Agreements made in contemplation of marriage between intended spouses and between intended spouses and third parties have been variously described as marriage settlements, marriage contracts, premarital contracts, premarital agreements and antenuptial agreements. For ease of reference, this outline will refer to such agreements as premarital agreements.[1]
Under the Uniform Premarital Agreement Act (adopted by California in 1986), a premarital agreement, to be valid, needs to comply with the following requirements: (i) be in writing; (ii) be signed by both parties; (iii) be voluntarily entered into and not otherwise unconscionable or made without required disclosures of property and financial obligations; and (iv) have a lawful object, which may include any of the following matters: (a) the rights and obligations of each of the parties in any of the property of either or both of them, whenever and wherever acquired or located; (b) the right to buy, sell, use, transfer, exchange, abandon, lease, consume, expend, assign, create a security interest in, mortgage, encumber, dispose of, or otherwise manage and control property;
(c) the disposition of property on separation, marital dissolution, death, or the occurrence or nonoccurrence of any other event; (d) the making of a will, trust, or other arrangement to carry out provision of the agreement; (e) the ownership rights in and disposition of the death benefit from a life insurance policy; (f) the choice of law governing the construction of the agreement; and (g) any other matter, including the parties’ personal rights and obligations, not violating public policy or a statute imposing a criminal penalty.[2]
Under no circumstances may a premarital agreement affect the child support rights of a child.[3]
A premarital agreement may be revoked or amended only by a written agreement.[4]
Spouses often seek to set aside a premarital agreement, or argue that the agreement is not enforceable as to them. Generally, for a spouse to set aside a premarital agreement, the spouse must demonstrate undue influence, usually coupled with misrepresentation.[5]
To determine the existence of undue influence, the courts will usually attempt to ascertain the parties’ respective bargaining power. Some of the factors that the courts will consider include: (i) extreme disparities between the parties in age, knowledge, or sophistication;
(ii) substantial differences between the parties in their respective degrees of business expertise; (iii) vulnerability of the party claiming undue influence at the time the agreement was executed due to illness, poverty, pregnancy, or similar circumstances; or
(iv) lack of representation for the party claiming undue influence by independent counsel during the preparation, drafting, and signing of the premarital agreement, especially when the other party was represented.
Previously, premarital agreements that sought to limit spousal support payments on dissolution of marriage were held to be unenforceable, as against public policy (they were sought to promote dissolution of marriage). However, in somewhat recent California Supreme Court case, the Court held that spouses may limit support payments to each other during marriage or on dissolution.[6]
Note: Premarital agreements (as well as the postnuptial agreements discussed below), are legally enforceable documents. That means that in the event of a divorce, the court will respect the division of property agreed to by the spouses in such an agreement. (Thus, the wife may transfer most of her assets to her husband and avoid her creditors, only to find that at some later date her husband files for divorce and gets to keep all assets.)
Consequently, clients must always be warned about this risk when entering into a premarital or a postnuptial agreement. When contemplating entering into such an agreement, specifically a postnuptial agreement, the spouses should carefully consider the strength of their marriage union, and weigh not only the possibility of a divorce, but also the likely division of property on divorce.
As the above summary of the
Clearly, in the context of asset protection planning, one would always want to convert community property to separate. One way of accomplishing that goal is for spouses to transmute their community property into separate. (Transmutation agreements were briefly discussed above, and will be addressed in more detail below.) However, transmutation agreements are subject to the fraudulent transfer laws. In light of that, premarital agreements are a much better way of converting community property into separate.
Example: Fred and Wilma fall in love and decide to get married. Wilma, afraid of losing Fred, forgets to mention to him that she owes a large sum of money to the Bedrock Tax Authority. The couple gets married, and lives off Fred’s earnings, Wilma is a housewife. The Bedrock Tax Authority proceeds to collect the tax liability from Wilma. Wilma considers filing an offer in compromise, but realizes that Fred’s earnings are sufficient to pay off the liability. Because Bedrock is a community property jurisdiction, Fred’s earnings can be used to satisfy Wilma’s tax liability. The spouses considered entering into a transmutation agreement, but realized that in light of an existing tax liability, the transmutation agreement would probably be a fraudulent transfer.
Fred and Wilma should have entered into a premarital agreement. Why?
Parties to a premarital agreement are generally permitted under the Uniform Premarital Agreement Act to waive property rights that they might otherwise acquire in the future as a result of marriage.[7]
Additionally, the California Supreme Court has suggested that a premarital agreement providing that the spouses’ earnings will be their separate property is valid as against subsequent creditors with a right to community funds, provided that no creditor is misled to his or her detriment by the failure of the spouses to inform the creditor that the supposed community assets on which the creditor relied in extending credit are in fact separate assets.[8] See section C. below about recording premarital agreements.
This means, that if Wilma waived her rights to Fred’s earnings by using a premarital agreement, Wilma could have filed an offer in compromise. (Prior to marriage, spouses have no interests in each other’s property, and Wilma’s waiver of future rights is not a transfer for fraudulent transfer purposes. As there is no transfer, there is no fraudulent transfer.)
A waiver of property rights through a premarital agreement will be enforceable only if the spouses understood the nature of the rights they were waiving. That is why it is usually recommended that a detailed inventory of assets be attached to a premarital agreement.
It is important to note that certain rights cannot be waived through a premarital agreement, because such rights can only be waived by spouses. An example is a joint and survivor annuity under ERISA.
To a certain extent, premarital agreements may be also challenged as violating the fraudulent transfer laws. For example, if the premarital agreement not only addresses the property rights upon marriage, but also transfers the separate property of one spouse to the other spouse, without property consideration, such transfer may be deemed as being fraudulent as to the present creditors of a spouse.
It should be also noted that transfer of separate property through a premarital agreement is subject to the gift tax, as the parties are not yet married at that time.
Premarital agreements may be executed and acknowledged or proven like a grant of realty and subsequently recorded in each county in which real property affected by the agreement is located; but acknowledgment, proof, and recordation are not required as such for the agreement to be enforceable.[9] Recording or non-recording of a premarital agreement has the same effect as recording or non-recording of a grant of real property.
An unrecorded instrument is valid between the parties and those third parties who have notice of the instrument.[10] Accordingly, an unrecorded premarital agreement is valid as between the spouses. It may also be valid as to third parties who have actual notice of the terms of the agreement. This appears to be the rule, regardless of whether the subject matter of the agreement is real property, personal property, or a combination of the two.
This means that a premarital agreement entered into for asset protection purposes should be recorded to the extent it concerns real property. If the agreement is not recorded, a creditor dealing with one spouse may assume that all of the spouses’ property acquired during marriage will be available to satisfy the debt. Consequently, the creditor should be put on notice that this is not the case.
Because spouses usually would not want to disclose to the world all of their financial interests and business dealings, practitioners would often record a document known as a Memorandum of Premarital Agreement. The memorandum is a brief summary of the premarital agreement that does not contain the inventory of spouses’ assets, other than real property. The ownership of real property is always a public record.
Some practitioners record the premarital agreement with the full inventory, but deleting the values of the assets. Liabilities never need to be listed.
Even if the creditor was not put on notice as to the fact that there is no community property, or that assets that would ordinarily be community are in fact separate, the creditor can disregard the premarital agreement only if both spouses signed the contract giving rise to the debt. If only one spouse signed, then even if the creditor was not aware of the existence of a premarital agreement, the creditor is precluded from proceeding after the separate property of the non-debtor spouse.
An agreement between spouses after the marriage ceremony and affecting the spouses’ property rights is referred to as a postnuptial agreement. A transmutation agreement is a postnuptial agreement that changes the character of the spouses’ property from community to separate, or vice versa.
Postnuptial agreements are governed primarily by the California Family Code Sections 721, 1500 and 1620. Section 721 provides that postnuptial agreements (as opposed to premarital) are subject to the general rules governing fiduciary relationships that control the actions of person occupying confidential relations with each other.
Section 1500 provides general authority for spouses to alter their property rights by a marital property agreement. Section 1620 states that, except as otherwise provided by law, a husband and wife cannot, by a contract with each other, alter their legal relations except as to property.
As discussed below, postnuptial agreements that are transmutation agreements are subject to certain other statutory provisions.
Many postnuptial agreements have as their purpose the change, or transmutation, of the character of the parties’ property from separate to community, or vice versa. Spouses are free to alter the character of property in this manner, provided that all statutory requirements are met. A transmutation agreement may be used to change the character of property to be acquired in the future, as well as property that the spouses own at the time of the agreement.[11]
The principal limitation on transmutation agreements between spouses is that (i) they must be fair and based on full disclosure of the pertinent facts, and (ii) they must not be a fraudulent transfer of assets.
The following are the major considerations pertaining to transmutation agreements: (i) except for certain interspousal gifts, transmutations of real or personal property are not valid unless made in writing by an express declaration that is made, joined in, consented to, or accepted by the spouse whose interest in the property is adversely affected; (ii) transmutations may be made with or without consideration; (iii) transmutations of real property are not effective with respect to third parties without notice of the transmutation, unless the transmutation is recorded (see, Recording Premarital Agreements, above); (iv) transmutations are subject to the laws governing fraudulent transfers; and (v) a statement in a will of the character of property is not admissible as evidence of a transmutation of the property in any proceeding commenced before the death of the person who made the will.
Transmutation agreements have certain tax implications. For income tax purposes, if spouses file a joint return, then characterization of property as community or separate is irrelevant, as all income is aggregated. However, if spouses file a separate return, then each spouse must report his or her one-half share of community income, and his or her separate income. Because transmutation agreements change the nature of the property (including earnings and other income), they have the greatest income tax impact on separate tax returns.
Transfers of property between spouses are generally nonrecognition events for income tax purposes, as they are always considered to be gifts with basis carryover. There are a couple of exceptions: (i) transfer to a spouse who is a nonresident alien at the time of the transfer; (ii) transfer in trust, to the extent that the sum of the liabilities assumed, plus the liabilities to which the property is subject, exceeds the total adjusted basis of the property; or (iii) transfer in trust, of an installment obligation.[12]
The more important tax aspect of a transmutation agreement is the effect that it has on basis step-up (or step-down) at death.
On a spouse’s death, one-half of the community property belongs to the surviving spouse, and the other half belongs to the decedent.[13] If the property has appreciated in value during the time that it was held, the entire property will receive a stepped-up basis equal to its fair market value on the date of the deceased spouse’s death, if the decedent’s half of the property was included in his or her estate.[14] The surviving spouse will receive a stepped-up basis in his or her half of the property, and will therefore have a smaller gain on disposition of that property.
By comparison, if the spouses had held the property separately in joint tenancy with a right of survivorship, the surviving spouse would automatically receive his or her half of the property by operation of law through the original joint tenancy title, and not through inheritance or any other type of succession after death. Consequently, his or her basis would not be stepped up if the property has appreciated, but instead would remain at the original cost basis.
Thus, while transmutation agreements are generally desirable from an asset protection standpoint, they may have adverse tax consequences, because of the loss of one-half of basis step up. By carefully coordinating the transmutation agreement with the spouses’ will or trust, many of the adverse tax consequences can be minimized or eliminated. For example, if the spouses’ residence is the separate property of the surviving spouse, then while the residence will not receive a step-up in basis, up to $250,000 of gain will be sheltered on the sale of the residence.
It is important to remember that the loss of the basis-step up on one-half of property is important only if it is anticipated that the surviving spouse will be selling his or her separate property. Thus, if the surviving spouse retains her separate assets and sells the property inherited from the decedent (which received a basis step up), no adverse tax consequences will result.
The practitioner should also keep in mind that spouses may enter into a transmutation agreement at any time, during marriage. Accordingly, while the spouses are working or practicing their profession (and they are exposed to risks) they can enter into a transmutation agreement and transfer certain assets to the low-risk spouse. When the spouses retire and risks dissipate, the spouses can enter into another transmutation agreement and convert their separate property back to community, regaining the full step up.
While postnuptial agreements are generally subject to the same notice and recording rules as premarital agreements, the rules for transmutation agreements are slightly different.
A transmutation of real property is not effective with
respect to third parties who are without notice of the transmutation unless the
transmutation instrument is recorded.[15] While recording is not a prerequisite to the
validity of the transmutation as between the spouses, it is a prerequisite in
making the transmutation effective with respect to third parties who are
otherwise without notice. This requirement is consistent with the
fact that transmutations are subject to the laws governing fraudulent
transfers.
When clients are first apprised of the uses of transmutation agreements their first impulse is to transfer all the assets to the low-risk spouse. While this impulse is logical, transmutation agreements are subject to fraudulent transfer laws. This means that when assets are divided between spouses pursuant to a transmutation agreement, the division should be on a somewhat equal basis. Approximately 50% of net fair market value of the assets should go to each spouse.
While this practice minimizes the fraudulent transfer likelihood, now only 50% of the assets are protected, and not 100%. However, the usability of the transmutation agreement can be buttressed by allocating “desirable” assets to the low-risk spouse and the “undesirable” assets to the high-risk spouse. In this context, desirable and undesirable is evaluated from a creditor’s point of view.
Example: Mrs. Curie is a physics professor at Cal Tech, and Mr. Curie is a plastic surgeon. Mr. Curie gets sued by patients on a bi-weekly basis (he is the high-risk spouse) and Mrs. Curie has never been sued and will probably never get sued (she is the low-risk spouse). The assets of the two spouses are: the medical practice valued at $1 million and a house valued at $1 million. How should the transmutation agreement divide these assets?
The transmutation agreement should make the medical practice the separate asset of the husband and the house the separate asset of the wife. From a creditor’s standpoint, the house is a desirable asset (easy to collect against), and the medical practice is an undesirable asset (no value to the creditor other than receivables). Consequently, while the allocation is on a 50-50 basis (each spouse gets an equivalent amount of assets), the asset that is easy to collect against has been moved to the low-risk spouse (where the asset is unreachable by the creditor of the high-risk spouse).
Accordingly, when Mr. Curie is sued again by one of his
patients, the patient can collect only against the medical practice, and not
against the house.
For spouses planning a divorce, the timing of the divorce can be an effective asset protection tool.
In common-law jurisdictions, a creditor can proceed only after the debtor spouse, and only if the debtor spouse has property vested in his or her name. This means that if pursuant to the divorce the debtor spouse will vest in certain assets, divorce should be postponed, if possible. As soon as the assets are vested in the name of the debtor spouse, the creditors of the debtor spouse will be able to reach such assets.
By the same logic, if the debtor spouse is currently vested in certain assets that are desired by the creditor and divorce would vest such assets in the nondebtor spouse, divorce should be accelerated. Pursuant to the divorce the assets will be transferred from the debtor spouse to the nondebtor spouse, and thus outside of the reach of creditors.
In most common law jurisdictions, marital property is divided equitably on divorce, but not necessarily equally. “Equitably” means that the court is allowed to take a host of factors into account in allocating property between the spouses, such as the respective incomes, ages, health and future income potential of the two spouses. This means that if the two spouses are planning to divorce while minimizing their exposure to creditors of either spouse, the spouses should consider both the timing of the divorce and the division of property on divorce. While the division of property should always be undertaken at arm’s-length, certain amount of flexibility is allowed to make the division “equitable.”
In most community property states, the general rule is that community property can be seized to satisfy community debts even after a divorce. This means that once the community incurred a debt, both spouses are liable for that debt, even following a divorce, and even if the liability has been allocated entirely to only one spouse.[16]
However, in
With respect to the separate property of spouses following a
divorce, the allocation and division of liabilities on divorce in
1. Separate property owned by a married person and property received by that person pursuant to the division of property is liable for debts incurred by the person before or during marriage whether the debt is assigned for payment by that person or that person’s spouse.
2. Separate property owned by a married person at the time of the division and other property received by that person is not liable for debts incurred by the person’s spouse before or during marriage and the person is not liable for such debt unless it was assigned to him or her in the division of property.
3. Separate property and other property received by a married person is liable for debts incurred by the person’s spouse before or during marriage and the person is personally liable for the debt if it was assigned for payment by the person pursuant to the division of property.
While a community debt can be assigned to only one spouse
(in
For example, in Britt v. Damson,[19] the spouses divorced and the husband filed for bankruptcy. There was a claim that the property transferred to the wife pursuant to the divorce was fraudulent. The court held that although the division of property was not fraudulent under state law, it could be under the Bankruptcy Code’s fraudulent conveyance provisions. The court stated:
To the extent that the value of the community property ordered to [the wife] was offset by the value of the community property awarded to husband, the ‘transfer’ to [the wife] was, as a matter of law, supported by ‘fair consideration,’ …
To the extent that the award of community property to [the wife] may have exceeded half of the total value of the community property, there is a question whether, under all the circumstances, [the husband] received fair consideration as a matter of law.
The Ninth Circuit thus made it apparent that even on divorce, transfers of property can be scrutinized and tested under the fraudulent transfer laws.
In a more recent case, the California Supreme Court
attempted to harmonize California Family Code Section 2551 and the UFTA.[20] As discussed above, Section 2551 provides
that the property received by a person on divorce is not liable for debt
incurred by the person’s spouse before or during marriage, and the person is
not personally liable for the debt, unless the debt was assigned pursuant to
the divorce to that person. This means
that in
In contrast to Section 2551 is the UFTA which provides that any transfer of property is subject to the laws of fraudulent conveyances.
The California Supreme Court reasoned that the California
Legislature has a general policy of protecting creditors from fraudulent
transfers, including transfers between spouses.
Despite the court’s holding the transfers of property on divorce are subject to the UFTA, challenges under the UFTA are still limited in the context of divorce and leave room for planning opportunities. Under the UFTA, a creditor can allege that the transfer was either actually or constructively fraudulent.
Constructive fraud requires little more than a finding that one of the spouses was left insolvent – a straight forward and objective analysis. However, actual fraud requires a subjective analysis which makes it more difficult for a creditor to prevail in the context of divorce. Courts are most reluctant to delve into the inner thoughts of spouses in an attempt to discern the intentions behind a divorce.
[1] See also, California Family Code Sections 1500 et. seq. (general provisions governing marital agreements), and 1600 et. seq. (Uniform Premarital Agreement Act).
[2] Family Code Section 1612(a).
[3] Family Code Section 1612(b).
[4] Family Code Section 1614.
[5] Prior to marriage, the soon to be spouses do not owe each other fiduciary obligations. The fiduciary obligations of fair dealing and good faith arise only on marriage.
[6] In re
Marriage of Pendleton & Fireman, 24
[7]
[8] In re
Marriage of Dawley, 17
[9]
[10]
[11]
[12] See, Code Section 1041.
[13]
[14] Code Section 1014(b)(6).
[15]
[16] Wikes v. Smith, 465 F. 2d 1142, 1146 (9th Cir. 1972).
[17]
[18]
[19] Britt
v. Damson, 334 F. 2d 896, 902 (9th Cir. 1964), cert. denied, 379
[20] Mejia
v. Reed, 31