The issue of “income available for support” in divorces can be huge, particularly if only one spouse works. The issue gets complex if the earnings of one or both spouses are non-traditional. Regular wages are usually easy to evaluate in a divorce case, while income from businesses, real estate, and other investments become more complicated.
As a general rule, there is latitude in state courts when it comes to income and what is included or excluded for support calculation. There are general rules about the most common forms of income, but they don’t cover every issue and they all have a bit of “gray area” within them.
It is important to know the tricky kinds of income and cash flow that come up in divorces, as well as the varying views of how and why they should be included or excluded. Some of the types of income or expenses that may be treated differently from divorce to divorce and jurisdiction to jurisdiction include:
- Capital gains – While this is income for income tax purposes, it is not always considered income in a divorce case. Instead, it is sometimes considered to be a liquidation of assets. It is important to evaluate what happened with this asset leading up to the sale. For example, if the asset is a rental property for which depreciation and other expenses reduced the party’s income available for support in previous years, the sale of the asset may need to be treated as income to remain consistent. (That is, it would be unfair to allow the party to reduce the income available for support with expenses like depreciation, but then never increase the income available for support when the asset is sold.)
- Deferred compensation – Employees at higher levels often have non-traditional earnings that must be considered. Stock options or other forms of compensation may be recognized as earnings on a current income tax return, but the cash may not be received by the spouse for months or years in the future. The amount of cash to be received in the future is often unknown, as it may depend on the price of the company’s stock at a point in the future, or other changes in interest rates and the stock market.
- Ordinary and necessary business expenses – Jurisdictions typically allow a business owner to utilize funds for ordinary and necessary business expenses. These funds are excluded from the calculation of income available for support. This is a hotly contested area because there is no hard and fast rule about what is “ordinary” or “necessary.” The spouse who owns the business and will be paying support often wants to throw in everything but the kitchen sink to reduce the net profits of the business, thereby reducing the support that must be paid. The other spouse often claims that many of the business expenses are unnecessary (or are of a personal nature) and are just a ruse to reduce support. Additionally, the court must decide whether it is proper to use some of the business funds to grow and expand the business (or begin new business ventures) before support is calculated.
- Depreciation – Depreciation of business assets, including real estate, is treated inconsistently by courts. Some courts allow depreciation on real estate to reduce the person’s income available for support, while others disallow depreciation because it is only advantageous at tax time (it reduces the taxable income) but is not an actual cash expense. Additionally, since real estate typically appreciates over the long term, some courts do not allow depreciation to reduce the income available for support as it is not a true cost of holding the real estate. Depreciation on assets such as equipment is typically allowed as a business expense that reduces income available for support, as the assets have little value at the end of their lives and therefore represent a true ongoing expense.
- Income from pass-through entities – Entities such as partnerships, LLCs, and S-Corporations earn income that is passed through to the owners and reported on their individual income tax returns. While an owner is entitled to a share of the entity’s income, cash may not actually be distributed to the owner. Thus, courts have differing views of whether this item is income available for support. Complicating the issue further, owners who are divorcing their spouses may intentionally not distribute the earnings to themselves in order to bolster claims that this is not really income because cash was not received. The more control the owner exerts over the entity, the more successful you may be in arguing that it is income available for support as the owner controls whether or not the funds are disbursed to him or her. Ensure that the owner can’t forgo distributions now to reduce support, and wait to distribute profits sometime in the future after the funds will not be included in support calculations.
- Unreported revenue – A frequent issue when divorcing spouses own closely held businesses is unreported revenue. There are often allegations of cash sales or other sources of revenue that are concealed from income tax reporting, the divorce court, or both. It is difficult to prove that there is unreported revenue, since at its heart it is concealed. However, a financial investigation may uncover evidence (either direct or circumstantial) to support a claim of unreported earnings. Evidence may include things like cash deposits exceeding reported revenue or business expenses that suggest a higher level of revenue. A lifestyle analysis could show that the spouse is spending funds at a rate that exceeds reported earnings.
- Non-taxable income—Items that are not reported on an income tax return may still need to be considered in a divorce. These can include things like disability insurance benefits and nontaxable interest or dividends.
- Imputed income—Courts can impute income to a spouse who is not working or is working below his or her capabilities. The courts can also impute income to a business entity if it is determined that the spouse is purposely depressing earnings of the business in order to manipulate support calculations. This can be tricky, however, as the spouse may cite economic conditions or the loss of a key customer as legitimate reasons for the decreased earnings. Courts can also impute earnings on capital assets that could earn interest or dividends if invested.
Evaluating potential components of income can be complicated, especially with the latitude that family court judges have. Evaluating income in multiple ways can help bolster the arguments you want to make.
For example, if you are arguing that several of these types of income ought to be included in the support calculations, you can support that argument by presenting an analysis of the income tax returns, an evaluation of personal and business bank deposits, and a lifestyle analysis which demonstrates the spending patterns of the spouse. Relatively consistent results from these analyses will lend more support to your position that these items represent income available for support.
Tracy L. Coenen, CPA, CFF is a forensic accountant and fraud investigator with Sequence Inc. She specializes in cases of embezzlement, financial statement fraud, white collar crime, securities fraud, and family law. She can be reached at 312.498.3661 or [email protected]