriage as community property, especially earnings during marriage. The prenup here is a departure from these principles, so the courts will probably read the agreement narrowly so that only true wages are exempted from community property treatment.

1. Drawing
The character of property follows source. Here, the source of funds for the drawing was money from H’s parents.

Property acquired during marriage is generally community property, unless it is a gift or a bequest. Here, H’s parents gave him $15,000. Parents are likely to give their children gifts. There is no indication H did an work to earn the payment.
Therefore, it is likely the $15,000 was a gift.

H used the $15,000 gift to buy the drawing, so the drawing is probably H’s separate property.

Transmutation
The character of property may be transmuted by one or both spouses during marriage. Generally, a writing is required to change the character of property, unless the property is a personal gift of relatively minor economic value, in comparison to the community’s entire assets.

Here, H gave the drawing to W for her birthday. On one hand, H gave it to W on an occasion where gifts are usually given, her birthday. That argues in favor of transmutation. On the other hand, a drawing is not a personal item in the same way jewelry or clothing is. Both members of the community can enjoy a drawing, do it may not be personal. Further, W hung the drawing in the bedroom, a room that is undoubtedly community space. The drawing is expensive at $15,000, but this may not be disproportionate to the value of the community assets as a whole, when considering that H is employed as an accountant.

Conclusion: It cannot be said with certainty that the drawing was transmuted. If it was, it is W’s SP. If it is not transmuted, it retains its original character, H’s SP.

Effect of prenup on character: Since the source of funds for the drawing was a gift, the prenup, covering only wages, has no effect on the character.

Conclusion: If giving the drawing to W successfully transmuted it, it is W’s SP. If it did not transmute, it remains H’s SP. Since the source is not wages, the prenup has no effect.

2. Coinco
Character follows source.

Bequests.
Bequests are the separate property of the spouse, regardless of when received. Here, W received a bequest from her grandfather. Therefore the $10,000 bequest is W’s SP.

CP share of SP business appreciation
When SP funds a business that the spouse works in during marriage, it is a SP business. While profits from SP are SP, some portion of the appreciation from a spouse’s labor in the business is a CP asset.

The community is entitled to a portion of the appreciation of a SP business. There are two possible formulae:

Van Camp.
When the nature of the economy or the nature of the asset itself is the primary reason for the appreciation in the business, the community receives a reasonable salary that the spouse would receive if working for a third party and the remainder is attributable to the SP. Here, the coin business experienced a resurgence when valuable coins were discovered buried in the neighborhood. Arguably, the Van Camp formula would apply.

If Van Camp applies, the community receives a reasonable salary, similar to the amount it would receive if the spouse were an employee.  All the rest is attributable to the SP investment and is awarded as SP.

Under Van Camp, the CP share is fixed and the SP share is reduced or eliminated according to what remains. So if there is not enough appreciation to satisfy both shares, the CP share is paid out first.

Here, if Van Camp is the appropriate formula, the CP would receive a reasonable salary paid by private industry for W’s services, of $40,000 a year. The business operated for five years. So the CP is entitled to $200,000. The appreciation at the time of property settlement is $100,000. Therefore, the CP would be awarded the entire value and the SP would receive nothing.

Deduction for W’s wages and CP expenses. Under Van Camp, all deductions from profits for salary and payment of CP expenses are deducted from the CP share. Here, W paid herself $25,000 a year and paid CP expenses of $5,000 a year for five years. The total profits deducted from the business are $150,000. Since the CP is entitled to $200,000 minus $150,000, the CP will be awarded $50,000. W will be awarded $50,000 as her SP.

Effect of prenup. W deducted $125,000 as salary, which, under the prenup is her SP. This sum would not be deducted from the CP share. Only W’s withdrawals for the community expenses, of $5,000 per year, totaling $25,000, would be deducted from the CP share of $200,000. Deducting $25,000 from $200,000, the CP should be awarded $175,000. The business is only worth $100,000 at the time of the property settlement agreement, so W could be ordered to reimburse the CP the difference of $75,000.

Pereira
When the skills, talents, or efforts of the spouse working in the business are the primary reason for the appreciation in value, then the SP receives the original investment and a reasonable return on investment of 10%. The remainder is CP.
Under Pereira, the SP share is fixed and the CP share is reduced or eliminated entirely depending on what remains. Here, W’s original capital was $10,000. Figuring a reasonable rate of return at 10% per year for five years, the return on the original investment is $5,000, for a total due to W’s SP of $15,000. W will be awarded $15,000 and the remaining $85,000 will be awarded to the CP.

Deductions for CP expenses. After the SP is awarded the capital plus return, all the rest is CP. Here, W already prepaid the CP $25,000 in community expenses. Since this is money that would be awarded to the CP on dissolution in any case, there will not be an adjustment for these deductions.

Deductions for salary. Salary is normally treated as CP. Here, W withdrew $125,000 as salary, or CP. The CP was only entitled to $85,000 but W gave it $125,000. Since she voluntarily labeled this as “salary” which is CP, W gave a gift to the CP of excess over $85,000, or a gift of $40,000 to the CP which W will not be able to recover.

A court would interpret W’s labeling of the funds as salary as a transmutation. The general requirement that a transmutation be in writing does not apply in the context of property division of separate property businesses.

Effect of prenup. Under the prenup, W’s withdrawal of $125,000 as salary was W’s SP. But under the Pereira calculus, the SP is only entitled to capital plus return, or $15,000; the remainder is CP. Therefore, the court may order W to reimburse the CP the $125,000 she withdrew, making the CP share $85,000 plus $125,000.

Which formula applies. The only argument for Van Camp is that the discovery of coins in a garage sale stimulated interest in coin collecting. Therefore the appreciation may be attributable to the nature of the business.

However, there are stronger arguments in favor of applying Pereira. Wendy worked in the business every day. She was the only employee. Customers appreciated her enthusiasm and her ability to obtain special coins at reasonable prices. A court would probably give more weight to W’s skills, efforts talents in growing the business, and apply the Pereira formula.

Conclusion: Pereira applies and under its traditional application, W would receive $15,000 and CP would receive the remaining $85,000.

Prenup complication. But if the prenup applies W could be ordered to reimburse the CP the $125,000 she withdrew as her “separate property.” The court could avoid this harsh result in one of two ways.

Court’s avoidance the prenup.
First, the court could narrowly construe the prenup to include only actual wages paid by an employer. In that case, even though W labeled her withdrawals “salary,” the court would not give the prenup effect to treat the withdrawals as separate property. Since one of the most basic precepts of community property is that earnings during marriage are community property and the prenup upsets this basic rule, a court may be justified in such a narrow construction.

Second, the court could consider the hardship on W, in light of her serious illness. If W is unlikely to recover enough to resume earning a livelihood, she has no source of funds with which to reimburse the community. A court would be unlikely to consider equity if there was any indication that the decrease in the value of the business from $150,000 when W filed for dissolution do $100,000 at the time of property settlement was a willful dissipation of the asset. However, in light of W’s hospitalization during this period and the fact that she had to close the business since she was the sole proprietor, a court is not likely to find willful dissipation and may reduce or forgive W’s need to reimburse the community.

Conclusion. Since W’s skills, efforts, talents resulted in the separate property business’ appreciation, the Pereira apportionment will apply. Under traditional Pereira rules, the salary W took out of the business would be deducted from the CP share. In that case the CP would be awarded $50,000 and W would be awarded $50,000.  A court may reach this result by narrowly construing the prenup’s agreement on “wages” as not applying to appreciation from separate property businesses. Alternatively, the court may find that application of the prenup to require that W must reimburse the CP $125,000 of separate property “wages” operates as a hardship in light of her serious illness and may reduce or eliminate the reimbursement requirement.

3. W’s medical bills.
Debts acquired after the community ends are the SP of the debtor spouse. The community ends at permanent separation with no intent to resume the community. Here, W and H separated and filed for dissolution. Therefore, the community ended in 1998, before the medical debt was acquired. Therefore the medical debt is W’s SP.

Duty of support. However, The central tenet of community property law is the duty of support. A spouse has a duty to pay for the medical care of his spouse even after permanent separation all the way to final dissolution.

Both the CP and the non-ailing spouse’s SP are liable to medical creditors. We are not told the CP’s assets or Hs assets, but one of these two sources paid W’s medical bills. Either source is entitled to reimbursement if the debtor spouse had assets to pay the medical bills at the time the bills came due.

Here, it appears that W’s only asset is Coinco. She closed but did not sell Coinco when she was hospitalized, so she had not cash on hand, Therefore, W has no source of funds with which to pay the medical bills, and neither the CP nor H’s SP (whichever paid W’s bills) will be reimbursed.

Effect of prenup on duty of support. The SP of the other spouse is liable to pay medical necessaries, along with the CP. Therefore, treatment of wages as SP would not affect the duty of support. The prenup would likewise not be void as in conflict with the duty of support.

Conclusion: Because W incurred medical expenses after permanent separation but before a property settlement agreement was reached, H still has a duty of support toward W to pay medical necessaries. Both the CP and H’s SP are liable to pay these bills under the duty of support, which lasts until final property settlement agreement. If W had a source of funds to pay these bills when they became due, the CP or H’s SP is entitled to reimbursement. However, W had closed but not sold Coinco, so she did not have her own money to pay these medical bills. Therefore, the CP or H’s SP (whichever was used to pay W’s medical expenses) would be liable to pay W’s medical bills and would not be entitled to reimbursement.

Answers © 2010 Vivian Dempsey, The Writing Edge™ All rights reserved.

© 2010 Vivian Dempsey The Writing Edge™
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