Active vs. Passive Appreciation

Minnesota’s intermediate court recently clarified the distinction between active appreciation in the value of premarital property, which is considered marital property under Minnesota law, and passive appreciation, which is separate property, in In Re Marriage of Ellingson (2007). The subject business was a custom kitchen cabinetry manufacturer and installer, which the husband began prior to the parties’ marriage. Under relevant case law in Minnesota, active appreciation is defined as increase in value resulting from marital efforts. Conversely, passive appreciation that results from inflation or market forces only is excluded from marital property.

In Ellingson, the appellate court cited to a line of Minnesota cases holding that the retained earnings of businesses over which the spouses lacked controlling interests would be presumptively excluded from marital property as passive appreciation unless there were evidence proving such earnings resulted from marital efforts. Yet, the appellate court distinguished Ellingson from that line of cases, finding that the husband’s management efforts in marketing, purchasing, human resources, location and business strategy were primarily responsible for the increase in value of the business. Also, Husband as 100% shareholder did not lack control over the retention or distribution of earnings.

The report of Husband’s business valuation expert was not admitted at trial, due to late filing. However, it is interesting to note that his expert distinguished the passive appreciation from the active appreciation by looking at the elements of risk in the capitalization rate. Since the capitalization rate contained a six percent company-specific risk premium, husband’s expert deducted that percentage from the company’s overall growth rate, concluding that the difference was equal to the passive appreciation of the company. This methodology was rejected, however, because it was not adequately explained in the expert’s report.

Pennsylvania does not distinguish between active and passive appreciation under statute or case law. This case, however, presents an interesting glimpse at how other states and experts have approached the issue.

No Silver Lining for Divorcing Spouse

In Silver v. Silver, a 2007 decision of the Ohio Court of Appeals, Second Division, the court discussed a business owner’s income for support purposes in conjunction with a business valuation for equitable distribution purposes. The husband was the sole shareholder of a marketing business, which was marital property subject to equitable distribution. Both spouses offered expert reports and testimony as to income and business valuation. While husband’s expert averaged his net income over a period of three years, wife’s expert used his most recent year’s net income, which was greater than the average of the prior three years. The appellate court endorsed the trial court’s finding on this issue, noting that income had been growing constantly throughout the period. Since husband was a sole shareholder but failed to present evidence of capital expenditures, the trial court declined his request to reduce income for capital needs.

This case is consistent with decisions of the Pennsylvania appellate courts, which have held that retained earnings and undistributed income of a business controlled or owned solely by a spouse will be presumed to be income for support purposes unless there is strong evidence of a need for capital expenditures. On the other hand, if the business owner is a minority shareholder, lacking the ability to manipulate income and expenditures, the burden shifts to the non-owner spouse to show that the retention of earnings is not justified.

Valuation of Private Investigation Firm

The Pennsylvania Superior Court’s 2007 decision in Dalrymple v. Kilishek is relatively unremarkable from a valuation perspective. The subject business was a private investigation firm owned by the husband, which was the chief marital asset. Apparently its assets, which were valued at $45,000 as of the date of separation, were mostly or entirely dissipated by the time of trial. Since there were few or no assets left to distribute, the trial court applied the concept of “equitable reimbursement,” requiring Husband to pay Wife 60% of the DOS value of the business in installment payments over time. Additionally, Wife received an award of alimony based upon the gap between her income and her reasonable needs.

The husband argued that the trial court had erred in its valuation of his business, but his argument was deemed waived for failure to cite relevant authority in his brief. The Superior Court also noted that he had not produced business records in discovery, citing confidentiality of his clients’ matters. The Superior Court noted that the records could have been produced in a redacted or summary form. For these reasons, the trial court’s decision was sustained.

One issue that did not arise in this decision is personal vs. enterprise goodwill. A private investigation firm would seem to be a good example of a business whose goodwill is not transferrable. Therefore, a capitalized earnings approach may not have been fruitful in determining the value of the business. This issue was not reached by the Superior Court, however.

PBI Family Law Update 2007 – Support

For those of you who asked for a copy of my PointPoint slides, I am posting them below at the bottom of this page. They are embedded through SlideShare.net, where you can also find my presentations from 2006 Family Law Update (PBI) and 2007 Tax Issues that Family Lawyers Care About (National Constitution Center).