Family Law Economics, Child Support, and Alimony:Ruminations on Income, Part II
This article continues the analysis of the child support guidelines statute, F.S. §61.30(2)(a), begun last month, picking up with the suggested format for improving category 3 of the statute by organizing it around the various formats business enterprises may take.
• S corporations. Many small businesses incorporate and elect S corporation status.1 This is especially the case with those that the child support statute refers to as “close corporations.” An S corporation is a “pass-through” entity for tax purposes.2 It pays no federal tax; instead, shareholders pay tax on their pro rata share of entity income. Significantly, the income need not be distributed for it to be included as income for tax purposes.
The statutory reference to “business income” from “close corporations” probably refers to the shareholder’s pro rata share of S corporate income. That is certainly the number that will appear on the shareholder spouse’s tax returns. But, is use of that number fair to either spouse? Arguably, it is not. It can be unfair to the shareholder spouse because it includes as income items that are not received and often not receivable. Some of the valid business reasons for a corporation retaining (rather than distributing) income are: the corporation may have paper income, but no liquidity; the corporation may have plenty of cash, but need the funds for business purposes; or the majority shareholders of the corporation may simply vote not to distribute excess liquidity. In any event, having a federal tax on undistributed income is acceptable because it is elective. Shareholders could, instead, choose C corporation status for tax purposes, which would result in an entity tax but no shareholder tax absent any distribution. But, should tax- or business-motivated decisions—to elect S status and to retain income—obligate a spouse to pay more alimony or child support? If so, an incentive results for the shareholder spouse to seek C corporation status from inception or possibly convert the corporation form from an S corporation to a C corporation when planning for divorce.3 C corporation status will result in additional tax—probably an additional 15 percent, deferred to distribution—but it may save additional obligation for child support or alimony.
Pension, Retirement, or Annuity Payments
While generally clear, category 7, pension, retirement or annuity payments, is astonishingly unfair: it actually disadvantages both sides. The term “payments” surely refers to the cash method of accounting, i.e., what is actually received. This encourages a recipient spouse to defer receipts. For example, many plans provide for the commencement of retirement annuities as early as age 59 and a half or as late as 70 and a half. They likewise provide for other elections, such as fixed-term annuities, single life annuities, or joint annuities. Naturally, the various elections result in differing payments. No apparent authority exists for a court to impute amounts not elected and received.
The reference to “annuity payments” provides even greater opportunity for manipulation. Consider a spouse with $150,000 cash invested at five-percent interest, yielding $7,500 annual interest income. If invested in a deferred annuity, it would produce no income during the deferral period. It would increase in value, but would produce neither taxable income nor payments considered income under the cash method of accounting. Presumably, it would also produce no “payments” under this category and thus no income for family support purposes.
A court’s power to consider such deferred assets is far less significant than the power to consider the relevant income from the assets. But, the only statutory authority for imputed income applies to voluntary unemployment or underemployment. It does not apply to under performing assets. Hence, a spouse with substantial assets can invest excess funds in a deferred annuity while depleting the remaining assets. The resulting lack of cash flow should reduce family support obligations.
This category is also unfair to the payor spouse. Annuity, pension, and retirement payments typically have both interest and principal components. For example, the hypothetical annuity, with current payments would produce $1,590.88 monthly for 10 years. During the first month, $625 of the payment would be interest and the remaining $965.88 would be principal. Counting the entire cash flow as income—which the statute clearly does—is unfair. The $965.88 is no more than a withdrawal of assets from an investment account, analogous to a withdrawal from a checking account. No one would consider a checking account withdrawal to be income; yet, that is exactly the impact of counting annuity payments as income. At most, the principal portion of the payments should count as available assets rather than income.
Similar analysis applies to retirement payments. To determine income, F.S. §61.30 permits a deduction for mandatory retirement contributions, but not for voluntary contributions. As a result, the amount of the employee contributions counts as income in the year contributed, as salary, category 1. To again count it as income in the year withdrawn is unfair on its face.
Social Security Benefits
Category 8, Social Security benefits, is subject to manipulation through deferral. The reference to “benefits” suggests the cash method of accounting. A spouse may be eligible for reduced benefits at age 62, greater benefits at age 66, and maximum benefits at age 70. Clearly, a spouse who elects to receive the reduced benefits at age 62 has income in the amount received. But what is the income of a 63-year-old spouse who elects to defer benefits until age 66 or 70? The term “benefits,” by implying the cash method, suggests the amount of income recognition would be zero until actual receipt. But, such an interpretation encourages manipulation. Why would a spouse with otherwise adequate funds elect to receive early benefits if such an election would result in significantly increased child support or alimony obligations? While a court has the authority to consider “available assets” in determining an award, the use of potential social security benefits seems unfair. Early retirement results in significantly reduced benefits in addition to increased income tax liabilities. Sound rational reasons—other than divorce planning manipulation—exist to support deferral. Imputation of unelected benefits not only lacks statutory authority, but it also appears punitive to the retiring spouse.
Interest and Dividends
Initially, category 10, interest and dividends, seems to be clear, but it is not. Does the term “interest” include deferred interest? Such interest is taxable as income and would constitute accrued income for financial accounting, but it does not result in any cash flow until received. Including deferred interest in family law’s “income” is unfair to the earner in that it would require payment of alimony or child support based on unavailable resources. Not counting it, however, encourages manipulation: an investing spouse would simply purchase long-term instruments, deferring receipt of interest until later, possibly irrelevant periods.
Money does not deteriorate, at least not in a tax sense, and thus is not subject to depreciation or amortization; hence, all interest is considered income. Inflation, however, causes deterioration in the value of money deposits. Arguably, to the extent interest earned includes compensation for past inflation, it is not income.4 This argument has been unsuccessful for tax purposes, but it seems fair for family law purposes.
The analysis is even more profound in relation to dividends. Historically, most stocks paid regular cash dividends. More recently, most stocks paid small, if any, dividends, favoring capital appreciation. Recent tax law changes reducing the tax on dividend income will probably prompt greater current dividend payments. Nevertheless, an investor spouse will always have choices between investments that pay substantial dividends and those that do not. Ignoring taxes and family law considerations, the choices are probably equal in a macro sense: the market should result in equal rates of returns for comparable risks. Tax considerations and family law considerations, however, will affect the choices made.
Another problem with the use of the term “dividends” involves stock dividends and splits. Generally, a stock split involves a pro rata increase of more than 25 percent of outstanding shares. It involves no accounting entry and has no tax consequences. While providing greater liquidity to shareholders, it typically causes a per share price reduction balancing the increase in the number of shares. Thus, it commonly produces no wealth increase and should not be considered income. A smaller stock dividend, however, typically involves a financial accounting entry involving the capitalization of retained earnings. While it results in no current tax consequences, it typically results in a wealth increase: the per share price drop will not fully balance the increased value resulting from a greater number of shares. Economically, it differs very little from a cash dividend. As such, it probably should be considered income for family law purposes. Thus, it is unclear whether we should include stock dividends and splits in the calculation of “income” for family law purposes and, if so, how we are to value them.
An investor must currently pay 15 percent of any dividends to the government, but need not pay a comparable capital gains tax for capital appreciation (which occurs when a corporation retains earnings) until a sale. Similarly, an investor may need to share a portion of dividends received with an ex-spouse through alimony and child support, but would not typically share as great a portion of capital appreciation. Because the effective family tax will typically exceed the 15 percent government tax, the effect on investment decisions should be substantial.
No statutory authority for imputation of dividends exists, just as no general authority exists for imputation of income on under performing assets. Such authority is not unprecedented, as it effectively exists for Florida trust law purposes.5 The lack of such authority is particularly significant in light of the explicit listing of “interest and dividends” as well as the explicit listing (category 14) of only recurring gains on property. Thus, looking at the child support statute, it appears that nonrecurring gains would not be considered income. Hence gains resulting from retained corporate earnings do not count as income. Economically, however, no important difference exists between retained and distributed earnings: both are available for future investment. Substantial tax and family law differences exist; but those are arbitrary and thus prompt manipulation.
Similarly, an investor spouse might invest in nonperforming assets, such as vacant land. Such assets may produce substantial gains over time, but often produce little current cash flow. Because the statute so clearly refers to interest and dividends, and excludes nonrecurring gains, an investment decision to choose nonperforming or underperforming asset seems a safe method of reducing potential alimony and child support, just as it is a safe vehicle for income tax. Such investments, considering their lack of liquidity, come with a significant risk. That risk, however, when weighed against substantial taxes, alimony, and child support may be comparatively small. Would a spouse make such investment decisions for the purpose of reducing family support obligations? I predict many would and do. Should a court have the power to undo such decisions? Perhaps, but how would such power be exercised? Should it involve an imputation of income or a guideline deviation? Should a court exercise such authority only when evidence of manipulation exists? What if the spouse has a family history of investing in vacant land or growth stocks? Requiring partial liquidation for payment of child support seems reasonable, but requiring it for payment of alimony seems less fair unless the assets were somehow relied upon during the marriage. In any event, the current statute appears to eliminate such authority.
Rental Income
This analysis of category 11 (“Rental income, which is gross receipts minus ordinary and necessary expenses required to produce the income.”) follows that of category 3, business income. An important difference involves the impact of the various categories on the definition of marital assets. For purposes of child support and alimony, classifying “income” as being from one source, such as business, or another, such as rent, does not matter. But, for equitable property division, the source of the asset is paramount. Although income is not an asset, it certainly produces assets and assets certainly come from wealth increases, i.e., income. But which income creates marital assets and which income creates nonmarital assets?
Full analysis of this is best dealt with in a later article focusing on property division. For now, note that listing income in one category or another may have no significance for child support or alimony; however, that classification could have major significance for a determination of which assets are marital and which are nonmarital. Arguably, business income is active and produces marital assets, while rental income is more passive and may remain nonmarital if derived from nonmarital property. Hence, counsel focusing on support issues in filing the income portion of the financial affidavit should consider the collateral equitable distribution consequences.
Income from Royalties, Trusts, or Estates
No reason exists to interpret the meaning of income from trusts and estates (category 12) differently from that of corporations or partnerships. Unfortunately, however, categories 3 and 11 add the specific qualifier that “ordinary and necessary expenses” are deductible from the income, while category 12 has no such provision. Fairly, this category should allow such deductions (whatever the terms mean). However, a literal reading would not permit them: The legislature clearly knew how to provide for ordinary and necessary expenses, but failed to do so.
Royalties (which have nothing particular to do with trusts and estates) refer to earnings from patents, copyrights, other intangibles or minerals, each of which have limited lives. Royalties are thus part true income and part compensation for deteriorating principal. Arguably only the true income portion should be income for family law purposes. To the extent an owner has a cost in the underlying property, that cost should be recoverable for family law purposes, although the statute fails to provide for deductions. Whether such cost recovery should be limited to historic costs, rather than value deterioration, is unsettled.
Timing is also an issue: A spouse who sold a patent or copyright would have taxable gain but no “royalties.” The gain would be taxed differently than would be ordinary royalty income. Similarly, for family law purposes such a sale would seem to be covered by category 14, dealing with recurring gains. Royalties are comparable to recurring gains, but lump sales of a patent or copyright would be more comparable to nonrecurring gain, which would have no impact on family law income. The reduced tax consequences already provide authors and other intangible asset holders some incentive to sell their products, rather than seeking royalties. Due to the potential “family tax” consequences, the incentive to sell the item rather than seeking royalties is even greater. This, too, might be considered manipulation.
Mineral royalties provide an additional problem: depletion. No apparent allowance for depletion exists in family law, which seems unfair. Production of mineral royalties involves a selling off of assets, much like the recurring gains in category 14. Hence, an investment decision—to develop minerals—punishes a spouse in comparison to a similarly situated spouse who invests in nondepleting assets. A countervailing argument exists with regards to spouses who decline to develop minerals.
Reimbursed Expenses or In Kind Payments That Reduce Living Expenses
Category 13 (“Reimbursed expenses or in kind payments to the extent that they reduce living expenses.”) is too narrow.To the extent it refers to “payments” it relies on the cash method of accounting; thus, it prompts manipulation through elective deferrals. Further, the condition that such amounts “reduce living expenses” seems unduly restrictive. To the extent in kind payments result in greater savings—perhaps they involve equipment or other property with a life greater than one year—they would not seem to reduce living expenses except to the extent currently consumed. Yet the entire value would normally constitute taxable income and would certainly involve an accession to wealth. Unless nontransferable, they could be sold to produce cash flows comparable to cash payments of income items. Hence, the living expenses restriction is overly restrictive.
Another possible consequence of the restriction involves in-kind payments that fulfill business rather than personal needs. A lawyer spouse may receive a computer or free use of electronic research. These items would not reduce living expenses, at least not directly. To the extent they were current consumed, they would indirectly increase business income and thus effectively count; however, to the extent they were not consumed or did not reduce business expenses, they could increase wealth but not increase “income” as defined for family law purposes.
The narrowness criticism involves the limitation to “payments” and “reimbursed expenses.” It says nothing about many other types of “fringe benefits” such as discounts. When a spouse is able to travel for a reduced price, purchase clothing or appliances or automobiles at a reduced cost, or eat for a modest price, wealth accession results. However, classifying price reductions as “payments” is at least problematic. They should be so classified, but it requires a clear stretch of the statute.
Gains Derived from Property, Unless Gain Is Nonrecurring
Category 14 (“Gains derived from dealings in property, unless the gain is nonrecurring.”) has great importance not only for family support calculations, but also for property division. The importance is particularly large because of the implied “cliff effect.” Gains derived from dealings in property constitute income for child support purposes, but only if the gains are recurring. Nonrecurring gains are not included in the income calculation. At the margin, the difference between recurring and nonrecurring is slight; at some point, one additional similar dealing “breaks the camel’s back,” causing a series of deals to become recurring. Viewed individually, that marginal deal is insignificant. In context, however, it is profoundly important.
Posit a husband/father (HF) who separately owns 100 acres. Sold in a single block, any resulting gain would not be recurring. If HF divided the property into two 50-acre tracts, the resulting gains would similarly not be recurring. Whatever recurring means, two is probably not it. But if HF divided the property into 90 single acre tracts, added roads and common ground on the remaining acres, and then sold the lots in a single-family home subdivision, the resulting gains would almost certainly be recurring. While anyone can distinguish two sales from 90, the distinction at some point becomes very difficult. Which sale tips the scale? The 15th? The 30th? The issue is often litigated for tax purposes, although the resulting answer is not always predictable. For purposes of this article, I am not so concerned with the classification analysis; instead, I am much more concerned with the consequences of the classification.
For tax purposes, such a marginal deal—be it the 15th or the 30th—causes the series of transactions to become ones involving “property held primarily for sale to customers in the ordinary course of a trade or business,” and thus taxed at ordinary rates—up to 35 percent. However, one less deal results in capital gains treatment, and tax rates of 15 percent. While such greater development may result in greater total profits, it thus also results in a higher tax rate. For example, the 100-acre tract may produce a price of $100,000. The 90 single acre lots, however, may result in total sales of $1,000,000. Even after considering development costs, the excess profits may be very large. But the owner/developer must be cognizant of the changing tax consequences. At some point—and that point may be very unclear—an additional sale results in an extra tax of approximately 20 percent on the whole series of transactions. That marginal transaction thus is very costly unless the additional profits exceed the additional taxes.
The same is true for family law. Without the marginal deal—tipping the series in to the recurring category—the profits from property development are not included in income for child support purposes and matter less for alimony purposes.6 With the marginal deal, the entire series of similar deals become recurring and the resulting income counts as income. The combined child support and alimony share could easily be 20 to 30 percent. Hence, the “family tax” consequences may significantly exceed the government tax consequences.
But that is not all. If the underlying property is nonmarital, the importance of the marginal deal is even greater. Nonrecurring gains suggest relative passive involvement of the owner-spouse and thus the production of additional nonmarital assets. Such assets remain the separate property of the owner spouse. Recurring gains, however, suggest more of an active involvement of the owner spouse and thus the production and acquisition of new marital assets with the proceeds. Half of the value of such assets, presumably, becomes the property of the nonowner spouse. Effectively, that results in a marginal “tax” of 50 percent of the recurring gains. Combined with the additional government tax of 20 percent and the additional family “tax” of up to 30 percent or more, the total “tax” on recurring gain can quickly approach 100 percent, or even exceed 100 percent.
Additional analysis should focus on the individual words used in this category. The term “gains” suggests gross receipts reduced by various costs. At least, it would involve reduction for direct costs of the property sold or exchanged. In addition, it should include direct costs related to the sales and probably should include indirect costs, such as overhead, as well. Unfortunately, the statute fails to refer to costs, unlike the analogous references in categories 3 and 11. At some point, recurring gains become a “business” and the analysis shifts more to category 3, which clearly allows deductions, presumably including indirect costs.
Another interesting aspect of the term “gain” involves what to do with losses. If a spouse must share recurring gains with an ex-spouse, fairness suggests at the very least, for family support purposes, recurring gains should be reduced by recurring losses. Surely the existence of losses predicts less of an ability to pay support. But what about losses in excess of gains? The answer is not necessarily the same as that for losses that merely reduce, but do not exceed, gains. Excess losses, if they count, could potentially eliminate other income from such sources as wages and salary. Even if recurring, do they necessarily predict an inability to pay support? Not necessarily, as they may indicate the existence of substantial assets, such as a stock portfolio, that has recently declined in value. Naturally, if that were the case, the existence of remaining asset value would affect child support and alimony. However, if the losses count, the issue becomes one of guideline deviation for child support purposes, so the question can have real significance.
The word “nonrecurring” is also confusing. For tax purposes, the classification is not merely a function of the number or frequency of the deals; instead, it involves many other factors. How much time did the owner spend on the deals? How much extra development was involved? Did the owner use a broker or did he conduct the transactions himself? Such extra involvement and development suggests business dealing rather than passive gains, and thus results in higher government taxes. Is the analysis the same for family law purposes? The family law statute suggests that the answer is perhaps no. It only lists the frequency of deals as a factor in the classification. For purposes of resulting asset classification, other authority suggests the personal involvement of a spouse becomes important.7
Conclusions
Calculations of child support, alimony, and property division can be complicated. But, none of the admittedly complicated issues can be accurately settled without a fair, accurate determination of income and assets in the first place. More effort probably goes into the division of income and assets, and less effort probably goes into the initial determination of what constitutes income and assets. If so, the fairness of the resulting divisions is illusory.
I ask many questions herein and provide few answers or solutions. That is troubling, but not easily resolved. Our system moved to one grounded in spousal “income” almost 20 years ago with the creation of child support guidelines and the expanded requirement of financial information disclosure. But the touchstone of “income” is itself inherently flawed. A common joke (and probable reality) among accountants involves a client question of “What is my income?” “What do you want it to be?” is at least the unstated, if not explicitly stated, typical answer. The word “income” has no meaning without clearly defined principles and methods of accounting and rules for recording and reporting transactions. Those principles, methods, and rules are very complicated. No wonder accounting is often a five-year degree program at many universities and the first-time pass rate for the CPA exam is typically below 20 percent and in some jurisdictions below five percent.
Accounting is not easy. Yet our family law support system, as well as the division of property, is inherently a function of accounting. Requiring family law practitioners and judges to be CPAs and tax experts is a solution, but hardly a viable one. For now, however, I have no other solution. I mostly have only questions. In most cases, the lack of answers probably does not matter. Often the parents have so few resources, the lack of clarity regarding “income” is immaterial. In other cases, the parents are employed at a fixed salary or earn predictable amounts of wages; as a result, manipulation is unlikely. Still, many parents have small businesses. For them, the lack of answers and solutions to “what is income” becomes hugely important. The artificial, mechanically induced perception of “fairness” involving family support and property division is likely often an illusion. q
1 I.R.C. §1361(2003).
2 I.R.C. §1363(2003).
3 There are tax consequences of this conversion that the owner spouse and the corporation would have to consider. Such consequences are beyond the scope of this essay.
4 Lenders charge interest for three reasons: liquidity, inflation, and risk. To the extent interest payments compensate a lender for liquidity or risk, they constitute real returns. However, to the extent they compensate for inflation, they provide no economic increase in wealth. The tax system counts such inflationary compensation as income; however, no compelling reason exists for the family law system to follow suit. Indeed, economic income would seem to provide a fair basis for alimony or child support. Florida trust law permits such an analysis in that it permits a trustee to allocate the “inflation” component of income to principal. Fla. Stat. §738.104(2)(h).
5 Fla. Stat. §738.1041 permits a trustee to convert an income trust into a unitrust, which pays a percentage of asset value to the income beneficiary. Fla. Stat. §738.1041. Section 783.104 also grants a trustee power to invade principal to make increased income distributions. Fla. Stat. §738.104.
6 For child support purposes, if the profits are not income, they are only relevant to the extent the value of the spouse’s assets are relevant—for purposes of deviation from the guidelines. For alimony purposes, if the profits are not income, they are still considered as “financial resources.” However, substantial authority suggests that income, rather than assets, is the most important factor in determining alimony.
7 Fla. Stat. §61.075(a)(2) classifies as marital assets, the enhancement in value of nonmarital assets resulting from the efforts of either party.
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.
