One of the most common documents utilized in a financial investigation is the income tax return. It’s a key document in any divorce case, so the personal income tax return is always examined. And if there is a business, the tax return for that entity should be examined too.
What can we learn from the tax return? Maybe more than you imagine. Today I’m going to walk through the lines on the personal tax return (Form 1040) and some ways that these items can be analyzed to search for hidden income and hidden assets.
- Wages – The figures reported on the income tax return should be matched to the W-2. The W-2 and the pay stubs will provide additional information on the employers, pay rates, total pay, certain benefits, and taxes withheld. Additional analysis may include tracing bank deposits to ensure that all wages were used for the benefit of the family.
- Taxable Interest and Tax Exempt Interest – These items of income must be considered when calculating income available for support. They are also important because they can point to bank, investment, and brokerage accounts that may not have been specifically disclosed in the family law case.
- Dividends – Like interest, this item of income must be considered in calculations of income available for support, and can point to bank, investment, and brokerage accounts that may not have been disclosed.
- Taxable Refunds or Credits – Refunds should be examined to determine if they were shared by the parties, and the expert should evaluate whether a spouse is having unusually large amounts withheld from paychecks. This could be a technique used to hide funds until after the divorce is final.
- Alimony Received – This relates to a prior marriage, and will likely not be a factor in the current marriage and divorce.
- Business Income or Loss – This form shows income or loss from a sole proprietorship or single member LLC. A business lifestyle analysis may be needed to evaluate this.
- Capital Gains or Loss – Along with interest and dividends mentioned above, this portion of the income tax return can point to assets in investment and brokerage accounts.
- Other Gains or Loss – This line item often relates to sales of property used in business, so it should be evaluated to determine if other assets or income streams exist.
- Distributions from IRAs, pensions, or annuities – Any activity on these lines should be evaluated to determine if all retirement accounts have been disclosed and considered.
- Income from Rental Real Estate – This item should be investigated in the same way as many business interests, so refer to Chapter 12 for information regarding the business lifestyle analysis.
- Income from Royalties, Partnerships, S-Corporations, or Trusts – This item should also be analyzed in the same fashion as business interests.
- Farm Income or Loss – This is also a business interest that might need a detailed analysis.
- Unemployment Compensation – Information about unemployment benefits should be used in conjunction with wage information to determine if all of the income benefitted the family.
- Social Security Benefits – Two figures are reported for Social Security, the total amount received and the taxable amount. The total amount received is the important figure for an analysis of income.
- Other Income – Many types of income could fall under this category, so any income reported on this line on the income tax return should be carefully evaluated.
The personal income tax returns can also be useful when quantifying the spending of the family for the lifestyle analysis. The items of most interest include:
- Mortgage interest deduction – This item helps verify real estate owned (the asset side) and loans outstanding (the liability side). It also allows the financial expert to calculate an estimated monthly payment.
- State and local income tax deduction – The accounting expert can match the deduction to the underlying accounting records. The deduction should be evaluated to determine if it is excessive and/or used to hide cash until the divorce is complete.
- Real estate tax deduction – Similar to mortgage interest, this line item points to the ownership of real estate.
Income tax returns can be audited or amended, or both. The taxpayer can also be notified by the taxing authorities that there is an error or omission in the tax return, and taxes have been underpaid or overpaid. The family law attorney should inquire as to whether any of these have happened, and request documentation of the notices, audit results, and/or amended income tax return. Inquiries should also be made about whether there are any unpaid taxes, interest, and penalties, or any existing tax liens.
In addition to the income tax return itself, the 1099s that were used to help prepare the tax return can provide useful information. 1099s are issued for items such as rent, royalties, non-employee compensation (subcontractor or self-employed income), fees received by an attorney, dividends, interest, government payments, and a variety of other kinds of income. The 1099s might provide information on real estate or other valuable assets owned, investment accounts, the activity within the accounts, and the account balances.