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Accounting for Income in Divorce

ACCOUNTING FOR INCOME IN DIVORCE

Understand that I, Eric Roy, drafted this article for my own personal benefit as I find this subject matter interesting. I am an attorney who loves nothing more than to work on high asset divorce cases. However, I am not a forensic accountant. If you wish for a more thorough explanation of the subject material I suggest you purchase one of the many books written on the subject or speak to a forensic accountant who regularly testifies in high asset divorce litigation.

Many of the concepts used to determine income are consistent with the same concepts used to determine assets. However there are differences as well. As we all know, the breadwinner spouse is often recalcitrant to pay his soon to be ex-wife alimony or child support. Alimony and Child support are typically determined by calculating net income or gross income. Alimony obligations are generally determined by examining the discrepancy in income of the parties and discretionary income left over after necessary expenses are paid by the income producing spouse. Child support is determined by looking at total gross income from all sources. As a result the income producing spouse will do what he or she can do to reduce the amount of observable net and/or gross income. As divorce counsel you need to know how to get to the bottom of this true income amount, don't rely on the financial disclosures turned over to you.

You need to know what documents are the best for demonstrating both high and low income depending on the spouse that you represent. If you wish to prove high income you need to know what documents will not be sufficient. Often times before discovery can be had you as counsel will have to determine income for temporary maintenance purposes. Given the lack of discovery conducted at this point you will have limited resources to draw from. Know that tax returns in themselves may not be sufficient. The reason for this is that not all income is taxable and a tax return of course only demonstrates taxable income. Loan applications are typically better as the loan applicant will disclose all sources of income, not just taxable, in an effort to obtain good financing. The best tactic when considering income, like consideration of assets, is to look at more than one source of documents reporting income. As with asset discovery look to tax returns, W-2s, pay stubs, declarations in discovery, declarations for loan purposes, financial statements prepared for credit acquisition purposes, bankruptcy filings, and so forth.

Although income reported on loan applications will typically be the most reliable source of income report don't stop there. Continue on and request that the opposing party declare his or her claimed income in response to your discovery responses. The reason for this isn't to find the true value of the person's income. The purpose of having the other party declare their income is so that you can impeach the party when you find inconsistencies in the claimed income in response to discovery as opposed to the reported income they gave to financial institutions in the past. Highlight these inconsistencies to opposing party and opposing counsel leading up to trial. The threat of impeachment becomes leverage in settlement negotiations. If opposing counsel pushes the matter to trial make his client pay dearly on the stand for his or her transgressions. Once the lie is out in front of the trial judge that individual will have no credibility going forward on any other representations he or she may make to the court.

The question then becomes where should you go to find loan applications if you are unsure as to where the loans were obtained from. It isn't uncommon for your spouse client to be completely in the dark as to the parties' finances. Look to the county recorder as all loans secured by real property are recorded there. This will give you the name of the institution holding the loan. You can then subpoena this lending institution for the loan application and reported financials. If a business pledges its own assets as security for a loan then there will be a UCC – 1 or financing statement listing the securitized assets. These are public listings. If you have neither of these things then look at the title of a vehicle that is being paid down on. Likely the lender has a lien on the vehicle. This lien will appear on the face of the title certificate. Use this info to determine what financial institution made the loan and then subpoena the loan application and supporting documentation from the financing institution.

Keep in mind that businesses which have outstanding loans are typically required to update their financials on a yearly basis. This means financial statements, personal and business tax returns, personal financial statements, and a formal loan application must be submitted. Know that business loans are advantageous to you as counsel as they were likely prepared by the businesses CPA. In discovery, seek all documentation supplied to the CPA for preparation of this application. This info will include various ledgers, schedules, and returns which will tell a thorough story.

You are going to have times when you can't directly prove the other parties income but you know it is more than what they declare to you and the court. There are several techniques to be employed in this case. At a very basic level look to proof of luxury spending. When you find the luxury spending you can always fly this in the face of representations of poverty in the courtroom. Keep these luxury expenditures in your back pocket to use in oral argument or use them on cross examination, forcing the opposing party to tell a compelling story for your client's benefit on cross.

An effective technique for proving income includes using a detailed transaction listing. In this way you can add up all deposits to calculate actual after tax income and compare this to the parties' declarations. You can do the same thing by comparing actual spending to the declarations made. If spending exceeds declared income and there are no loans or asset dispositions to explain the inconsistency then you know you have a lying spouse. The difference using either method is the amount of money this spouse is receiving and not declaring and likely not reporting to the IRS as well. Get tax fraud on the declarant's mind and your case will be ripe for favorable settlement. Prior to trial you may not necessarily have to have a forensic accountant to put the fear of god in the opposing party. However, if you plan on presenting evidence at trial of the discrepancy in hopes that your trial judge will impute the true income upon the other party you should have your forensic account testify. Put your forensic accountant on the stand for direct and have him explain why he or she believes to a reasonable degree of accounting certainty that there must be other income to explain the deposit or spending patterns.

Another method, similar to the imputed income method described above, is the net-worth method. Using this method you compare the net worth at one starting point to the person's net worth at another point later in time. You then subtract the initial net worth value from the later value to get the difference in net worth over a period of time. You then need to back out factors such as appreciation of assets and/or investment gains and the like. You should also back out depreciation and investment losses. If the reported annual income is then inconsistent with the change in net worth over that period of time then you know the individual is lying. To determine the starting net worth value look to loan applications, where the individual would have been compelled to fully disclose the highest possible net income. Use the individual's self-reported declarations as your second valuation point. If the individual tries to explain the discrepancy by stating that he inflated his net worth in the loan applications for purposes of obtaining better financing remind him or her that this is a crime. Remind them of this prior to trial to keep them honest on the stand.

Once you determine that the differences in net worth don't correspond to the differences in income take it one step further to try to get some idea of where the unreported money is coming from. Does this individual operate a cash business? If so then this is likely your source. Know what types of businesses are often paid in cash transactions. This is where the depositions become useful. Ask employees and other agents of the business about cash transactions. How often do they occur? How much are they typically? Use the totality of this evidence to prove that the other side is a liar and then more importantly demonstrate to the court what his or her true income is and tell the court to impute this income upon them for alimony and child support purposes. If you obtain a finding on the record that the court doubts the other side's credibility you have done your client a solid. For the remainder of that proceeding or in future proceedings you can reference the court back to an earlier determination that the court found this individual lacking in credibility. Therefore going forward what you say is the truth and what opposing party represents is likely a lie.

If the opposing party lied in declarations to the court he may quite likely have done so on his tax returns as well. This is when you employ the net worth or imputed income techniques. In addition to pointing out the discrepancy to the court be sure to remind the opposing party that his or her failure to record and disclose income to the IRS is a federal crime. Put federal income tax fraud on his or her radar and at the same time ask for favorable settlement terms. Your client can thank you later.

Business owners will often try to move property and money in and out of their business so as to make the business look less valuable and to make their income look lower than it truly is. Be on the lookout for some of these common ploys. The business owner will try to infuse capital into the business in hopes that a business valuation will not occur or that in the evaluation the capital infusion will be missed. To do this the business owner must either pay personal cash into the business, transfer non-cash assets into the business, or loan the business money or repay the business an existing loan. If you can get your hands on all of the personal and business account statements with the bank then you will be readily able to observe any cash transfers. Business owners will get tricky and try to sell an asset to the business for an unrealistically low value. For instance, the owner could sell his $40,0000 vehicle to the business and record the asset as only being worth a few thousand on the company books. Your forensic accountant should be all over this.

Also look out for the business owner who uses the business to loan him or herself money. The business owner knows that this loan will not result in taxable income and thus will not surface on tax returns. This is why the tax returns individually are not enough. You must cross reference all of your evidence. Also, when dealing with corporations keep an eye out for retained earnings and excess retained earnings. A smart business man will pay himself a small salary proceeding divorce years while retaining all business profits in the retained earnings account. Since the money is not taxed to the business owner until he receives the money in salary or as distribution this money will not be reflected on his tax returns. Of course, if you have an accountant to value the business you will get your ½ interest in final dissolution. However, for purposes of support you need to argue that this excess retained earnings needs to be taken into consideration by the court.

As divorce counsel you need to have a strong understanding of how to read various financial documents. One of the most common of those is the W-2. The boxes of most import to you for income determinations will be boxes one, three, and five. Know that these boxes should not be treated the same. The reason for this is for one, that box one "wages, tips, other compensation" does not record income that is not subject to federal income tax. So, for example if the employee spouse receives income by way of a SIMPLE retirement account this money will not be recorded in box one as it is not taxed on the way into the account. Yet it is still income. Box three of the W-2 is better than box one. Box three reports all income relevant for social security wages. Income taxed for social security will include income from contributions to a SIMPLE retirement account. Thus if box three is higher than box one argue for its implementation. Remember that child support generally takes into consideration income from all sources. Box five lists income taxed for Medicare purposes. Box five is similar to box three in that it also records contributions into a SIMPLE retirement account.

Between boxes one, three, and five you should prefer to use box five. The reason for this is that as stated above it accounts for income placed into a SIMPLE retirement account. Additionally, it differs from box three, the social security wages box, because there is no wage base limit. Social security taxes wages up to $118,500 currently as of 2015. This means that if the employee has wages beyond that value their taxable portion will not be reflected here. This differs from Medicare wages which have no wage base limit. Thus often times box three and box five will be the same. Yet if the employee makes an income greater than the wage base limit, currently $118,500, then the income reported in box five will be higher. If you are seeking child support and alimony always argue for the court to use this higher number. If you are fighting against alimony and child support then of course you'll be arguing for taxable income wages reported in box one to be applied.

For more information on this subject I direct you to Miles Mason, Sr.'s work. He is a JD and a CPA and has written thoroughly on these subjects. Most of my learning such as the information provided above comes from his mastery and writing on the subject matter.

Categories: Family Law