Family Law Economics, Child Support, and Alimony: Ruminations on Income, Part I
My economics of the family course covers the quantitative aspects of family law: Who gets what, who pays what, and why. To me, the quantitative aspects of family law and the practice of tax law are very similar. Both deal with money, income, property, who gets them and why, and how does my side keep more of them. Legions are the tax lawyers and accountants who seek to minimize income and assets to save client taxes. While doing this, they do not (or at least should not ) strive to minimize client wealth, as that would be counterproductive. Instead, using legal, technical definitions of income and assets, tax practitioners minimize what is reportable and thus keep all of the nonreportable income and assets for their clients. This huge tax planning industry exists to minimize the government’s approximate 35 percent tax share of income or 50 percent of assets (through estate/gift taxes).
But an ex-spouse’s share of income and assets often equals—and may greatly exceed—the government’s tax share. I refer to this as a “family tax.” Whatever incentives exist to minimize reportable income and assets for tax purposes, also exist for alimony, child support, and property division purposes. Thus, techniques to plan income streams and asset creation for tax purposes apply to the quantitative part of a family law practice, as well as IRS techniques to detect and to defeat income or asset planning. Tax practice is often likened to a game. Analogously, game theory should help explain spousal behaviors, especially in cases of divorce planning.
This article focuses on “income” as it relates to both child support and alimony. Isolating this factor is helpful because the definition of income is critical to a child support determination and is a major factor for an alimony determination. But, the isolated focus is risky because other factors are also important. For child support, factors such as expenses, age, and special needs are also relevant. For alimony, while “income” is a major factor, its role in the calculation is far less significant than that of child support. Because a judge may consider “any factor to do equity and justice,” an overemphasis on quantifiable “income” may risk an unjust result. I believe this is unlikely, however, for two reasons. First, “need” and “ability to pay” are by far the most important factors for alimony1 and “income” is paramount to each. Second, a court using equitable powers should consider the possibility of misleading “income” figures. To do so, the court must understand the term “income.”
For child support, F.S. §61.30(2)(a) defines gross income and F.S. §61.30(3) defines allowable deductions. Despite the many ambiguities, at least a statutory definition exists. In contrast, for alimony purposes, F.S. §61.08(2)(g) provides that “all sources of income available to either party” are relevant, but fails to define “income” for purposes of alimony. Presumably, the child support definition would apply—after all, the parties file a single financial affidavit, used for both purposes. The child support statute is deceptively detailed, including 14 specific items as gross income.2
The statute defines “gross income” but uses both gross and net figures, as discussed later. Neither the statute nor the related financial affidavit3 provides explicitly for losses—such as those from a business. Presumably, these constitute negative income; however, traditional tax and financial accounting uses of the term “gross income” would not include such losses. Instead, losses would be a factor in net income. Anecdotal evidence suggests that tax definitions of income and other terms are relevant for family law purposes; however, the unusual use of the term “gross income” to lead the statutory definition, followed by the inclusion of net numbers, calls such evidence into question. If we do not rely on a tax definition of “gross income,” then why would we use tax concepts at all?
Additionally, the statute fails to list any accounting principles. Tax and financial accounting both require consistency of accounting methods from year to year. For tax purposes, any taxpayer, or for financial accounting purposes, any audited company, could not change their depreciation or inventory methods without violating the consistency principle. Presumably, this would also be the case for family law. Without such a rule, a potential payer of child support or alimony could easily manipulate income by changing various accounting methods during the relevant periods. But if the consistency principle applies, where is the statute or court decision that says so?
The statute generally fails to require any particular method of accounting.4 In contrast, financial accounting requires (for external reporting) the complicated accrual method.5 Tax law sometimes requires the accrual method, but generally permits, for individuals, the cash method.6 The child support statute appears to use the cash method for some items—such as for retirement and annuity payments; however, it fails to discuss a method of accounting for major items such as business income, rental income, or trust income. Without a defined method of accounting—or clear rules for favoring one method over another—the statute leaves much room for manipulation and confusion. The following categories are confusing and are discussed below.
1) Salary or wages : Initial observation suggests this category relies on the cash method of accounting: Salary and wages are income during the year received. Yet for many individuals, deferred or prepaid compensation is commonplace. Suppose, for example, in 2001 husband/father received $100,000 as an advance payment for work to be performed over several years. Would that be income in 2001 for family law purposes? Financial accounting would spread the income out over the period that the work is supposed to be performed, while tax law would include the full value in the year the payment is received. For family law purposes, it probably should be spread over the time earned, as that would involve the periods to which it properly relates (particularly in relation to asset division). But that necessitates the accrual method of accounting, which would need to be applied consistently from year to year and from item to item (including deductions) if the measure of income is to be fair. The many difficulties of accrual accounting suggest that the cash method may be better, but under this method, the $100,000 would count as income during the year it is received.
That solution, however, presents two other problems. First, it permits spouses to accelerate income in advance of a planned (but likely undisclosed) divorce, effectively removing the income from the relevant base periods. Second, it permits spouses to defer income to years following a divorce. While such deferred income would be relevant to modifications of child support or alimony, the likelihood of such modifications is certainly less than the more certainty of the near-term awards. Attacking such accelerations or deferrals necessitates application of the accrual method, which itself necessitates consistency and thus daunting accounting rules. While it appears that there is no good answer for this issue, ignoring it merely rewards manipulation, which is clearly acceptable for tax purposes,7 but arguably less defensible for family law purposes.
2) Bonuses, commissions, allowances, overtime, tips, and other similar payments —As with salary and wages, do these items count as income when received or when earned? The word “payments” connotes the cash method of accounting for tax purposes. Taken at face value, it should mean the same for family law purposes; hence, bonuses and such are income based on the cash method—when received. The use of the word “payments” here suggests some deliberateness by the drafters. Perhaps such items are timed as income when received, but other items constitute income when earned. Such a literal reading is defensible under generally recognized principles of statutory construction. Yet, it seems to be an unwise policy. Why should some items be income when received and other items when earned? No supporting rational is clearly evident.
To the extent the word “payments” is taken literally, there is great room for manipulation. For example, a spouse could arrange to have a bonus or commission deferred to a period following the years expected to be considered in family law proceedings.8 In an apparent effort to defeat this arrangement, the long form financial affidavit requires the inclusion of “contingent assets and liabilities.” The instructions for the long form financial affidavit refers to accrued vacation pay, sick leave, or bonuses and income potential, as “possible” assets.
The references to contingent and possible assets are confusing for two reasons. First, the statutory authority for the financial affidavit appears in F.S. §61.075(a)(4),9 which deals with marital assets rather than income. Income potential and accrued bonuses would seem highly relevant to a definition of income; however, these items appear in the asset portion of the affidavit. Hence their relevance for an alimony or child support award is unclear. Second, accrued vacation, sick leave, and bonuses are more than “possible” assets. While not easily valued, to the extent accrued, they are assets, not contingent ones.
Listing deferred bonuses as assets rather than imputed income is particularly important, since imputed income would affect the guideline amount. Assets are only considered when courts decide if they want to deviate up to five percent from the presumptive guideline amount.10 Hence, assets are far less significant than income, real or imputed, in a child support award. The same is probably true of alimony awards in light of the notion that alimony is generally more of an award from income rather than assets. Further, the financial affidavit implicitly answers the question regarding methods of accounting. If the accrual method of accounting were to be used, accrued or deferred bonuses would be listed twice: under both income (for the year earned) and under assets until paid. Because the affidavit requires only one listing for such deferred assets, it must be contemplating the cash method of accounting. If so, this is profoundly important and should be more explicit.
3) Business income from sources such as self-employment, partnership, close corporations, and independent contracts. “Business income” means gross receipts minus ordinary and necessary expenses required to produce income. This category is the most confusing. specifically allowing deductions, it suggests that other categories constitute true gross amounts, unreduced by direct costs. As discussed above, the statute fails to provide for a general method of accounting, which is particularly important for business income computations. For tax and financial purposes, many businesses use the accrual method, while others use the cash method or a hybrid method. The lack of a specified accounting method provides no guidance to an expert that is asked to determine income.
The list of income sources is also troubling. First, the list is redundant in listing both self-employment and independent contracts. Second, are “close corporations” to be distinguished from publicly held corporations? Arguably, category 3 covers income from closely held entities, but not publicly held entities, which would be covered by category 10 (interest and dividends). Would that mean that all increases in wealth related to closely held entities constitute income, but only distributed dividends from larger entities are included in income? Surely this is not the case. But then what does category 3 intend to include for “close corporations”? Wages? No, because they are included in category 1. Dividends? No, because they are included in category 10. Gains from stock sales? No, because they are covered by category 14. What is left other than retained earnings? Apparently nothing else is left. But the inclusion of retained (undistributed) earnings as income is troubling, particularly when it applies to closely held corporations. The owner may not have control over distributions. Retained earnings may represent liquidity and thus a possible source of support, or, they may represent an investment in fixed assets that are not readily available for support. A better format for this category would be organized around the various formats business enterprises may take. It would also be designed not to discriminate between business formats and thus would seek to avoid creating incentives for manipulation. Such a list would include a variety of formats.
• Sole proprietorships . Sole proprietorships are the easiest to analyze, but they are still not easy to deal with. Sole proprietorships are not separate entities; hence, the ability to manipulate through assignment of income or expense is limited. The primary family law issue involves what constitutes “ordinary and necessary expenses required to produce income,” which may be deducted from “gross receipts.” That is a large loophole through which much income can “disappear”; hence, practitioners must carefully analyze each deduction.
The phrase, “ordinary and necessary expenses required to produce income,” is reminiscent of tax terminology.11 Tax law distinguishes the term “ordinary” from “extraordinary” or unusual.12 & #x201c;Day-to-day” and “short-term” also connote “ordinary.” The term “ordinary” is generally redundant with the term “expense,” which also connotes expenditures with lives of less than one year.13 Pencils and paper are short-term assets, and thus expenses. Desks and tables are long-term assets, and thus capital expenditures. Tax law generally defines “necessary” with reference to a business judgment rule: If the owner believes it is necessary, then it probably is.14 Some reference to comparable businesses is also relevant. Luxuries are not always “necessary”; however, for tax purposes, they often are deductible.15 Interestingly, according to the child support statute, ordinary and necessary expenses must be “required” to produce the relevant income. The word “required” is not typically used in tax law in relation to expenses and seems redundant with the term “necessary.”
Whatever the words mean for family law, large amounts of deductible expenses for income tax purposes are not “ordinary and necessary,” but are nevertheless deductible. For example, IRC §179 permits most businesses to “expense” up to $100,000 of capital expenditures annually. Such rapid expensing of assets reduces the after-tax cost of those assets and thus promotes investment and employment. However, §179 is not grounded on being “ordinary and necessary” and thus not deductible for family law purposes. Nevertheless, §179 costs are tax deductible and are thus certain to be part of any initial calculation of business income.
Additionally, Congress recently enacted §168(k), which allows a business to deduct 30 percent of the adjusted basis of specified property. Because §168 is grounded—for tax purposes—on the expenditure being “ordinary and necessary,” this acceleration would seem to qualify as a deductible expense for family law purposes. This definitely allows for some manipulation and may impact the decision of whether the business makes a §179 election.
Spouses seeking family support have the task of showing that “ordinary and necessary” expenses, as defined for tax purposes, are not necessarily “ordinary and necessary expenses required to produce income” for family law purposes. Of course, many are; however, many are not. While this should not be difficult, it does require a familiarity with tax terminology by both the family law practitioner and the court, or, at the very least requires the use of a forensic accountant—often an expensive item.
For example, a husband/father (HF) with a sole proprietorship has many opportunities to manipulate income. They largely overlap with well-known tax planning techniques. If HF knows of a planned dissolution two or three years in advance, he can diminish his potential family support responsibilities. . . particularly if wife/mother (WM) is unaware of the plans.
Through accelerated depreciation, renovation expenses, accelerations of receipts to early years, and deferral of receipts to years following the dissolution, HF can eliminate a large portion of his income from the sole proprietorship. This can be coupled with an investment in under-performing assets and deferred annuities. This plan will provide short-term tax savings; plus, if the years become the base period, it would also save substantial family support obligations. A good-faith disclosure of income will be substantially lowered, as will be a good faith list of assets. To the extent the expensed or under performing assets are leveraged, liabilities can be greater than the assets’ stated value. All this can present a poor financial picture. A forensic accountant, particularly one with significant tax law knowledge, should be able to attack most of these manipulations. But will WM be able to afford the forensic accountant? Will her attorney know to hire one? Will her attorney understand the issues sufficiently to explain them to the court? Will the court understand their arguments?
Surely this manipulation occurs and surely many spouses successfully overcome the manipulations. I suspect, however, most do not. The upside for husband is large: lower taxes—35 percent at the margin—and lower family support obligations—perhaps 50 percent at the margin, while the downside of the manipulations is small. In the worst-case scenario, husband will likely succeed at the tax savings and in at least some family savings. This produces an important ethical issue for business and tax attorneys, most of whom are probably not sophisticated family law practitioners. Divorce planning may produce a greater return than does tax planning, hence, the failure to at least inquire into the status of a marriage would seem to be malpractice for attorneys constructing a business plan. While many of the family law planning techniques may overlap with those used for tax planning, they must be tailored to the client and their needs.
• C corporations. C corporations are taxpayers: they pay taxes on income at up to 34 percent.16 Shareholders are again taxed on corporate income upon distribution.17 However, undistributed income—retained earnings—is not included in shareholder income. This double taxation has resulted in most eligible corporations electing to be treated as S corporations (discussed later). Nevertheless, many C corporations exist, and they prompt special issues for family law purposes. Therefore, only dividends should constitute income for family law purposes. For financial accounting, it would be income if consolidated financial statements were appropriate, but since the Florida statute specifically includes “dividends,” any inclusion of retained earnings would be incorrect.
Until recently, the double taxation of C corporation earnings constituted a sufficient reason for most businesses to avoid the status. The 2003 reduction in the dividend tax rate to 15 percent changes the analysis. The total federal tax on C corporate earnings will now be approximately 44 percent.18 The top tax rate on S corporate earnings is 36 percent. But undistributed S corporate earnings are subject to current, rather than deferred tax, while the excess C corporate tax is deferred until distribution. Additionally, S corporate retained earnings are probably income for family law purposes, particularly if the shareholder/spouse has control over the distribution timing. C corporate retained earnings, however, are not income for family law purposes until distribution. Plus, to the extent C corporate retained earnings result in share appreciation, they may never count as family law income.19
Proper comparison between the two corporate formats thus involves the total of government and family “taxes.” For S corporations, the total “tax” could realistically approach two-thirds—36 percent federal plus a comparable amount for child support and alimony. For C corporations, the total “tax” is more likely limited to the 44 percent government tax.20 Hence what has, until recently, been a high taxed entity, may now be viewed as a moderately taxed entity, when considering family law consequences.
• Partnerships, LLCs, and joint ventures. For federal tax purposes, partnerships are “pass through” entities; hence, they pay no tax. Like S corporation shareholders, partners pay tax on their distributive share of partnership income.21 Limited liability companies follow federal tax laws but state corporate laws; hence, they are partnerships for tax purposes and corporations for limited liability purposes. Similarly, joint ventures are partnerships for federal tax purposes. As a result, each partner or LLC member will have his/her share of profits appear on the appropriate tax forms.22 Probably, these tax forms will constitute the preliminary determination of income for family law purposes. Anecdotal evidence suggests that most litigants will neither seek nor consent to income amounts other than those appearing on the relevant tax returns. This is probably unfair.
As with S corporations, legitimate questions arise regarding the inclusion of undistributed partnership income in family law’s definition of income. The funds are not actually available for support, and they may not even be effectively available. For example, the partners may elect to retain profits for use in funding capital improvements. Such choices and elections affecting the determination and the timing of income occur at the entity rather than the individual level. Thus, the individual partner/spouse may have no real power to seek current or even near-term distributions of retained profits. Hence, questioning and un-doing such deferrals are arguably unfair considering that the owner/spouse may not be responsible for them. Nevertheless, most authorities would likely argue that the reported taxable income is indeed the correct amount of family law income.
Partnerships involve additional complications. S corporations allocate income proportionately among shareholders—each share is entitled to the same portion of income or loss. Partnerships, however, may specially allocate items of income or loss among various partners inconsistent with their proportionate share of “ownership.” A partner’s reported distributive share of income may be artificially low because of such special allocations of income or deductions, gains or losses.23 Such special allocations will be reported on tax returns and will have “substantial economic effect”24 In the mid to long run; however, in the short run, such allocations can be very distorting. As a result, the opportunities for manipulation increase exponentially. Hence, with competent planning, a partner/spouse may have little family law “income from partnerships,” although he may have a large increase in wealth from partnerships.
Attacking the manipulations, albeit a formidable task, is a realistic task for the IRS. However, attacking the permissible manipulations for family law purposes is probably beyond the capabilities of most family law practitioners and even many “experts.”
• Trusts. For state law purposes, a trust is a trust. However, for tax purposes, a trust comes in two main varieties: simple and complex.
A simple trust requires all income to be distributed annually to the beneficiaries. Still, the trust may have insufficient liquidity for distributions. The legal requirement of distributions has the effect of the beneficiaries being taxed; it does not have the effect of actually forcing the distributions to be made. Required distributions would seem to be income for family law purposes, just as they are for tax purposes, regardless of whether they actually occur. For child support purposes, undistributed income would seem to constitute income from a trust; and, for alimony purposes, such undistributed income would be arguably available.25 Practically, family law litigants will begin with reported income for tax purposes, which would include the undistributed amounts. That seems unfair if the spouse is not responsible for the lack of a distribution. But, not including such amounts would be similarly unfair if they were indeed responsible.
Complex trusts are akin to C corporations: They are not “pass through” entities. Instead, they are themselves taxpayers. Hence, much of the analysis applicable to C corporations is also applicable to complex trusts. For tax purposes, accumulated income in a complex trust is not taxed to the beneficiaries and would not appear on their tax returns.26 Whether it would constitute income from a trust for child support purposes is problematic. For accrual accounting, the trust would have an obligation to the beneficiary (at least to the extent future distributions were nondiscretionary) and the beneficiary would have a receivable. Accumulations, in that sense, constitute income even though they provide no liquidity—they do provide an accession to wealth. This is different from the treatment of retained earnings in a C corporation, which do not legally belong to specific shareholders and may never be distributed to them.
Money is fungible, which means even nonliquid wealth increases effectively free up other liquid assets because they provide some assurance such other assets will eventually be replaced. As stated earlier, the use of the word “from” in the child support statute, likely refers both to the cash and accrual methods of accounting. Hence, it logically includes accumulated income in a complex trust, which provides an increase in wealth and frees up liquid assets. But is this fair? Arguably, since the specific items of income are not received by or available to the beneficiary spouse, they should not be included as income for family law purposes simply because they provide greater liquidity or security.
For alimony purposes, the analysis is a bit different. Accumulated income is not available to the beneficiary spouse and thus should not constitute income. That means child support income and alimony income may be different figures—a nontraditional, troubling, and complex situation. In any event, undistributed income of a complex trust will not appear on the spouse/beneficiary’s tax return. As a practical matter, what appears on the spouse/beneficiary’s tax returns will likely form the initial determination of income for child support or alimony purposes. This would include distributions of income from prior years as well as distributions of current income.
Requiring a beneficiary/spouse to include undistributed (and nontaxable) income is arguably fair; however, if that were the case, the spouse should not again include it in the year of ultimate distribution—when it will indeed be taxable and thus appear on tax returns. In a particularly unfair scenario, a spouse/beneficiary may include his undistributed share of income as an asset in the years prior to distribution—and thus pay additional child support or alimony. Then, in the year of actual distribution, he may again include the same item as income, again paying additional child support or alimony because of the same item. Unfortunately, this double-dipping scenario is probably common in cases involving complex trusts.
• Estates. Estates are a form of complex trust. They permit some post-death divorce planning opportunities. To the extent child support and alimony income is a function of the cash method—income received or available—items earned by an estate in administration would not seem to be income to the beneficiary spouse. Such a spouse may have significant influence over the timing of distributions from an estate even if he or she were not the executor.
• Foreign entities. To the extent a spouse has offshore interests, the accounting issues can be complex. Not only do foreign tax rules differ from those of the United States, but accounting principles and rules also differ. What constitutes income in this country is confusing enough. What is income for foreign entities varies from jurisdiction to jurisdiction and thus the room for confusion (and resulting manipulation) increases with the number of foreign investment opportunities. q
1 See Canakaris v. Canakaris , 382 So. 2d 1197, 1201 (Fla. 1980).
2 Fla. Stat . §61.30(2)(a) (2003).
3 Fla. Fam. L. R. P . 12.285(d)(1) (2003) requires the filing of a financial affidavit in conformity with Fla. Fam. L. R. P. Form 12.902(b) [“short form affidavit”], or Fla. Fam. L. R. P . Form 12.902(c) [“long form affidavit”], depending on the parties’ gross annual income.
4 This includes the lack of a designation that the method for family law purposes must be the same as tax or financial accounting purposes.
5 Under the accrual method, income exists when earned, whether paid or not.
6 Under the cash method, income exists when received, whether earned or not.
7 Acceleration and deferral of income are commonly used tax planning techniques. Manipulation is a strong but accurate word to describe them.
8 For purposes of filling out the financial affidavit, only current year “income” and “assets” are used. However, the court has discretion to look at previous years if it desires.
9 Fla. Stat . §61.075(a)(4) (2003) lists among marital assets: “All vested and nonvested benefits, rights, and funds accrued during the marriage in retirement, pension, profit sharing, annuity, deferred compensation, and insurance plans and programs.”
10 Fla. Stat . §61.30(1)(a). In addition, a judge may deviate more than five percent from the guideline amount with written reasons. Id.
11 The Internal Revenue Code uses the phrase “ordinary and necessary” at least 13 times, most prominently in §162, dealing with business expenses, and §212, dealing with production of income expenses.
12 E.g. , Deputy v. Dupont , 308 U.S. 488, 495 (1940).
13 Treas. Reg. §1.461-1(a)(1) requires capitalization of expenditures with lives extending substantially beyond the end of the current year.
14 Welch v. Helvering , 290 U.S. 111, 113 (1933).
15 A plush office and first-class travel might be viewed as a luxury and not necessary to most people. However, such expenses would typically be deductible for tax purposes if related to income production.
16 I.R.C. §11(2003).
17 I.R.C. §1(h) (2003). The tax rate on distributions (dividends) is 15 percent.
18 The 44 percent comprises a tax of 34 percent at the corporate level and an additional tax of 15 percent on dividends at the shareholder level. The total is less than 49 percent because the shareholder tax is a function of the corporate tax.
19 It is possible category 14 may include this, since it deals with recurring gains from property.
20 If the C corporation were to pay dividends, however, additional federal tax would be owed on the amount distributed. In addition, such dividends would constitute income for family law purpose, resulting in greater potential alimony and child support. The textual statement is nevertheless correct because, when used for planning purposes, the C corporation would be unlikely to pay dividends during a period of alimony or child support risk.
21 I.R.C. §702 (2003).
22 Form K-1.
23 I.R.C. §704(b)(2) (2003) permits special allocations of income, deductions, and other items to particular partners. Such allocations could potentially result in a partner/spouse being allocated a larger portion of deductions and a smaller portion of income than his ownership percentage might appear to justify. To be respected, allocations must satisfy complicated substantial economic effect rules.
24 The substantial economic effect regulations are the most complicated area of U.S. tax law. Their use can hugely affect a partner’s income in the short run. Treas. Reg. §1.704-1(b)(2).
25 Arguably, such items might not be available , as required by Fla. Stat . §61.08 (2003).
26 I.R.C. §662 (2003).
Steven J. Willis is a professor of law at the University of Florida College of Law and is a member of the Florida and Louisiana bars, as well as having an inactive CPA certificate in Louisiana. He thanks Kevin Jacobs, a J.D. student at the University of Florida who holds CPA licenses in Colorado and Florida, for his assistance.
This column is submitted on behalf of the Family Law Section, Richard D. West, chair, and Michelle Cummings and Jeffrey Weissman, editors.
