Court Explains Treatment of Undistributed Earnings in Valuing Law Firm Partnership InterestBurchfield v. Burchfield

Among a host of issues, this Virginia divorce case, which included a prominent Washington, D.C., lawyer and his estranged wife, raised an important valuation question related to the husband’s partnership interest in the firm: Whether undistributed earnings were includible in the marital property, as the wife’s expert claimed, or whether they were the husband’s separate property, as the husband’s expert maintained. The court agreed with the conclusion of the husband’s expert but disagreed with the rationale behind it. The court used the opportunity to explain the controlling legal principle, which was also applicable to valuing the assets in the husband’s profit-sharing 401(k) account and cash-balance pension plan.

Partnership interest

The couple married in 1996 and acquired great wealth during the marriage, primarily, the divorce court found, because of the husband’s efforts. He was a lawyer and equity partner in a number of prestigious international law firms. The spouses separated in September 2017. At the time of separation, the husband’s annual income was about $4 million.

One issue at trial was the value of the husband’s partnership interest in his current firm, which he joined in 2015. Upon a partner’s making a capital contribution, the husband’s firm allocated “participating units,” or “points,” to him or her. A policy committee was responsible for a “proposed schedule of points to be held by each partner during the subsequent accountability cycle.” Accountability cycles were two-year periods. For each year of the cycle, the policy committee determined the amount of undistributed earnings that were allocable to a partner based on projected firm profits “late” in the immediately preceding year.

Under his current employment agreement, the husband had a guaranteed annual income of $3 million. The court found the husband’s capital account for the partnership interest held $600,000 in capital and $833,000 in undistributed earnings.

The issue was whether the undistributed earnings represented marital property. The wife’s expert said these earnings were allocated to the husband in January 2017, thus before the couple’s separation in September 2017. Consequently, the undistributed earnings constituted marital property.

The husband’s expert said that, while the undistributed earnings were attributable to the points that were allocated to the husband pre-separation, they would not be disbursed into the capital account unless and until the husband worked and the firm realized the anticipated net profits in 2018, i.e., post-separation. Put differently, the undistributed earnings did not vest until after the couple’s separation, the expert said. Therefore, they were post-separation earnings and the husband’s separate property.

The court also found that the undistributed earnings represented separate property, but it arrived at the conclusion by different legal reasoning. The court noted that, under the applicable state statute and case law, when dealing with deferred compensation (e.g., a stock award) the date of vesting is not controlling as to whether the deferred compensation is marital or separate property. Rather “stock options, like retirement benefits, are acquired when they are earned, and not at the time of receipt, vesting or exercise.”

The court noted that, if the husband’s interest in the firm were a form of deferred compensation, the wife’s expert would be correct, and the entire partnership interest would be marital property. “Deferred compensation,” the court said with emphasis, was “remuneration for work performed antecedent to actual payment.” But this was not the case, the court said, because the husband’s undistributed earnings “were allocated for the distribution of the firm’s speculative anticipated net profits to be earned in the subsequent year.”

The court said that, under the applicable state statute, all profit-sharing interests acquired during the marriage are marital property absent evidence to the contrary. “Marital property,” the statutory provision says, is “that portion of the total interest, the right to which was earned during the marriage and before the last separation of the parties.”

The court emphasized that, under the high court’s ruling in Schuman, “this Court may only deem Husband’s partnership interest to be marital property to the extent any value of the asset was earned during the marriage.” Accordingly, the court rejected the argument by the husband’s expert that undistributed earnings were separate property because they would not vest until after the separation. However, the court said, the expert’s point that undistributed earnings depended on the husband’s performance of legal work for the firm after the separation was “well taken.”

In conclusion, of the total value of the husband’s partnership interest (i.e., $1.43 million), only $600,000 (the amount in the husband’s capital account) was marital property, the court found. The remaining $833,000 in undistributed earnings represented the husband’s separate property. Even though this amount was allocated to the husband before the separation, it was not earned until after the parties’ separation, the court emphasized.

Retirement assets

The court applied a similar analysis when deciding how much of the husband’s profit-sharing 401(k) account was marital property. On the valuation date, the account had a value of about $158,000. The husband claimed that only about $80,600 was vested at that time. Therefore, only that amount was marital property, the husband said.

“To decide the marital share of the 401(k) based solely on the date of vesting would constitute reversible error,” the court said. The issue was when that amount was earned. Since the $80,600 was earned during the marriage, it was part of the marital estate, the court found. Finally, the court applied the same analysis when determining how much of the husband’s cash-balance pension plan was marital property.

Nonqualified pension plan

The firm also had a nonqualified pension plan that was titled in the husband’s name. The court said that it would apply a coverture fraction to determine the marital portion of the plan. The court explained, “[T]he numerator of [the coverture fraction] represents the total time the pensioner is employed during the parties’ marriage, and the denominator … represents the total time the pensioner is employed through the date of retirement.” The husband claimed the entire account was separate property because receipt of the money was subject to certain conditions before he would be able to receive the money. For example, the husband would have to sign a non-compete with his current employer.

The court decided the coverture fraction of this asset, whose value could not be determined at the current time, was marital property to be valued “if, as, and when” received by the husband. The court characterized the asset as a hybrid, as it was in part separate and in part marital property. Its value, the court said, would be calculated at a later time.