This guide will describe the basic distinctions between separate and community property in California and why it matters to prospective clients considering estate planning.
The Basic Distinction Between Separate and Community Property in California
One of the first steps in estate planning for a married couple in California is discerning whether property is community property (meaning that it is owned by the marriage as a unit) or separate property (meaning that it is owned by either spouse alone). The distinction between separate property and community property is that property acquired by either spouse prior to a marriage, or property inherited or gifted to either spouse during the marriage (for example, from parents or other relatives), is considered to be that individual's separate property. Any earnings that come from separate property retain their character as separate property. Everything else is community property: cash, earnings during the marriage, wages, gains from investments of existing community property, assets purchased in the name of the community from community funds, etc. Proceeds from community property retain their character as community property.
Title vs. Character
There's an important distinction we should make between title to an asset and character of an asset: Title to an asset refers to whose name appears on an account or deed as the title to that account. Character of an asset refers to whether that asset belongs to one spouse, the other or the community as a whole. Title and character of an asset might not always be the same. In fact, many family law cases say that title to property is not determinative; in other words, the title can't be used to find out whether an asset is to be treated as separate property or community property in the event of a death or divorce. In Mary's case, these were important distinctions, because if a particular piece of property were to be determined "separate," it would affect their child's rights to the property.
How Character Affects a Couple's Estate Planning
This brings us to the "4-D's." The character of a property is relevant in the case of any of the following: 1. Death 2. Disability of one of the spouses 3. Debtor-creditor claim 4. Divorce Let's break each of these D's down a bit, which we do below.
In the event of death, each spouse has the right to dispose of all of his or her separate property and half of his or her community property by will, trust or a gift made prior to death. If a spouse fails to create a will or a trust, then that spouse's interests are distributed through what's called intestate succession. While this is a somewhat logical law, it is determined, unfortunately, by the legislature, which may or may not establish a plan that reflects the wishes of a particular decedent in the state. In California, the surviving spouse gets all of the community property and a portion of the separate property, depending on how many children there are. The surviving children get the balance of the separate property. When planning for the possibility (or, to be more frank, inevitability) of death, it's relevant to know what the character of all of the underlying property is, because each spouse can only will away what they own and have a right to give. As we said above, the character of property (community versus separate) is not always easy to ascertain, so it can be hard to sort out who has a right to make a will for which property. Prior to thinking about estate planning, it's a good idea to sort out what property is community property and what is separate.
Disability of One of the Spouses
In the event of a disability, California law says that the well spouse can control all of the community property and, in some instances, can also control the separate property of the ill spouse (with court permission). A one-off procedure in California allows the well spouse to go to court and get permission to handle the ill spouse's separate property for a single transaction--for example, a refinance of the couple's residence in order to pay for medical care. This is known as a "3100 Petition," named after the relevant Probate Code section. This is not always what happens, however. An unplanned disability of one spouse can also trigger a full-blown conservatorship, and while the well spouse would be the logical person to be the conservator over the ill spouse's separate property and the estate as a whole, it's not always a given that he or she will be appointed. Probate judges do their best to be predictable, but they are human and sometimes make mistakes. Even if the well spouse is appointed, she now has to report and account to the court for all of the separate assets of the ill spouse, and risk the court appointing a guardian ad litem to represent the interests of the ill spouse in litigation against the well spouse. This can happen even if the couple is very happily married, and it can happen even if there is not a dispute between them! A lawyer can be appointed by the court to create (or invent) a dispute if none exists. We've seen this happen in our practice, and our experience has been that conservatorships are an undesirable outcome in California.
Creditor Claims Against a Debtor Spouse
The general rule in California is that a creditor of one spouse cannot reach the separate property of the nontortfeasor spouse (the non-debtor spouse). However, the creditor can reach all of the community property. Example: Husband Harry crashed his Porsche into a traveling bus of plaintiffs' lawyers on their way from a convention. Several of the occupants of the bus were injured and sued Harry. Harry's insurance covered $250,000 of the claims, but many of the occupants were severely injured, losing years of their earning capacity and suffering disfiguring injuries. All of Harry's and his spouse's community assets were subject to collection by the injured occupants. But his spouse Sally's inherited separate property was unavailable to the occupants and their lawyers because it had not been "transmuted" to community property. If it had become community property through transmutation, it would have been accessible to the injured occupants to compensate them for their injury claims. In the normal course of events, the benefit of community property is that there is an automatic balance between the spouses. They each own half of the community estate. There is no need to make adjustments to maintain the equality of their estates, and if a disability comes up, either spouse is equally in a position to be presumptive manager of the community property, making it less likely to be turned over to a conservatorship. The down side of this is that more community property means slightly less creditor protection for each individual. If you or your spouse is in a very high-risk profession, such as anesthesiology or obstetrics, one mistake could lead to a ten-million-dollar liability, so you might want to consider maintaining larger separate property interests than another couple might.
How Community and Separate Property Are Handled in Divorce
When we talk about divorce, it's important to talk about transmutation. Spouses can agree among themselves to alter the default rule (described in the section above) with a written agreement. That written agreement is called a transmutation. A transmutation agreement might be part of an estate plan if there is a concern about differentiating between what is separate and what is community property. The downside of a transmutation agreement, and especially of transmuting from separate to community property, is that the agreement does not only affect what each spouse is entitled to bequeath in the event of their death, but it will also affect what each spouse will receive in the event of a divorce. You cannot have a transmutation that's conditional upon there being no divorce. There have been a number of California cases where lawyers have purported to try to do this on behalf of their clients. They attempted to make transmutations contingent upon the parties remaining married until one of them died in order to obtain estate planning benefits without divorce detriments. But the family law courts have been pretty unanimous in rejecting the idea that a transmutation for estate planning purposes would not equal a transmutation for all purposes. While from an estate planning perspective it might be beneficial to have community property, it's nevertheless potentially dangerous. In fact, it could be a time bomb in the event of a divorce. There is a possibility of doing a transmutation with a right of reimbursement--for instance, a husband may transmute a substantial amount of wealth to the community instead of to his wife, and reserve for himself the right to be reimbursed for that amount of transfer in the event of divorce. The California Family Code covers this circumstance, but it does not allow for the husband to receive any yield, interest or dividends on that amount transferred, or gain from any proceeds of the amount transferred. It's just a basic right of reimbursement for the exact amount transferred, without any right to subsequent appreciation whatsoever. It's important to note that this is a relatively underutilized law that is not always fail-safe in front of any judge. Example: Husband Harry transmuted $1 million worth of founders' shares in Moo-Com.com stock to community property. After an initial public offering, the shares were worth $11 million. Wife Wanda then filed for divorce. If the "right of reimbursement" was preserved, then the couple would have divided the11 million equally, but Harry would have had a right to be reimbursed (in addition to his half of the 11 million) the amount of his $1 million dollar contribution based on the value of the stock when the transmutation was first accomplished. The cautionary vignette below illustrates this problem: Ann, a wealthy heiress, was married to Andy. As a result of Andy's poor business-management practices, substance-abuse issues and risk-taking behavior, Ann decided to file for divorce. Immediately prior to the divorce, Ann wrote a check to Andy for $3 million, which he promptly cashed and deposited into his own account. Shortly after the divorce, Andy died. His distant relatives--heirs to his inheritance--contended that the 3 million that Ann had given Andy belonged to them as his "heirs at law." Ann contended that the transfer was in fact a loan, and that she had a right to be reimbursed that amount. Ann and Andy had distrusted lawyers their entire lives. For their consensual divorce, they had chosen to use a paralegal service instead. This decision proved costly to Ann. The paralegal service did not address the characterization of the transfer of the $3 million, and did not check the appropriate boxes in the divorce court forms to identify what this $3 million was supposed to be for. As a result, litigation ensued between Ann and Andy's distant relatives, which consumed more than half of the $3 million in attorney's fees. Ann walked away from the case with a nominal settlement at a fraction of the amount she had originally given Andy. This was not a result that either Ann or Andy would have intended, and had they sought competent counsel during their divorce, this result could easily have been avoided. Ann could have solved this issue with a little advance planning: hiring either an estate or family law attorney (or mediator) at the time of the divorce would have resulted in the issue being spotted. Ann could have insisted that Andy sign a promissory note (an IOU) for the loan or given her a written agreement to leave his estate to her in the event he predeceased her. Ann and Andy's distrust of lawyers had the ironic effect of enriching several of them who were engaged to address the dispute that ensued.
Additional resources provided by the author
Nolo Press, California Estate Planning
Bar Association of San Francisco, Lawyer Referral and Information Services
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