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Gray Areas in Gross Income Available Calculations
There are certain issues that affect the calculation of what is available for spousal and child support that are theoretically unclear. This article will present a few of them, showing the logic behind various positions.
Income or Cash Flow?
There are two schools of thought in this area, but sometimes the two converge. The first position is that one should look at the income that is earned by the spouses. The second position is that one should look at the cash flow that is available to pay spousal and child support. The following examples will illustrate numerous situations where the differences will be apparent.
Example 1-Money left in the business (undistributed income)
Imagine a business that earned $ 100,000 of profits during each of the past three years, but the owner(s) chose to draw out only $50,000 during each of the past three years, and they left $50,000 in the business each year so that their balance sheet and opportunity for future financing is enhanced. One opinion includes the full $100,000 as gross income available for support on the theory that the income is really available, but the owner(s) chose not to withdraw it personally. The other opinion states that only the gross cash flow available is what should be considered, and that is only $50,000. This cash flow opinion would agree that $100,000 (i.e. income) should be used if the income/money were kept in the business solely to deprive the spouse and children of support, but since there is an adequate business reason for keeping the money in the business, the cash flow alone should be used. The income opinion feels that looking at the cash flow is too arbitrary and subjective, since what owners take home can be based on many factors which are under their control. Furthermore, the cash flow method ignores the fact that a person's net worth is increasing by what is left in the business.
Example 2- Too much money is being taken out of the business
This is the opposite of the first example. Here a business earns $100,000 and the owners draw out $120,000. This pattern obviously cannot continue for too long, for the money won't be there, but for as long as it does, the income opinion would include only the income ($100,000) and the cash flow opinion would use the cash flow ($120,000). This example presents a difficult challenge to the cash flow opinion and would require additional analysis to determine what amount to include, especially where long term support is being calculated.
Shareholder loans often create this type of situation. A frequently-observed situation is where a shareholder will receive an annual salary of $ 100,000 for example, with an additional $20,000 every year as a shareholder loan. Assume that the business had $200,000 in cash a few years ago, and that money is funding the annual $20,000 in loans. In this situation, the income and the cash flow opinions might agree that at least until the $200,000 runs out, the annual amount available for support would be $120,000. In a more typical situation, where there is no specific sum of money funding the shareholder loans, and where the salary is $ 100,000 and, in addition, new net loans of $20,000 a year are being made to the shareholder, the income approach would most likely include only the $100,000 and the cash flow method would most likely include the full $120,000. However, both methods would analyze the books and records to determine how the business was able to pay out more than its income. The income method's analysis would be to see if there is justification to include the loans, whereas the cash flow method's analysis would be to see if there is reason to exclude the loans. One justification to include would be if there are non-recurring expenses which reduce income but are not paid with cash, such as depreciation expense of an asset that is not expected to be replaced for many years, such as real estate. One justification to exclude would be if the funds came from a short-term loan.
Example 3-Net corporate income
Assume a lawyer who is incorporated, with gross revenue of $900,000 and general overhead of $400,000, leaving a profit of $500,000. Assume further that she takes a salary of $450,000, leaving $50,000 as taxable corporate income. The income opinion would be that both the $450,000 as well as the $50,000 are available for support, for both represent income earned by the lawyer. The corporate veil should be pierced to show that, of the profit of $500,000, she took $450,000 as salary and the balance was not paid to her but it was still earned, and the profits are being left in the business. (See Example I above.) The cash flow opinion would probably want to include only the $450,000 as funds available for support.
Example 4-Pension contributions
In situations where pension contributions are completely optional, there seems to be agreement that those contributions would be included in funds available for support. The theory there is that since the funds could be paid into the pension or they could just as well be paid to oneself or one's spouse, the funds are available for support. The difficult situation arises where the contributions are mandatory. One school of thought treats the contributions as a necessary expanse, and so the funds are not available for support since they simply are not available. The other school of thought feels that while the funds may not be available, nonetheless, the net worth of the person who has the pension is going up as a result of the pension contributions. Since net worth is going up, the situation is analogous to a person who is earning income but the funds are not presently available. The first opinion looks at cash flow; the second looks at the income/net worth.
Example 5-Deferred compensation
Some employees have an arrangement with their employers to receive most of their income as they work, with the balance to be received many years in the future. The two opinions above regarding pensions would share the same opinions in a situation where the arrangement has become mandatory; one would look at the increase in net worth (income method) and the other would look at the cash flow.
A difference between pensions and deferred Compensation would be if the deferred compensation situation is only short term. Since the payout from the pension is normally very long term in the future, the cash flow method would ignore the pension contribution. However, if the deferred compensation situation is such that the compensation may be received in the short term future, even the cash flow method might include the deferred income as if it were currently available for support, since it will "soon" become available.
Example 6-Stock Options
Imagine a corporate executive who receives no salary but instead receives the right to acquire stock in the company over a period of years at very low prices. Assume further that the stock price rises from the time the options are granted. One position is that the person is not receiving any income during the period that she cannot exercise the options, and, therefore, there is not income or cash flow available for support. The other position asserts that the net worth of the person is continuously rising as the stock prices rises, and if her net worth is growing, then she should share it with her spouse. A similar discussion would result in a situation where a person's assets are held by a trust whereby he or she has no access to the funds for a period of time.
Refinancing and Other Loans
This issue is related to the above issue of income versus cash flow, but with a significant difference. Imagine a real estate developer who builds one apartment building a year, at a cost of one million dollars each, paid for completely with construction loans. At the end of each year, he refinances each construction loan for a permanent loan of $1,200,000. He uses the $200,000 for his living expenses.
This person is really living off loans. As such, one could argue that he has no income at all, and, therefore, has nothing available to support his spouse and children. On the other hand, he is managing to pull out $200,000 a year in equity from the construction; call it what you want, it's $200,000 of new money coming to him every year. Not only that but many people call that $200,000 the future profit to be realized if the building were sold. As such, he is receiving the profit now without the process of a sale, and as such, those funds represent profits and not loans. For that reason, one could argue that the funds should be considered income available for support.
Officer Loan Advances Used to Pay Taxes
Assume a Sub-S corporation (whose taxable income flows directly to the individual shareholder just like a partner in a partnership) with gross revenues of $900,000 and operating expenses of $600,000, for a net profit of $300,000. Assume further that the shareholder is at a marginal tax bracket or thirty-three percent and that the draws to the shareholder for the year totalled $100,000. Besides the above issue of income ($300,000) versus cash flow ($100,000) discussed above, there is a separate issue of amounts needed to pay taxes. the taxes due on the $300,000 of income will be, according to the thirty-three percent assumption, the same as the $100,000 paid to the shareholder as draws.
In a case that we were recently involved in, the opposing accountants did not include the $ 100,000 as income available for support because the money was needed to pay taxes and was, therefore, not available for support. Our position was that while taxes are eventually deducted from gross income/cash flow to obtain spendable income, they should not be deducted from the gross amounts. The gross income/cash flow should remain gross, and net amounts should not appear on a gross income/cash flow schedule.
To illustrate the above, imagine a person with gross salary of $100,000, with income tax withholdings of $30,000, for a net pay of $70,000. The first position, in effect, would include only $70,000 on the gross income schedule while the second position would include the entire $100,000 and would later deduct $30,000 when computing spendable income. The difference would be apparent if an attorney either carelessly or unintentionally uses $70,000 as gross salary because the Dissomaster will deduct taxes from $70,000 instead of taxes from $100,000.
There are two ways that one can view depreciation expense. Assume that a business acquired new equipment costing $500,000 that is expected to last for ten years. Since both tax and accounting rules require that the cost of the asset must be deducted over a multi-year period, let us assume that the business deducts the cost over ten years at $50,000 per year. One viewpoint is that the cost ($500,000) is being spread out over the life of the asset, so that, in effect, one is paying for the asset over the ten year period. The other viewpoint is that one is buying the entire asset now, but since we know it will only last for ten years, we must start saving now so that we can afford to buy the replacement equipment when this one wears out. The first viewpoint looks at depreciation as an allocation of cost; the second viewpoint treats depreciation as a reserve for future acquisitions.
The issue of depreciation results from the fact that it is shown as a deduction on financial records, but it does not necessarily reflect any cash outlay since the asset could just as well have been paid for with cash a few years earlier. Thus, in the financial period being analyzed, no cash was paid out.
The above may help explain why some accountants recognize depreciation expense as a decrease in income available for support only for long term support but not for short term. They seem to view depreciation conceptually as a reserve for long term future acquisitions, and, therefore, in the short term, depreciation is only an accounting or tax deduction, but not a real cash expense. Since, in the short term, it is shown on financial records as an expense, but it does not reflect any cash outlay, the expense should be ignored, and the amount available for support should be increased by the amount of depreciation expense.
One should note that it seems to be inconsistent for one to take the position that depreciation expense should be included for long term support (i.e., include the expense even though it requires no cash outflow), and to then take the position that cash flow and not income is to be used.
Cyclical Business Income
Imagine a person whose business income goes up and down every three years. For short term support, should the current year be used or should the average of the last cycle be used? Similarly, for long term support, which should be used?
A similar situation occurs with people who buy and sell stocks periodically and seem to consistently reflect capital gains every year or two. Should the capital gains be treated as income/cash available for support, or should it be treated as non-recurring, on the theory that such income is simply not predictable and may not recur.
In both of these situations, you will find accountants arguing either position. It is important to clarify which position is being taken and why, and analyze this in light of individual facts and circumstances.
In conclusion, the amount of funds available for support is often dependent upon underlying theories which are quire complex and divergent. Which theories a judicial officer adopts in any given case will determine the outcome. The judicial officer will not be guided by the law in this decision because there are no clear legal answers but he or she may be influenced by the effective arguments of counsel and a forensic accountant. Counsel also should consider the risk that a court will not follow his or her theory in a case in assessing a reasonable settlement posture and preparing for trial where gross income available is pertinent.
California divorce laws recognize that both spouses make valuable contributions to any marriage regardless of their employment. Property is labeled either "community property" or "separate property." Community property is all property, in or out of the state, that either spouse acquired during the marriage. Each spouse owns one-half of all community property. It does not matter if only one spouse worked outside of the home during the marriage or if this property is in only one spouse's name.
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