Forensic accountants are frequently called upon in divorce actions to trace assets which may or may not be subject to equitable distribution. They frequently assist the client and his or her legal counsel in establishing the burden of proof that the assets are exempt or immune from equitable distribution; in other words, they demonstrate that equitably the assets are entitled to remain the separate property of only one of the parties to the divorce and will not be divided between the parties as would other marital property. On the other side of the coin, the forensic accountant may assist counsel in demonstrating that the separate property has undergone what is called “transmutation.” Even though the property may have been premarital; that is, acquired prior to and brought into the marriage or acquired by inheritance or gift during the marriage, as opposed to marital property which was acquired during the marriage, certain actions or transactions may have occurred which connect or transmute the asset, in equity, to marital property which is then subject to the equitable distribution and division between the divorcing parties.
Property held by a married couple, regardless of whose name the property is titled, will generally be considered marital property subject to equitable distribution. The burden of proof, therefore, lies with the party claiming that the property is still separate property and, therefore, retains its exempt or immune status. Similarly, the party claiming that an asset has undergone transmutation must prove that there have been occurrences or specific actions taken by the titled spouse which demonstrate that the property should no longer be treated as separate property, but equitably as marital property.
The tracing process begins with demonstrating that the property was initially separate property when it was received by gift or inheritance or when it was brought into the marriage. Documents such as gift tax returns, inheritance or estate tax returns or other documents demonstrating acquisition and ownership prior to the marriage are usually appropriate and sufficient to demonstrate this. Failure to show that the property was initially separate, such as in a joint gift titled to only one party, could prove fatal. An example of this might be a gift of a car to newlyweds titled to only one spouse, the intent clearly being a gift to the marriage.
After having established that the specific property was separate property when received or at the date of the marriage, the process then begins to further trace those assets during the entire term of the marriage to overcome any presumption that the property was converted or transmuted into marital property. Certain presumptions may sometimes vary from state to state and should be researched by counsel, if possible or available.
Tracing procedures involve a significant amount of detailed work and a significant amount of specific document analysis. Depending upon the length of the marriage, this documentation may or may not all be readily available or it may no longer be accessible. For example, tracing stocks and bonds or cash which originated as separate property could logically be traced by examining all the related brokerage account statements or bank records from the time of their receipt until the present. Assuming that it would be expected that the brokerage firm or bank in which the asset was originally deposited has changed over time due to acquisitions and mergers, the forensic accountant should still be able to show their unbroken title and ownership over time as the securities went from one bank or brokerage house to another over the years, especially if the original account principal has remained entirely intact. This is also true even if the account generated interest or dividend income and even if sales and purchases of securities occurred within those accounts. If all the earnings and reinvestments remain in the separate account, titled to the original recipient, tracing should be relatively straightforward. Tracing, however, can become somewhat cloudy and more complex and even become subject to a transmutation argument when the separate property is commingled with marital earnings and/or assets or if income or sales proceeds from the separate property is used for marital purposes.
As previously mentioned, specific rules may differ from state to state and it is possible that both parties may take opposing positions with respect to a certain asset. One party may consider the commingled asset as transmuted while the other may consider the separate asset severable from the marital portion because it is traceable. This may be so whether or not title has changed.
If one is involved in this type of forensic analysis for either tracing or transmutation or both, as is sometimes the case, I would suggest reading two interesting and informative articles and looking into one recognized practice aid. The earlier article is entitled “Equitable Remedies in Family Law” by Frank Louis, Esq. printed in a 1990 issue of the New Jersey Family Law Journal. A more recent article is a two-part article entitled “When Title Matters: Transmutation and the Joint Title Gift Presumption” by Laura Morgan and Edward S. Snyder, Esq. published in the Journal of the American Academy of Matrimonial Lawyers, Volume 18, 2003. Both of these articles deal with tracing, transmutation and related equitable remedies in divorce. The recognized practice guide is Practitioners Publishing Company’s Guide to Divorce Engagements, a current and frequently updated two-volume loose-leaf practice manual used by forensic accountants which devotes a major section to acceptable tracing techniques and related forensic analysis.
There are numerous methods used for tracing assets. These methods go well beyond the direct tracing method of tracing a specific asset from one account to another as previously described above because typically there has been some commingling or some other occurrence which obfuscates or clouds its identity.
For example, if a withdrawal of funds takes place from a commingled account, one into which separate and marital earnings are deposited, and these funds are regularly used to maintain a piece of separate rental property and titled to only one spouse, that withdrawal may be assumed to be a withdrawal of separate funds. This would be in inference especially if the withdrawal was equal to or less than the separate (i.e., rental) earnings deposited therein. This approach or method is known as “specific identification.”
In other commingling circumstances, the character of funds withdrawn to pay family or marital living expenses are typically assumed to be marital funds. This is known as the Family Expense Doctrine. A variation of this method is often seen when family living expenses have equaled or exceeded the family or marital earnings. Any funds remaining in that account may be assumed to be separate funds under this doctrine.
Assume Jeffrey deposits $20,000 of inherited cash into a joint checking account with his wife, Dana. Prior to this deposit, the account had a balance of $5,000 which was all marital funds. If Jeffrey and Dana withdraw $10,000 from the account for various expenditures, a forensic accountant could argue that the $15,000 remaining in the account was Jeffrey’s separate property. This is known as the “marital property out first method.” Also, this methodology can be used in combination with the specific identification method described above.
If the balance in a commingled account never falls below the amount of the separate funds originally deposited into an account, the forensic accountant may argue that all of the separate funds still remain in that account. This is known as the “minimum balance method.”
In other situations, certain inferences may be drawn from the surrounding circumstances. For example, if Roy deposits separate inherited funds of $30,000 into a joint checking account or a joint brokerage account and several weeks later he withdraws $30,000 to purchase that sports car that he has always wanted, the forensic accountant would argue the “identical sum inference.” However, if the property newly acquired is titled jointly, there may be an inference of a gift or of transmutation into martial property.
In many of these tracing situations, intent and proof of intent may become the paramount issue. If separate property is removed from a commingled account shortly after it is deposited, one stands a better chance of winning the argument that it is still separate property under the identical sum inference. If a significantly long period of time elapses with the balances dropping and rising significantly over time, it may be more difficult to sustain one’s burden of proof as to the separate nature of any balance.
Some forensic accountants attempt to use a pro-rata approach in situations typically involving reinvestment. For example, if Joe and Jane have $5,000 of marital funds in their joint bank account and Jane deposits into that account $10,000 in cash that she just received as a gift from her parents and then both Joe and Jane invest the entire $15,000 in stock via a transfer to a joint brokerage account, using the pro-rata approach, one could argue that one-third of any balance is a marital asset and two-thirds of the balance belongs to Jane. Of course, you can see that the variations are endless.
In utilizing all of these methods, the forensic accountant should discuss his anticipated use with counsel as certain of these methods may be more acceptable than others in the home state in which you are practicing. Also, the law in some states may provide that titling certain types of property (i.e., real estate) as joint property presumptively transmutes that property into marital property regardless of intent. This may apply in situations where estate planning or convenience is argued for titling property in a certain way when the intent was to retain the identity of the property as separate property.
The last point I wish to make regarding tracing and transmutation is the importance of utilizing schedules, worksheets and timelines in illustrating the tracing and flow of assets and evidence of transmutation. It is most practical, logical and efficient to follow a worksheet set up in a timeline fashion from the date of establishing property as separate (i.e., the date of the marriage or the date the property was inherited or received as a gift) through the date of the complaint or even the date of the divorce.
The various intervening transactions, deposits, sales, and withdrawals, etc., can be indicated on the schedule as they progress throughout the marriage. Each transaction should include dollar amounts and specific dates. Each deposit or withdrawal should be categorized as either marital or separate. Events claimed to be transmuted events should be highlighted. References to attached detail, documents, source material and/or commentaries which support your client’s position should also be included and referenced to the lead schedule or worksheets. Again, each tracing assignment will be different and a good deal of creative thought should be given to the structure of any worksheet or diagram which may ultimately be transferred into a trial exhibit should it become necessary.
Tracing of assets to establish immunity from equitable distribution or transmutation of separate property to marital property can certainly present many challenges to the forensic accountant and the legal community. In many cases, it provides fertile ground for much creativity. However, one must not lose sight of the credibility and equity factors, which are paramount in our family law system.
Laurence G. Thoma, CPA, is an accountant, lawyer, and certified fraud examiner practicing at Withum Smith and Brown in Red Bank, NJ. In his 34-year career, he has served as an instructor at the American Academy of Matrimonial Lawyers and the New Jersey Judicial College.