423
PLANNER BEWARE: A PECULIAR EXCEPTION
TO
TEXAS COMMUNITY PROPERTY RULES
by
Nikki L. Laing
*
I. INTRODUCTION ................................................................................... 423
II. COMMUNITY PROPERTY VS. SEPARATE PROPERTY ............................ 424
A. General Rule ................................................................................ 424
B. Income from Separate Property ................................................... 425
C. Appreciation of Separate Property ............................................... 425
D. Mutations of Separate Property ................................................... 426
III. TREATMENT OF SEPARATE-PROPERTY STOCK ................................... 427
A. Application of the “Mule Rule” to Stock Held as Separate
Property ....................................................................................... 427
B. Distributions to Stockholders ....................................................... 427
1. Complete Liquidation of Corporation .................................... 428
2. Partial Liquidation of Corporation’s Assets .......................... 428
IV. TREATMENT OF SEPARATE-PROPERTY PARTNERSHIP INTEREST ....... 429
A. Application of the “Mule Rule” to Partnership Interest Held
as Separate Property .................................................................... 429
B. Distributions to Partners .............................................................. 429
1. Buyout of Withdrawn Partner’s Interest ................................ 430
2. Non-liquidating Distribution of Partnership Property........... 430
3. Distribution of Accumulated Partnership Profits—Timing
Is Everything! ......................................................................... 433
V. CONCLUSION ...................................................................................... 434
I. INTRODUCTION
So, you think you know Texas community property law? How about a
quick illustration to
test your knowledge of the basic rules? Suppose you
invested in ten city lots before you married
your spouse. Under Texas
community property law, the lots would be characterized as your separate
property because they were acquired prior to marriage.
1
During your
marriage, you decide
to sell one of the ten lots and invest the proceeds in a
different asset, such as rural real estate.
According to Texas community
property law, the cash you receive from the sale of your city lot is
your
* Attorney, Certified Public Accountant, Capshaw Green, PLLC; J.D., Baylor Law School; B.B.A.
Accounting, Baylor University.
1
. See infra Part II.A.
424 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 8:423
separate property, including any portion of the proceeds which represents an
increase in the
lot’s value that occurred during your marriage.
2
The same set of principles would apply if you decided to extract capital
from an entity that is
your separate property and invest the extracted capital in
a different asset—right?
3
Not necessarily!
4
Texas courts have held that
a return of investment from a separate-property partnership interest is
community property.
5
This peculiar departure from traditional Texas
community property rules, as
well as other alarming exceptions discussed in
this article, requires careful planning by investors and business owners and
their advisors.
6
Estate, business, and asset protection planners alike should be aware
of the exceptions and
inconsistencies that exist in the treatment of
partnership interests.
7
Whether a client is considering
investing separate
property in a partnership, making a distribution from a partnership, or giving
a
partnership interest to a child with the expectation that it will remain the
child’s separate property, the advisor should warn the client of the risks
involved.
8
This article examines some curious deviations
from traditional
Texas community property rules that exist and discusses why these rules
should
apply consistently to partnership interests held as separate property.
9
II. COMMUNITY PROPERTY VS. SEPARATE PROPERTY
A. General Rule
The following provides a brief review of some fundamental principles
of Texas community property law.
10
In
Texas, all of a spouse’s real and
personal property owned or claimed before marriage or
acquired during
marriage by gift, devise, or descent is the separate property of that spouse.
11
Generally, all
other property owned by either spouse is community property.
12
Texas courts have held that “[t]he character of property as separate or
community is determined at the time of inception of
title.
Inception of title
2
. See infra Part II.D.
3
. See infra Part II.D.
4
. See infra Parts II–III.
5
. See infra Part IV.B.2.
6
. See infra Parts III–IV.
7
. See infra Part IV.
8
. See infra Parts III–IV.
9
. See infra Parts III–IV. This article pertains to interests in legitimate, properly operated
partnerships validly formed under state law. This article does not address issues such as fraud on the
community and alter-ego theory. See Zisblatt v. Zisblatt, 693 S.W.2d 944, 946 (Tex. App.—Fort Worth
1985, writ dism’d); Young v. Young, 168 S.W.3d 276, 280 (Tex. App.—Dallas 2005, no pet.) (affirming
trial court’s judgment that husband’s corporation was alter ego for purposes of equitable estoppel).
10
. See discussion infra notes 11–15 and accompanying text.
11
. See TEX. CONST. art. XVI, § 15; TEX. FAM. CODE ANN. § 3.001 (West 2015).
12
. See FAM. § 3.002.
2016] A PECULIAR EXCEPTION TO TEXAS COMMUNITY PROPERTY RULES 425
occurs when a party first has a right of claim to the property by virtue of
which
title is finally vested.”
13
If inception of title occurs before marriage, the
law generally classifies the subject property as separate property.
14
B. Income from Separate Property
All property other than property obtained before marriage or acquired
by gift, devise, or
descent is community property.
15
This includes
“personal earnings” and “revenue from separate
property” received during
marriage.
16
Therefore, Texas law generally classifies income derived from a
spouse’s separate property as community property.
17
However, as discussed
later, the
timing of distributions of partnership earnings to a spouse who owns
his or her partnership interest
as separate property plays a huge role in the
characterization of those distributions.
18
C. Appreciation of Separate Property
Once it has been established that asset A is separate property, what
happens if the value of
asset A increases during the owner’s marriage?
19
Does asset A retain its separate character in its entirety?
20
What is the
character of the increase in the value of asset A that occurred during the
marriage?
Texas case law provides that separate property that appreciates in
value remains entirely separate
property, as to both its original value and the
increase in value.
21
This principle is sometimes referred to as the “mule rule”
due to the subject matter of its seminal case.
22
In contrast to the mule rule,
which stands for the premise that the appreciation in value of separate
property remains separate
property, the “crop rule” represents the principle
that in Texas, the income or “fruits” from separate
property is community
property.
23
Often, the determining factor in characterization issues is whether an
entity’s increase in value is viewed
as being the result of “income” that was
13
. Wierzchula v. Wierzchula, 623 S.W.2d 730, 731–32 (Tex. Civ. App.—Houston [1st Dist.]
1981, no writ) (citing Strong v. Garrett, 224 S.W.2d 471 (Tex. 1949)).
14
. Id. at 732.
15
. FAM. § 3.001.
16
. Id. § 3.102. The terms “personal property” and “revenue from separate property” are not defined
in the Family Code. See id.
17
. See id.
18
. See infra Part IV.B.3.
19
. See infra Part II.C.
20
. See infra Part II.
21
. See Stringfellow v. Sorrell, 18 S.W. 689, 689 (Tex. 1891).
22
. See id.
23
. See De Blane v. Hugh Lynch & Co., 23 Tex. 25, 29 (1859).
426 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 8:423
allowed to accrue in an entity or “appreciation”
of the entity itself.
24
As
discussed below, a problem facing owners of separate-property partnership
interests is the blurred line between income from the partnership and
appreciation of the partnership.
25
What is the distinction between income and
appreciation when an entity’s increase in value is the result of undistributed
profits that have been reinvested in the entity?
26
D. Mutations of Separate Property
Returning to our example, what happens if the owner sells asset A for
cash?
27
What is the
character of the cash?
28
Or, what if the owner trades
asset A for asset B?
29
What is the character of
asset B?
30
Under the traceable
mutation rule, “separate property [retains] its character through a series of
exchanges so long as the party asserting separate ownership can overcome the
presumption
of community property by tracing the assets on hand during
the marriage back to property that,
because of its time and manner of
acquisition, is separate in character.”
31
Property acquired “in
exchange for
separate property becomes the separate property of the spouse who
exchanged the property.”
32
“Property established to be separate remains
separate property regardless of the fact
that it may undergo mutations or
changes in form; its separate character is not altered by the sale,
exchange,
or substitution of the property.”
33
Now, imagine asset A is a partnership interest and the owner
surrenders a portion of the partnership interest in exchange for a cash or
property distribution from the partnership (such
distribution may be
described as return of capital, return of investment, liquidating distribution,
partial redemption, etc.).
34
What is the character of the cash or property
received by the owner in
exchange for the partnership interest?
35
Arguably,
the general rules applicable to any other asset
should apply, and under the
rules discussed above, the cash or property received in exchange for
the
24
. See Thomas R. Andrews, Income from Separate Property: Towards a Theoretical Foundation,
56 LAW & CONTEMP. PROBS. 171, 179 (1993).
25
. See id.
26
. See infra Part IV.B.
27
. See supra Part I.
28
. See supra Part I.
29
. See supra Part I.
30
. See supra Part I.
31
. Walton v. Johnson, 879 S.W.2d 942, 946 (Tex. App.—Tyler 1994, writ denied) (quoting Celso
v. Celso, 864 S.W.2d 652, 654 (Tex. App.—Tyler 1993, no writ)).
32
. Ridgell v. Ridgell, 960 S.W.2d 144, 148 (Tex. App.—Corpus Christi 1997, no pet.).
33
. Barras v. Barras, 396 S.W.3d 154, 167 (Tex. App.—Houston [14th Dist.] 2013, pet. denied)
(citing Harris v. Harris, 765 S.W.2d 798, 802–03 (Tex. App.—Houston [14th Dist.] 1989, writ denied)).
34
. See supra Part I.
35
. See supra notes 31–33.
2016] A PECULIAR EXCEPTION TO TEXAS COMMUNITY PROPERTY RULES 427
partnership interest should be classified as separate property.
36
However,
an exception to the
rules discussed above appears to exist for partnership
interests.
37
III. TREATMENT OF SEPARATE-PROPERTY STOCK
A brief look at how Texas courts treat corporate stock held as separate
property is instructive
before examining the current view Texas courts hold
toward partnership interests held as separate
property.
38
A. Application of the “Mule Rule” to Stock Held as Separate Property
Generally, the mule rule applies to any asset owned by a
spouse.
39
For
example, when one spouse owns stock in I.B.M., Xerox, or another
corporation as separate property, any increase in the value of the stock is
“deemed to be the separate property of the
spouse owning the stock.”
40
The
law is settled that “an original issue of corporate stock, which was
separate
property when issued to the husband, retains its separate character, no matter
how much it increases in value as a result of surplus accumulated out of the
earnings of the corporation.”
41
Any
“
increase in the value of separate-
property stock remains separate property.”
42
This principle extends even to stock in a Subchapter S corporation
holding retained earnings
which have been allocated to the shareholder and
reported on the shareholder’s federal income tax
return.
43
Because courts have applied the mule rule to stock that has appreciated as
a result of income
being plowed back into the corporation (no pun intended)
rather than distributed as dividends to
stockholders, this concept should also
apply to partnership interests.
44
B. Distributions to Stockholders
A dividend paid by a corporation to its stockholder is generally
characterized as community
property, regardless of whether the stock is
36
. See supra notes 31–33.
37
. See infra Part IV.A.
38
. See infra Part III.A.
39
. See Stringfellow v. Sorrell, 18 S.W. 689 (Tex. 1891).
40
. Bell v. Bell, 504 S.W.2d 610, 611 (Tex. Civ. App.—Beaumont 1974, rev’d on other grounds,
513 S.W.2d 20, 21 (Tex. 1974)).
41
. Scofield v. Weiss, 131 F.2d 631, 632 (1942). See also Johnson v. First Nat. Bank of Ft. Worth,
306 S.W.2d 927, 929 (Tex. Civ. App.—Fort Worth 1957, no writ) (holding that the increase in the value
of stock from accumulated earnings is not community property).
42
. Smith v. Smith, 22 S.W.3d 140, 150 (Tex. App.—Houston [14th Dist.] 2000, no pet.).
43
. See Thomas v. Thomas, 738 S.W.2d 342, 343 (Tex. App.—Houston [1st Dist.] 1987, writ
denied).
44
. See id.
428 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 8:423
community property or separate
property.
45
The treatment of other types of
distributions made to stockholders is discussed next.
46
1. Complete Liquidation of Corporation
In a divorce case involving the complete liquidation of a corporation
that took place during marriage, distributions to a spouse who owned the
corporation’s stock as separate property were determined to be the spouse’s
separate property in accordance with the mule rule and the rule of
mutation.
47
The court acknowledged that “[d]istributions received in
exchange for the cancellation
of stock upon the corporation’s dissolution
retain the character of the stock.”
48
Therefore, “when a
spouse owns separate
-property stock in a dissolving corporation and receives distributions of
liquidated assets, the distributions remain the stockholder’s separate
property.”
49
The court recognized that the distribution included the
corporation’s retained earnings, which would typically
be classified as
community-property dividends upon distribution.
50
The court stated that “[i]t
is immaterial to
the characterization of the property in this case that the assets
distributed on dissolution were the
corporation’s retained earnings.”
51
2. Partial Liquidation of Corporation’s Assets
In addition to distributions received by a shareholder upon the
complete liquidation of a
corporation, the mule rule and the rule of mutation
have been applied to distributions made to a
shareholder in partial liquidation
of corporate assets.
52
In a fairly recent divorce case, a corporation
distributed
property to its shareholder who owned the stock as separate property.
53
The court
applied the rule of mutation to the distributions, noting that
“separate property that merely
undergoes mutations or changes in form
remains separate property.”
54
The court classified the
distributions as
separate property in their entirety without addressing any component of
45
. See Bakken v. Bakken, 503 S.W.2d 315, 317 (Tex. Civ. App.—Dallas 1973, no writ).
46
. See infra Part III.B.1.
47
. See Legrand-Brock v. Brock, 246 S.W.3d 318, 321 (Tex. App.—Beaumont 2008, pet denied).
48
. Id.
49
. Id.
50
. See id. at 322.
51
. Id. The court also pointed out that this treatment mirrors the treatment under the Internal
Revenue Code of liquidating distributions from a corporation. Id. at 322 n.5.
52
. See Sanders v. Sanders, No. 02-08-00201-CV, 2010 WL 4056196, at *16 (Tex. App.—Fort
Worth, Oct. 14, 2010, no pet.).
53
. Id. at *1.
54
. Id. at *16. In this case, the court placed much emphasis on the fact that the shareholder
was the sole owner of the corporation and that the deed conveying the property from the corporation
to the shareholder contained a recital which stated that the property was conveyed to the shareholder
as his sole and separate property. See id. at *14, *16.
2016] A PECULIAR EXCEPTION TO TEXAS COMMUNITY PROPERTY RULES 429
the
distributions which may have been attributable to the corporation’s
increase in value (through
retained earnings or otherwise) during the
marriage.
55
The treatment of separate-property stock differs significantly from the
treatment of separate-property partnership interests, as discussed next.
56
IV. TREATMENT OF SEPARATE-PROPERTY PARTNERSHIP INTEREST
A. Application of the “Mule Rule” to Partnership Interest Held as Separate
Property
Courts have held that, “if a married partner contributes separate
property [to a partnership],
then his interest in the partnership is separate
property to that extent, and any appreciation in its value as a result of general
economic conditions . . . remains separate property.”
57
As discussed earlier,
because courts have applied the mule rule to stock that has appreciated as a
result of earnings being retained in the corporation rather than distributed as
dividends to
stockholders, it follows that this concept should extend to
partnership interests.
58
B. Distributions to Partners
In theory, a distribution of profits made by a partnership to a partner
should be characterized
as community property.
59
However, in practice,
there is not always a clear distinction between income from the partnership
and appreciation of the partnership, the latter of which is often the result of
reinvested earnings.
60
When a spouse owns a partnership interest as separate
property, under what circumstances is a
distribution from the partnership
properly classified as income from separate property?
61
When is a
distribution from the partnership properly classified as a mutation of
appreciated separate property?
62
Any such distinction between income and
appreciation due to reinvested earnings has been called “illusory” by experts
55
. See id. at *14–16.
56
. See infra Part IV.
57
. Smoot v. Smoot, 568 S.W.2d 177, 180 (Tex. Civ. App.—Dallas 1978, no writ) (citing Norris
v. Vaughan, 260 S.W.2d 676, 681 (Tex. 1953)).
58
. See supra Part III.A.
59
. See supra Part II.B.
60
. See supra Parts II.B–C; infra Part IV.B.3.
61
. See infra Part IV.B.3.
62
. See Andrews, supra note 24, at 210–11.
430 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 8:423
in the field.
63
The treatment of partnership distributions by Texas courts is
discussed next.
64
1. Buyout of Withdrawn Partner’s Interest
In Harris v. Harris, the husband owned a partnership interest as
separate property.
65
The
husband withdrew from the partnership during the
marriage, and at the time of the divorce he was
receiving monthly payments
from the partnership as a buy-out of the value of his interest.
66
The
court
applied the mule rule and the rule of mutation to the husband’s partnership
interest and
characterized the payments under the buy-out agreement as the
husband’s separate property, noting that “mutations and increases in separate
property remain separate property.”
67
Although the
partner was successful
in obtaining separate-property treatment for the entire amount that he
received for the redemption of his partnership interest, this case cannot
necessarily be extended to
other similar situations.
68
The court pointed out
that the wife may have been successful in pursuing
a community-property
claim on grounds that there was an income component included in the buy-out
payments, but the wife failed to do so at trial.
69
2. Non-liquidating Distribution of Partnership Property
In Lifshutz v. Lifshutz, the husband owned a partnership interest
that was his separate
property.
70
The court determined that, during the
marriage, the partnership effected a constructive
distribution of partnership
assets to the husband, and held that the entire distribution was
a “non
liquidating community distribution” of property to the husband.
71
Curiously,
63
. See id. The problem has been described as follows: “[O]ur modern forms of wealth make [the
distinction between income and appreciation] illusory. If a spouse decides to invest his separate
property in a growth stock for its appreciation, he preserves the separate nature of that property. If,
instead, he buys a bond for its interest, the bond generates community income. Moreover, with stocks
the choice between interest and appreciation may not even be in the owner’s hands. If the company
decides to issue a dividend, it is community property. If the company declares no dividend and instead
reinvests its profits in capital development, the stock appreciates in value and that appreciation remains
separate property . . . . Furthermore, in the individual business, partnership, or closely-held corporation,
the allocation between appreciation and income is in the hands of the managing spouse since he or she
decides whether and how much to draw out of the business. . . . The nub of the problem is that
appreciation and income are economically indistinguishable.” Id. (quoting GRACE GANZ BLUMBERG,
COMMUNITY PROPERTY IN CALIFORNIA 100 (1987)).
64
. See infra Part IV.B.1.
65
. See Harris v. Harris, 765 S.W.2d 798, 802–03 (Tex. App.—Houston [14th Dist.] 1989, writ
denied).
66
. See id. at 803.
67
. Id.
68
. See id.
69
. See id. at 802, 805.
70
. See generally Lifshutz v. Lifshutz, 199 S.W.3d 9 (Tex. App.—San Antonio 2006, pet. denied).
71
. Id. at 24.
2016] A PECULIAR EXCEPTION TO TEXAS COMMUNITY PROPERTY RULES 431
the court did not differentiate between the portion of the distribution that may
have represented a return of the
husband’s investment in the partnership (i.e.,
the husband’s separate property) and the portion that
may have represented a
distribution of income from the partnership (i.e., community property).
72
Instead, the court held that all distributions made from a partnership during
marriage are community property, regardless of whether a distribution
represents income from the partnership or a return of
the partner’s separate-
property capital contribution to the partnership.
73
This phenomenon of
separate
property contributed by a partner to a partnership being re-
characterized by courts as community
property when it is later distributed
from the partnership to the partner during marriage has been referred to by
commentators as the inadvertent “conversion” of separate property to
community
property.
74
The court in Lifshutz relied heavily on a broad interpretation of
Marshall v. Marshall in holding that all distributions made from a
partnership during marriage are community property.
75
However, it is
important to note that in Marshall the partnership agreement provided for
a
guaranteed salary to be paid to the husband, and it stated that all other
partnership distributions
made to the husband consisted of the husband’s
share of partnership profits.
76
The court in
Marshall expressly narrowed
its holding to the specific situation that existed in that case—where
the
partnership agreement provided that all distributions constituted a share
of the partner’s
profits.
77
The Texas Business Organizations Code provides
that distributions from a partnership
are governed by the written partnership
agreement.
78
Is the holding in Marshall properly extended
to cases where
the partnership agreement characterizes partnership distributions differently
from
the partnership agreement in Marshall?
79
The court in Lifshutz also relied on commentators’ interpretations of
Marshall from as far back as 1993 and 1997.
80
The court cited one
commentator’s assertion that the rule of mutation of separate
property does not
72
. See id.
73
. See id. at 27.
74
. See Paige Ben-Yaacov & Randall B. Wilhite, Marital Property Issues in Drafting Planning
Documents, Texas Bar CLE, 26th
Annual Estate Planning & Probate Drafting Course.
75
. See Lifshutz, 199 S.W.3d at 26–27.
76
. See Marshall v. Marshall, 735 S.W.2d 587, 593–95 (Tex. App.—Dallas 1987, writ ref’d n.r.e.).
77
. See id. at 595. The court held as follows: “In this case, all monies disbursed by the partnership
were made from current income. The partnership agreement provides that ‘any and all distributions . . .
of any kind or character over and above the salary here provided . . . shall be charged against any such
distributee’s share of the profits of the business.’ Under these facts, we hold that all of the partnership
distributions that Woody received were either salary under the partnership agreement or distributions
of profits of the partnership.” Id. (emphasis added).
78
. See TEX. BUS. ORGS. CODE ANN. § 153.208(a) (West 2006).
79
. See Marshall, 735 S.W.2d at 593–95.
80
. See Lifshutz, 199 S.W.3d at 26–27.
432 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 8:423
apply at all to the characterization of a partnership distribution from a
partner’s
capital account:
To the extent that income distributions are made from the partnership, the
distributions will be characterized as community property. Further, to the
extent
that distributions from the partnership include a return of the
partner’s separate capital contribution, the distribution will be characterized
as community income because the partnership entity becomes the owner of
the capital contribution.
81
The court also cited another commentator’s assertion that “when
an individual partner
contributes property into a partnership, the partner
loses individual interest in the property and,
since the partnership itself is
the new owner, the property can no longer be classified as separate or
community.”
82
It is the author’s opinion that both of these assertions miss the mark.
While it is true that the
partnership becomes the new owner of the contributed
property and the contributed property owned
by the partnership loses its
designation as separate or community property, this contributed
property
should not be the focus.
83
Instead, the asset that the partner received in
exchange for his contribution of separate property to the partnership—the
partnership interest—should
be the subject of the mutation analysis.
84
When
the focus properly shifts to the partnership interest
that is owned by a spouse
as his or her separate property, it is clear that the partnership interest
should
retain its separate-property character through any subsequent traceable
mutation of the
partnership interest, whether via sale, exchange,
redemption, or other method. Rather than
indiscriminately classifying all
partnership distributions as community property, each distribution should be
analyzed on a case-by-case basis to determine into which of the following
categories it
falls: (1) a distribution of partnership profits; or (2) a distribution
of partnership assets to the partner
in exchange for all or a portion of his or
her separate-property partnership interest.
85
If it is a distribution of profits,
it should be classified as community property.
86
However, if it is a distribution
of assets in exchange for all or a portion of the partner’s interest in the
partnership (sometimes
referred to as a redemption, liquidation, return of
81
. See id. at 26 (quoting Lisa H. Jamieson, Marital Property Issues in the Modern Estate Plan, 49
BAYLOR L. REV. 391, 402 (1997)).
82
. Id. at 27 (quoting ALOYSIUS A. LEOPOLD, 38 TEX. PRAC.: MARITAL PROPERTY AND
HOMESTEADS § 4.10 (1993)).
83
. See id.
84
. See id. at 26.
85
. See Andrews, supra note 24, at 179. Of course, determining whether a distribution consists of
partnership earnings or a return of investment in a partnership which has increased in value over time due
to reinvestment of partnership earnings raises the problem of distinguishing between income and
appreciation. See id.
86
. See supra Part II.B.
2016] A PECULIAR EXCEPTION TO TEXAS COMMUNITY PROPERTY RULES 433
investment, etc.), it should be treated as a traceable
mutation of the separate-
property partnership interest and classified as separate property.
87
3. Distribution of Accumulated Partnership Profits—Timing Is Everything!
Perhaps just as concerning to the partner’s spouse as the Lifshutz view
is to the partner is the
premise that partnership income can effectively be
shielded from community property treatment as
long as it is not distributed
during the marriage.
88
It could be said that the Lifshutz holding allows
for
the potential inadvertent conversion of separate property to community
property, while the
holding of Smith v. Grayson
allows for the manipulation
of profits in a manner that prevents those profits
from ever becoming part of
the community estate.
89
In Smith v. Grayson, the husband acquired a partnership interest prior to
marriage.
90
While he was married, the partnership distributed some profits to
the partners, but kept a portion of the profits
within the partnership.
91
In the
divorce proceeding, the husband claimed his partnership interest was his
separate property.
92
However, the wife argued that the portion of the
value of the husband’s
partnership interest that represented undistributed
income was community property.
93
Ruling in
favor of the husband, the court
reasoned that “[p]artnership earnings are owned by the partnership prior to
distribution to the partners and cannot be characterized as either separate or
community
property.”
94
In reaching its decision, the court referred to the earlier case Cleaver
v. Cleaver which held that both
“corporate management may invest company
earnings in corporate assets rather than distributing
those earnings to
shareholders”
and “[p]artnership management may withhold earnings.”
95
The
court pointed out that “[t]he partner’s spouse has no interest in the assets
of a partnership until they
are actually distributed” and acknowledged that
“ a partnership can be an effective means of
preserving the separate
property character of assets contributed to the partnership and the
undistributed income thereon.”
96
87
. See supra Part II.D.
88
. See Lifshutz, 199 S.W.3d at 26; Jamieson, supra note 81, at 402.
89
. See Smith v. Grayson, No. 03-10-00238-CV, 2011 WL 4924073, at *1 (Tex. App.—Austin Oct.
12, 2011, pet. dism’d) (mem. op.); Lifshutz, 199 S.W.3d at 26.
90
. Smith, 2011 WL 4924073, at *1.
91
. Id.
92
. Id. at *2.
93
. Id.
94
. Id. at *6 (citing Cleaver v. Cleaver, 935 S.W.2d 491, 494 (Tex. App.—Tyler 1996, no writ)).
95
. Cleaver v. Cleaver, 935 S.W.2d 491, 495 (Tex. App.—Tyler 1996, no writ) (citing Heilbron v.
Stubblefield, 203 S.W.2d 986, 989 (Tex. Civ. App.—El Paso 1947, writ ref’d n.r.e.); Fain v. Fain, 93
S.W.2d 1226, 1229 (Tex. Civ. App.—Fort Worth 1936, writ dism’d)).
96
. Smith, 2011 WL 4924073, at *6 (quoting Lifshutz v. Lifshutz, 199 S.W.3d 9, 26 (Tex. App.—
San Antonio 2006, pet. denied)).
434 ESTATE PLANNING AND COMMUNITY PROPERTY LAW JOURNAL [Vol. 8:423
As discussed previously, income derived from separate property
generally
belongs to the community.
97
The partner’s spouse may wonder
how a partner’s right to partnership
profits is not intrinsically community
property when other assets such as retirement plans, promissory notes, and
life insurance policies are characterized as community property upon divorce
even when no distributions or payments were made during marriage.
98
In
contrast to
other assets in which a spouse does not possess a present
possessory interest, as long as partnership
profits are not distributed to the
partner during marriage, the partner’s right to partnership profits
is somehow
immune from community characterization.
99
If the profits are distributed one
day before
the marriage is terminated, the distribution is characterized as
community property—meaning that the partner’s spouse has a one-half
undivided interest in the profits.
100
If those same profits are
distributed
one day after the marriage terminates, the profits belong entirely to the
partner.
101
Is it logical that the timing of the distribution is the sole factor
that determines whether the partner’s right to
partnership profits will
ultimately be classified as separate or community property?
102
V. CONCLUSION
A review of case law in light of traditional Texas community property
rules reveals puzzling inconsistencies in the treatment of partnership
interests as compared to other types of
property, such as corporate stock.
103
A spouse who intends to rely
on the general rules regarding income derived
from separate property, appreciation
of separate property, and mutation of
separate property may be surprised to find that the interpretation of the rules
may vary where partnership interests are concerned.
104
In addition, straight-
forward
application of the rules is not always possible due to the inability to
distinguish between income
from a separate-property entity and appreciation
of a separate-property entity.
105
97
. See supra Part II.B.
98
. See TEX. BUS. ORGS. CODE ANN. § 1.002 (West 2015). Under Texas law, a “‘[p]artnership
interest’ means a partner’s interest in a partnership,” including the right to receive distributions. Id.
§ 1.002(68). Distributions may consist of the partner’s share of profits or return of capital. See id. §153.208(b).
“[W]hen a partner becomes entitled to receive a distribution, the partner has with respect to the distribution
the status of” a creditor of the partnership. Id. § 153.207.
99
. See id. § 152.101.
100
. See id.; Marshall v. Marshall, 735 S.W.2d 587, 594–95 (Tex. App.—Dallas 1987, writ ref’d
n.r.e.).
101
. See Marshall, 735 S.W.2d at 594–95.
102
. See generally Lifshutz v. Lifshutz, 199 S.W.3d 9 (Tex. App.—San Antonio 2006, pet. denied).
103
. See supra Parts IV.B.1–3.
104
. See supra Part IV.A.
105
. See supra Parts II.B–C.
2016] A PECULIAR EXCEPTION TO TEXAS COMMUNITY PROPERTY RULES 435
A number of factors impact the treatment of transactions involving
partnership interests.
106
Distributions made in complete redemption of a
withdrawing partner’s interest—including any
component attributable to
retained income—may be characterized entirely as separate property.
107
Distributions made in partial liquidation of a partnership’s assets—
including any component
representing the partner’s original separate-
property capital contribution—may be classified entirely as community
property.
108
Finally, the portion of a partner’s share of partnership earnings
that accumulate during
marriage, which are generally treated as community
property when distributed, can escape
community property treatment
altogether if distributions are simply delayed until after the marriage
terminates.
109
Without a doubt, this unpredictable treatment of partnership interests
and departure from the
usual rules that apply to marital property is a cause for
concern among current and would-be owners
of partnership interests and
their advisors.
110
Until the existing inconsistencies are reconciled by
lawmakers or clarified by the courts, practitioners should be familiar with
these exceptions to traditional community property rules and assist clients
with careful preparation for transactions
involving partnership interests.
111
106
. See supra Parts IV.A–B.
107
. See supra Part IV.B.2.
108
. See supra Part IV.B.2.
109
. See supra Part IV.
110
. See supra Parts III–IV.
111
. See supra Part IV.
