Active vs. Passive Appreciation
October 29, 2007 | Business Valuation, Court Decisions, Divorce, Legal Perspective
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.