Attribution of Corporate/phantom Income—are You Sure?

• Publication year: 2015
• Author: Marc Peter Kaplan

ATTRIBUTION OF CORPORATE/PHANTOM INCOME—ARE YOU SURE?

Marc Peter Kaplan

Marc Peter Kaplan, CFLS, was formerly a forensic CPA, went to law school to become a family law attorney only to have the Courts and the Family Law Bar say he should be a Special Master instead. Having now served almost twenty years as a neutral, he is a frequent lecturer on financial topics in family law and presents for The Rutter Groups CFLR Seminars. He also writes a Family Law News email for San Diego area Family Law Attorneys. To contact Marc, be added to the San Diego Family Law News or receive other Family Law Financial articles (free) contact marc@kaplanspecialmaster.com

Example:

$100,000 Salary received.

$1,000,000 "Sub S"¹ Income (owned 100 %)

What is the Income Available for Support?

There are four possible answers:

1) $1,100,000 -Expert for the Out spouse

2) $100,000 -Expert for the In spouse

3) $1,100,000 -Some Experts regardless of the side they're on, just their view

4) $ Depends -A case by case factual determina tion, no bright line

What is the answer? I believe the last response is the correct answer. It is a case-by-case factual determination. There is no bright line formula.

It is not necessarily automatically $1,100,000, nor is it automatically $100,000. Some forensic accountants automatically presume it is $1,100,000 because those are the accounting numbers that are on the tax return, but that doesn't mean that you use the numbers on the tax return and say that is the income available for support—they may not be. (In all cases we are presuming no additional add-backs for benefits, personal expenses, etc.)

A case-by-case factual determination takes into consideration several factors and then determines, based on the facts, the amount that should be included as income available for support. In most instances, no one should dispute the salary received as being income available for support. The real question is the corporate income that shows up on the tax return. Should that be included as income to the supporting party in part, in full, or not at all?

The discussion could be about a "Subchapter S" corporation, where individual owner(s) reports their pro rata share of income, or, a "C" corporation that doesn't distribute the income to be picked up on the individual's tax return, or a partnership, operating similarly to a Sub S corporation, where each partner reports his or her pro rata share of income, etc.²

Consider the two "A's": "Available" and "Accessible." Is the income "Available" to the owner? Is it "Accessible" by its owners?³

Available?: Availability has to do with whether funds are available. For instance, if the business bank account has little or no funds during the year, or at the end of the year, how can the income be available? Contrast a company flush with funds in the bank, at all times.

If the owner borrows the funds for her own personal use, and leaves no funds in the business, isn't that really disguised distributions of the income? Contrast the problem of a struggling business, never having enough funds to pay the bills, always late, bouncing checks—where is the excess cash flow?

What is the historical trend of the business? Is operating capital of some specific amount always kept on hand to cover bills that must be paid before the receivables are collected? Is the amount reasonably related to the business needs?

If the funds aren't legitimately available, all the argument in the world is not going to create income available for support.

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Accessible?: Can the owner/supporting party access the funds? If the owner is a ten percent non-operating partner in the business, how can they have unfettered access to the funds within the corporation? Usually they cannot. Alternatively, the 100% owner usually has unfettered access to the funds in the account. Of course, when ownership is less than 100%, accessibility is always at issue, notwithstanding fiduciary duty issues.⁴

Consider the suggested spectrum of factors and issues below, and then always ask whether the funds are available and accessible under each analysis.

Case Law:

There is only one attribution of income case in California. In re Marriage of Blazer (2009) 176 Cal.App.4^th 1438.

The Appellate Court affirmed Mr. Blazer's right to accumulate corporate net income and invest it in new business ventures to ward off competition and a resulting loss of business, thus denying the supported spouse the right to have income assessed for support on the accumulated income earned by the business.

The court affirmed the trial court's finding "The need to maintain higher capitalization in the company and the need to diversify the company's work are reasonable expenses that should not be charged against [husband's] income but rather should be taken out of the company before assessing what his reasonable income is for purposes of support."

This is the only case to date in California to address this issue of accumulating business income at the detriment of the supported party for important business reasons.

There are some attorneys who raise the issue of where the court will draw the line on the accumulation of business equity at the expense of a supported party. For instance, do we allow the loan principal pay down on a piece of plant equipment, necessary to expand the plant to produce more widgets and generate a higher income, or do we instead assert the concept of building up equity in the increased business should not be allowed at the expense of a supported party?

A manufacturer borrows $40 million dollars to expand the plant. Business net income quadruples from $2 million to $8 million per year. The debt service on the $40 million loan is four million dollars per year. Under normal circumstances would the debt service be a proper operating expense under Family Code Section 4058(a)(2) "...gross receipts of the business reduced by expenditures required for the operation of the business?"⁵

But for the plant expansion (financed and expanded before the divorce commenced), income would not have increased, and it increased dramatically due to efficiencies of scale, etc.

However, is it fair over the next ten years to allow the business to pay down the debt at the expense of the supported party? This wasn't divorce planning enacted after separation to lower support. This was real. It is a necessary business expense. This is no different than Mr. Blazer acquiring new companies to survive and grow.

I believe this is a reasonably allowed expense. However, there is no case law on the issue to date. Further, it gets more interesting when the issue becomes real estate rental properties and the owner is paying down the debt and accumulating equity, in contrast to equipment which may be truly depreciating and thus not worth its cost, the latter being more truly a necessary operating expense. Again, one day, we may have that answer.

My recommendations for legitimate business operations include allowance of the debt pay down. For real estate investments, I will provide dual calculations to the court with and without the equity buildup considered as part of the income.⁶

Factors to Consider: "A Case by Case Factual Determination"

The chart below reflects numerous possible factors to be considered in assessing whether the corporate, partnership or company income should be included as income available for support. This presumes the income is not distributed but left within the company. The chart should not be considered to be exhaustive, but it fits most situations.

In any specific case, some factors may be more important than others, and others may not be applicable. Merely meeting the goal of one factor may not necessarily mean the answer is to include or exclude. I believe it is for the court to weigh all the factors in making its decision. There is also a spectrum ranging from a holding that the income is totally includable, to only partially includable, to not includable at all.

We must understand the decision of how much, if any, to include as income available for support is not a bright line rule one way or the other, but a decision of the court, based on the facts and circumstances, on a case-by-case basis. It is not a decision of someone (parties, experts or attorneys) trying to manipulate the income available for support...