Tax returns can be one of the most important pieces of information a forensic accountant evaluates in a divorce case. Of course, there are other very important financial documents, but income tax returns provide summary information about of lot of financial issues, including income, expenses, and assets. I typically recommend reviewing three to five years of tax returns, but the further you can go back, the better the picture you will get of the personal or business finances.
If a party claims that personal or business tax returns are unavailable for any reason, consider requesting the records directly from the Internal Revenue Service. This requires the consent of an individual or business owner, and can be done with Form 4506, Request for Copy of Tax Return.
On the business side, it will be important to compare the financial statements with the income tax returns. Because of differences in accounting rules and the tax law, numbers for the same period may differ between the financial statements and tax returns. Depreciation is one example of a line item that typically differs between the financial statements and income tax returns. The expert should investigate any differences between the financial statements and tax returns, and refer to the tax laws to confirm whether such a difference is legitimate.
Some of the key information that may be found in the income tax returns includes:
- Assets of the business – Do assets exist? How have they been depreciated? Does an adjustment need to be made to the depreciation for a business valuation or calculation of support?
- Income – Have there been increases or decreases in income? How are these explained? Have market conditions played a role? Might there be manipulation of income intended to affect calculations in the divorce? Changes from period-to-period should be evaluated both in terms of dollar changes, and percent changes.
- Expenses – Have there been increases or decreases in business expenses? How are these explained? Have market conditions played a role? Might there be manipulation of expenses intended to affect calculations in the divorce? Changes from period-to-period should be evaluated both in terms of dollar changes, and percent changes.
- Ownership – Has there been a change in ownership of the company? Does this change appear to have anything to do with the divorce?
- Compensation – Has there been an unusual change in any owner’s compensation? Is this change related to any known changes in the operations of the business or market conditions? Have cash withdrawals occurred outside of normal compensation (i.e. has the owner withdrawn cash from his or her capital account)? Does there appear to be an attempt to influence support calculations with a change in compensation? Does compensation need to be adjusted by the accounting expert prior to making any calculations or performing a business valuation?
- Benefits – Have there been any major changes in non-wage compensation and benefits? Should these benefits or perks be included in or excluded from any calculation of support or valuation of the business?
A detailed examination of the income tax returns and financial statements might show that a company’s expenses have remained constant over the period of analysis, while the reported income fell dramatically around the time of the divorce. A decrease in income with no related decrease in expenses may be indicative of a business owner that is intentionally underreporting income.
Consider evaluating not only annual financial statements, but also quarterly or monthly statements. It is common for adjustments to be made by in-house or external accountants at year-end, so interim financial statements may provide information on the classification of income, expenses, assets, and liabilities prior to this adjustment. Look for inconsistencies in the numbers and determine whether any of the adjustments were made for the purpose of manipulating figures for the divorce.