Deferred Compensation & Divorce: Premarital Assets, Post-Marital Valuation | PART THREE

In this third installment in our series about the treatment of deferred compensation in Tennessee divorce, we continue working through the various challenges these assets pose to courts, attorneys, and their clients.

Part One was an overview of various retirement plans and fringe benefits falling within the scope of deferred compensation. Included were select provisions of the Internal Revenue Code (IRC) on federal tax law. With Part Two, we looked to decided cases for clues on how to properly classify deferred compensation and any appreciation thereon as either marital or separate property.

One Tennessee Supreme Court case stands out in its construction of T.C.A. § 36-4-121(b)(1)(B)’s “first clause” and “second clause” – that is, Langschmidt v. Langschmidt, 81 S.W.3d 741 (Tenn. 2002). Picking up in 2002 where we left off, here’s how the Tennessee Court of Appeals sensibly applied Langschmidt to two groups of premarital IRAs.

Classifying Premarital IRAs and Appreciation in Tennessee Divorce,

Smith v. Smith

Classifying premarital IRAs and appreciation in Tennessee divorce.

The Smiths’ marriage lasted about 13 years. Each had two children from a previous marriage. Smith v. Smith, 93 S.W.3d 871 (Tenn. Ct. App. 2002). At the time of the wedding, Dr. Smith was a 51-year-old physician with a lucrative medical practice earning as much as $500,000.00 annually. Mrs. Smith was a 38-year-old nurse earning about $25,000.00 annually. Shortly after they married she gave up nursing, taking on the responsibilities of homemaking and running a nonprofit shelter for cats. The feline rescue was indeed a not-for-profit operation costing the spouses $50,000.00 to $60,000.00 a year to operate.

Marital Component of Appreciation on Premarital IRAs

Dr. Smith had six premarital IRAs. Only two IRAs were funded during the marriage (the aggregate value was $177,500.00 at marriage; and $385,000.00 at divorce). The remaining four IRAs were not funded during the marriage (the aggregate value was $650,000.00 at marriage; and $2,276,673.00 at divorce).

An issue raised on appeal was whether the trial court erred in classifying the IRAs’ aggregate appreciation as divisible marital property. Dr. Smith argued the trial court “should only have classified any marital funds that were contributed to the accounts and their corresponding appreciation as marital property.” The Court of Appeals agreed with him.

Because a premarital retirement fund exists at the time of divorce does not make it “deferred compensation during the marriage” within the second clause of T.C.A. § 36-4-121(b)(1)(B). The trial court erred in classifying as marital assets the aggregate appreciation accrued on all six IRAs; and then erred in awarding Mrs. Smith 45% of that aggregate appreciation. First, the trial court should have traced marital appreciation to actual marital contributions and, second, divided the traced portion and distributed it equitably as marital deferred compensation.

Reversing the trial court’s ruling, the appeals court held the four premarital IRAs funded only before the marriage were the doctor’s separate property. Separate property includes “[a]ll real and personal property owned by a spouse before marriage.” T.C.A. § 36-4-121(b)(2)(A). Appreciation on those premarital IRAs was “due to market factors and the compounding of interest earned on the investments,” per doctor’s accountant who testified at trial. Mrs. Smith failed to prove a Langschmidt nexus between her contributions to their marriage and appreciation on husband’s separate IRAs.

On the two premarital IRAs funded for 10 years during the marriage, the appeals court again held the portion funded before marriage was the doctor’s separate property. That appreciation thereon was due to market forces and compounded interest. And again, Mrs. Smith failed to carry the burden of proving substantial contribution or Langschmidt nexus. The analysis continued.

Next, it must be determined whether transmutation or commingling transformed separate IRAs into marital ones. Reviewing the record below, the appeals court found neither transmutation nor commingling. (On the latter, doctor’s accountant testified as to how those assets were segregated from marital ones.) The case was remanded to determine the value attributable to Dr. Smith’s pre-marriage deposits to the two IRAs with the “remaining value … properly classified as marital property, subject to equitable distribution.” Tracing would be necessary.

Transmutation or Commingling

Was the separate premarital IRA transformed into a marital asset through commingling or transmutation? As stated in Smith, the doctrine of commingling recognizes how “separate property becomes marital property if inextricably mingled with marital property or with separate property of the other spouse.” The doctrine of transmutation recognizes the creation of marital property “when separate property is treated in such a way as to give evidence of an intention that it become marital property.” When an asset is classified as separate property, a spouse may allege and prove transmutation or commingling. (After the 2015 statutory amendment, as you’ll see, not with regard to appreciation on premarital deferred compensation!)

Separate property becomes marital property if inextricably mingled with marital property or with separate property of the other spouse.

A 2009 Tennessee Supreme Court case took appreciation of deferred compensation in yet another direction. At least until the Assembly settled the foray in 2015. A reminder of why one should consult an experienced family law attorney who stays abreast of trends in divorce law and is current on proposed domestic relations bills circulating through the state Assembly.

Premarital 401(k) Plans Contributed to During the Marriage,

Snodgrass v. Snodgrass

In this case of first impression, the Tennessee Supreme Court attempted to clarify and distinguish its decision in Langschmidt. Once salaried employees with Alcoa, Mr. and Mrs. Snodgrass were married for about 23 years. Snodgrass v. Snodgrass, 295 S.W.3d 240 (Tenn. 2009). Both participated in employer-provided 401(k) plans. Before their wedding day, his 401(k) was valued at $54,000.00; hers was valued at $17,000.00. The spouses stipulated that an equitable division of their marital property would be an equal one. Retired when they divorced, his 401(k) was valued at $2,301,000.00; hers at $691,000.00.

What was the marital component of the 401(k)s? The trial court awarded each spouse the premarital balance of his and her 401(k) as separate property. It classified all gains accrued during the marriage as marital property and divided it as marital deferred compensation (departing from Smith). Mr. Snodgrass appealed.

The Court of Appeals held the trial court erred in ruling that all marital growth on the plans was divisible marital deferred compensation (in keeping with Smith). The Supreme Court affirmed the trial court and reversed the appeals court, holding the account values at the time of the wedding were separate property. Net gains on both 401(k)s during the marriage were marital property.

The Supreme Court honed in on the first and second clause of T.C.A. § 36-4-121(b)(1)(B). The Snodgrass analysis went something like this: Was a fringe benefit, stock option, pension, or retirement plan related to employment during the marriage? If “No” as in Langschmidt (IRAs funded in individual capacity entirely with premarital funds before the marriage), then apply the first clause. If “Yes” as in Snodgrass (employer-employee 401(k)s funded before and after marriage), then apply the second clause to all post-marital gains. When funded during the marriage through employment, the net increased value of the 401(k) that accrued during the marriage is marital property. The statute at that time did not distinguish between value added passively and value added by direct or indirect additional contributions during the marriage.

Here’s how the Tennessee Supreme Court summed it up:

“We clarify today that 401(k) accounts held through a spouse’s employer are ‘retirement or other fringe benefit rights relating to employment.’ Accordingly, net gains from any source accruing in such accounts during a marriage are all marital property within the meaning of the second clause of § 36-4-121(b)(1)(B), and it is not necessary to consider the relative contributions of the parties to the increase in value. Also, we agree with the parties that the balances that existed in each of their 401(k) accounts as of the date of their marriage remain their separate property.”

Painting facts with a broad legal brush seldom bodes well.

Reflect on the earlier Smith decision for a moment. If Dr. Smith’s two IRAs funded for 10 years during the marriage were determined, as in Snodgrass, to be the result of employment during the marriage under the second clause of the statute, then all increased value of those IRAs accrued during the marriage would have been marital property.

An important difference between Snodgrass and Langschmidt was the premarital IRAs in the latter were funded entirely before the marriage. They were not deferred compensation within the second clause of T.C.A. § 36-4-121(b)(2)(B) because they were not fringe benefit rights relating to employment during the marriage.

In Snodgrass, the increased value of the respective 401(k)s accrued during the marriage was held to be divisible marital property. Simple solution? Yes. Any problem with that? Yes. Both 401(k)s were partially funded before the marriage. Had Snodgrass followed Langschmidt and Smith, marital appreciation on premarital 401(k)s would have been traced to actual marital contributions before being equitably distributed. Appreciation traced to that portion of the 401(k) funded before the marriage (traced to premarital contributions) would have remained the owning spouse’s separate property.

Confusing? Jump ahead several years. A statutory amendment effective July 1, 2015, essentially overturned Snodgrass, putting the law back on its former Langschmidt path. All is well again. Or is it?

Snodgrass Overturned Legislatively – Appreciation Rule on Deferred Compensation

What is a reasonable method of accounting when determining amounts of separate vs. marital property?

This is the rule under the amended T.C.A. § 36-4-121(b)(1)(B): Separate property includes any “account balance, accrued benefit, or other value of vested and unvested pension benefits, … stock options rights, retirement, and other fringe benefits” that accrued before the marriage along with any “appreciation of value” on that benefit. The exception being if each spouse substantially contributed to the retirement’s or fringe benefit’s preservation and appreciation during the marriage (rendering appreciation a divisible marital asset).

First, when additional contributions are made during the marriage to a premarital deferred compensation plan, the pre-marriage portion remains separate with separate appreciation traced back to it. Second, commingling and transmutation do not transform premarital deferred compensation into marital property.

This is the full text of T.C.A. § 36-4-121(b)(1)(B)(iii) as amended in 2015:

(iii)  The account balance, accrued benefit, or other value of vested and unvested pension benefits, vested and unvested stock option rights, retirement, and other fringe benefits accrued as a result of employment prior to the marriage, together with the appreciation of the value, shall be “separate property.” In determining appreciation for purposes of this subdivision (b)(1)(B)(iii), the court shall utilize any reasonable method of accounting to attribute postmarital appreciation to the value of the premarital benefits, even though contributions have been made to the account or accounts during the marriage, and even though the contributions have appreciated in value during the marriage; provided, however, the contributions made during the marriage, if made as a result of employment during the marriage and the appreciation attributable to these contributions, would be “marital property.” When determining appreciation pursuant to this subdivision (b)(1)(B)(iii), the concepts of commingling and transmutation shall not apply;

[Emphasis added.]

What is a reasonable method of accounting? While it settled the conflicting analysis of Snodgrass, the amended statute opened another can of worms. By not dictating the exact method of calculation to be used, the courts are left to determine the appropriate amount by “utilizing any reasonable method of accounting to attribute postmarital appreciation to the value of premarital benefits.” In many cases, this could lead to a battle of forensic accountants over what accounting method is reasonable in the case. The saga continues with Part Four.

References, Resources and More:

• Tennessee Child Custody Laws
• Tennessee Child Custody Laws in Divorce – Answers to FAQs
• Top 7 Tennessee Custody Divorce Strategies | How To Win Custody in a Tennessee Divorce
• Child Custody – Tennessee Family Law Blog for updates, analysis, commentary & case law summaries
• Tennessee Parenting Plans and Child Support Worksheets: Building a Constructive Future for Your Family