I Thought California is a No-Fault State
By Ron J. Anfuso, CPA, ABV, CFF, CDFA, FABFA
Family law practitioners need to be familiar with the numerous types of income tax returns that are essential for financial analysis relevant to several issues in dissolution of marriage cases. These include matters such as child support, spousal support, division of property, tracing, and Family Code §2640, to name a few. It is advantageous, also, for you to have a general understanding of the relevant items on common tax returns that have an impact on such analyses. This article discusses the role of tax returns in determining income— sometimes referred to as gross cash flow available for support calculations.
Determining Support Payments
The analysis of tax returns is an integral part of determining the appropriate cash flow available for support. Although it is only a starting point, an understanding of various tax returns will enable you to identify the sources of income and areas that may require further investigation.
Evaluating Business Tax Returns
When one or more of the divorcing spouses own a business, there will be a need to evaluate business tax returns. Although there are several types of business tax returns, the business tax returns one will encounter most often are Corporation (IRS Form 1120), S-Corporation (IRS Form 1120-S), Partnership (IRS Form 1065), and Limited Liability Company (IRS Form 1065/CA Form 568).
Subchapter S-Corporations, Partnerships and Limited Liability Companies are considered pass-through entities. This means that the net income passes through to the shareholders’, partners’ and members’ individual income tax returns via Schedule K-1s.
Corporations: Sometimes referred to as a C-Corporation, a Corporation differs from the other entities in that a C-Corporation does not pass net income through to the shareholders. The net income of a C-Corporation is paid to its shareholders generally as salaries and perquisites, and less often as dividend distributions. Most closely held C-Corporations salary out all of the income to the shareholders at year-end to avoid double taxation by the payment of dividends out of retained earnings.
When reviewing a Form 1120 for a C-Corporation, start by analyzing Line 12 on page 1 (Compensation of Officers); Schedule E on page 2, which also lists compensation of officers by each individual officer; and Line 30 on page 1 (Taxable Income). The balance sheet (Schedule L) on page 4 of the tax return should also be reviewed for increases in loans to shareholders or decreases in loans from shareholders, which may represent cash flow to the shareholders. Several years of the tax return should be reviewed in order to determine if the shareholders have intentionally decreased salaries pending the dissolution action. If this occurs, the information should be presented to the Judicial Officer in the case. In addition, the net income of the corporation will usually increase since the shareholder’s salary is treated as an expense of the corporation. Unless there is a valid business reason, such as the requirement for upcoming capital expenditures, closely held C-Corporations rarely retain earnings.
S-Corporations: S-Corporation tax returns also include a line for compensation to the officers, however, it is Line 7 instead of Line 12 as it is on the C-Corporation returns. Unlike the C-Corporation, the compensation by officer is not reflected on Schedule E, so the Form W-2s or other payroll data for the officers must be requested in order to identify each officer’s compensation in situations when there is more than one officer on payroll. In addition, shareholder distributions are reflected on the Schedule K-1, Line 16 and marked with a “D”. These distributions represent cash distributions received by each shareholder in the year under investigation, which are in addition to any salary received by the officers as previously discussed. This amount does not always reflect the amount on Line 1 of the Schedule K-1 (ordinary business income or loss). Accordingly, when using DissoMaster™ or other support calculation software, adjustments may need to be made in order for the computer program to calculate the taxes correctly.
Partnerships
Owners of Partnerships are taxed as self-employed individuals based on their Partnership ownership percentage. Like with an S-Corporation, partners receive a Schedule K-1 reflecting their pro rata share of the Partnership net income. However, Partnership income is subject to self-employment tax whereas S-Corporation income is taxed only as ordinary income. Distributions on Partnership K-1s are reflected on Line 19 and marked with an “A”.
Limited Liability Companies (LLCs)
Owners of Limited Liability Companies are known as members. LLCs that have two or more members report taxes on IRS Form 1065, which is the same form used for Partnerships. The state of California has a separate form for Limited Liability Companies, which is Form 568. Members of LLCs receive Schedule K-1s for their proportionate share of the LLC’s net income.
Individual Income Tax Returns
Individual income tax returns (IRS Form 1040/Franchise Tax Board Form 540) contain the road map for the various sources of income and tax deductions utilized in the preparation of support calculations. Although they are presumptively correct per In re Marriage of Loh (2001) 93 Cal.App.4th 325, 112 Cal.Rptr.2d 893, caution should be exercised in placing entire reliance on what is reported on tax returns since taxpayers are generally adverse to paying taxes. It is possible that not all income has been reported on the tax returns as well as deductions for unsupported expenses or personal expenses that have been categorized as business expenses.
Wages and salaries from the business entities previously discussed are reported on Line 7. Taxable interest income is reported on Line 8A and non-taxable interest income (primarily from municipal bonds) is found on Line 8B. It is important to note that with the exception of some taxpayers who are subject to alternative minimum tax (AMT), the amounts found on Line 8B are generally non-taxable and should be input into the non-taxable income box of the support calculation software.
Dividends are found on Line 9A on the individual income tax return. If the combined income and dividend income exceeds $1,500, the detail of the sources of interest and dividends can generally be found on Schedule B attached to the tax return.
Rental income and expenses are found on Schedule E, page 1 of the individual income tax return. The net rental income may require adjustments such as the adding back of the non-cash expense depreciation and/or the reduction of the cash flow for principal paid on the mortgage loan, if any.
Schedule E, page 2, reflects the taxable income that is passed through from the business entities (S-Corporation, Partnership, LLCs) as discussed earlier. Note this is the taxable income only, and does not necessarily correlate with the distributions.
Tax deductions known as itemized deductions are found on Schedule A. Since most support calculation software utilizes gross income and then calculates the taxes, it is important that material tax deductions be included when utilizing such software. The two most common tax deductions are real estate taxes found on Line 6 of Schedule A, and mortgage interest, found on Lines 10 and 11 of the Schedule A. Other potentially relevant deductions are medical expenses found on Line 4, recurring charitable contributions listed on Line 18, and unreimbursed business expenses and other miscellaneous itemized deductions noted on Line 26.
Self-employed individuals who are owners of sole proprietorships report the income, expenses and net profit from their businesses on Schedule C attached to the individual income tax return. In cases of self-employed individuals, the Schedule C should be examined carefully for expenses that are personal in nature (i.e. perquisites) as adjustments to income may be required in order to reflect the owner’s true ability to pay support.
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