Why Use a Forensic Accountant in a Divorce Case?

divorce financial analysisOne of the hot new things in the area of divorce, especially for high net worth clients, is using a law firm that has forensic accountants on staff. Sometimes the divorce attorneys themselves have credentials in the area of forensic accounting, such as a CPA license, CFE (Certified Fraud Examiner) credential, or CFF (Certified in Financial Forensics) credential.

These law firms tout a number of advantages of retaining them:

    • Expertise in financial matters, including business valuations, tax law, and forensic accounting
    • Ability to investigate the value of financial assets
    • Skills necessary to perform a lifestyle analysis

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Calculating Income in Divorce Cases

There are four widely recognized methods of calculating income in family law cases. These four methods have been developed for use by the Internal Revenue Service in calculating unreported income in tax cases, and are the primary ways a lifestyle analysis can be completed.

Specific Items Method
One of the most straightforward ways to complete a lifestyle analysis is through an analysis of specific items of income. This method is possible when there are substantial documents detailing cash inflows, and is considered a “direct method” of verifying income.

Income-related information is gathered from bank and brokerage statements, tax-related documents, and business records. Inflows are identified and summed, theoretically verifying the income disclosed in the family law case. This method is easy to understand and present, which makes it an attractive option for evaluating claimed income. The court will easily be able to understand how income was calculated.

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Using Tax Return Information in Divorce Cases

Income tax returns and supporting information such as W-2s and pay stubs are the most common and basic documents which evidence income in family law cases. This article discusses the sources of income that are disclosed on a personal income tax return (Form 1040), and some ways the items can be evaluated 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.

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Using Expenditures to Calculate Income in Divorce

It is sometimes difficult to determine the income of individuals who will be paying child support or spousal support. This can often be the case when dealing with self-employed individuals.

If the reports of income made by the spouse or parent don’t seem to make sense, it may be necessary to look at his or her lifestyle to determine income. In this situation, we look at the expenditures made by the person and calculate the level of income necessary to fund those expenditures.

Tracy Coenen explains the process in this video.

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Paycheck Protection Program (PPP) Loans and Child Support (COVID-19)

A family lawyer asked if a loan received under the Paycheck Protection Program (PPP) will be considered income for purposes of the child support obligations of the business owner.

The simple answer:

Loans are not income. The business is not receiving money as a result of selling any products or services. It’s simply a pile of cash from which the business can operate, and under normal circumstances, the business has to pay back the money.

The complicated answer:

A business owner often has two sources of income that are factored into child support calculations: a paycheck and the net profits of the business. Let’s start with the paycheck. The purpose of the PPP money is to continue paying employees. That includes the business owner. For many business owners, there will likely be no change here. He or she got a paycheck before, took out the loan, and continues to get the same paycheck.

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Don’t Cash Out Your 401(k) in Divorce

It is common for divorcing spouses to cash out retirement funds at divorce time. And it seems to make sense at the time. There are expensive lawyers and all sorts of expenses to establish a new residence. Support payments may be delayed or non-existent. A retirement fund seems like great solution. It’s a pile of money that you weren’t going to use for a long time, and you have financial needs now.

But it should be the absolute last resort, because it’s so costly in both the short term and long term.

Retirement accounts like 401(k)s and IRAs create a tax deduction now (when money is contributed to it), and then taxes are paid when the funds are withdrawn at retirement time. The government wants us to keep the money in those accounts until we retire, so there are disincentives to withdraw the money early. If you take an early distribution from a retirement account, you’re going to pay income taxes on the money you withdraw, plus a 10% federal penalty for early withdrawal, plus any penalties your state may impose. I tell people to count on losing about 50% of the money they withdraw to taxes and penalties.

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Divorce Fraud Red Flags

The vast majority of family law cases are settled without trials. However, a client should not enter into a voluntary settlement if there are significant concerns about the truth of the financial disclosures and indications that assets or income may be hidden. The first step in determining whether a forensic accountant is needed to evaluate the finances of the parties is the identification of “red flags” of fraud. A red flag is simply a warning sign or an unusual item or circumstance.

Attorneys often use their instinct to determine when a forensic accountant is needed in a family law case. If something does not feel right, it probably should be investigated. A client is often suspicious of the spouse even before they are separated. The spouse may even be known to manipulate the money.

Beyond using intuition to determine if something is wrong, there are plenty of warning signs that indicate the finances should be evaluated carefully. These red flags by themselves do not mean that money has disappeared or the finances are being manipulated. But they are signs that an investigation is warranted. Because divorce is so adversarial, it is likely that one or both of the spouses will conceal or manipulate financial facts.

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Divorce Lifestyle Analysis Data Entry

A question often comes up relative to the lifestyle analysis in divorce cases: Isn’t is just data entry that anyone could do? Why do I need a forensic accounting expert? As I explain below, the lifestyle analysis is NOT just a data entry exercise. A level of quality control is necessary in order to ensure … Read more Divorce Lifestyle Analysis Data Entry