Tax Returns Can Make or Break Your Case

The primary purpose of a tax return is for government entities to assess income taxes on the earnings of a business or individual, but in divorce, the role of the tax return is much broader and serves various purposes. Business and personal tax returns should be thoroughly analyzed before marital assets are divided and before income is set for the purpose of determining spousal maintenance and child support. If analyzed properly and creatively, they can help show whether: 1) there was financial irresponsibility; 2) income is much greater than appears on the surface; or 3) assets no longer exist that one spouse assumes still do exist.

Financial Irresponsibility

I was recently approached by a divorce attorney who was handling a litigated divorce that involved a custody battle for two small children. In addition to developing a picture of the husband's inadequate parenting, she wanted to make a case for his financial irresponsibility as well. He was the primary breadwinner and made most of the financial decisions in the marriage. The only documents I had available were 5 years of personal tax returns, the W-2 forms and the Statement of Net Worth. The husband and wife were both wage earners. They had been renting their apartment and were barely able to make ends meet. When her generous parents gifted them a sizeable amount of money to be used as a down payment on a home, they purchased an expensive residence, taking on a very high mortgage. This spiraled them into enormous debt, which they could not sustain. The final result was that both spouses had to file for personal bankruptcy.

A Hypothetical Case Study

The case study that follows closely mimics this case. The first step we took in analyzing the husband's finances was to develop an Excel spreadsheet (see exhibit in Sidebar, below) detailing “cash inflow and cash outflow” for the five most recent consecutive years for which I had tax returns. Gross income items are at the top, in the same order in which they appear on the tax return.

The first thing to note is that taxable wages are not necessarily the same as gross wages. The W-2 form is very helpful in this regard. Line 7 of the federal 1040 personal tax return reads, “Wages, salaries and tips, etc.” In our example, without the actual W-2 form for the husband for the year 2000, his wages appear to be $80,100. However, analysis of his entire W-2 form and, if available, the “Employee's Reference Copy” with the “Earnings Summary,” shows that his actual gross wages are $95,000, because he received other benefits of value, such as life insurance premiums of $100, paid by his company, for insurance exceeding $50,000; $700 of transit checks; a $9000 401(k) plan contribution; and flexible spending plans for medical insurance premiums of $300 and dependent care of $5000. Dependent care, transit checks, medical insurance and life insurance affect the FICA tax calculation, which is critical for calculating child support. The first three benefits decrease FICA income, while the fourth — life insurance — increases it.

Deducting the total tax liability for FICA and federal and state income taxes for each year, yielded “disposable income,” ie income after taxes. Additional “outflow” items came from “itemized expenses,” as detailed on Schedule A of the subject's federal tax return, the detail of the W-2 form, the “Statement of Net Worth” and client discussions. By subtracting the outflow from disposable income, it became obvious that the inflow was not able to support the needs of the family, even though the family was modest in its spending habits.

In 1999, prior to buying their home, the couple in question was barely able to make ends meet. By the end of that year, they had increased credit card debt from zero to $8855. After buying their home in 2000, their finances went totally out of control. They could no longer contribute to their pension plans, and their small amount of savings had to be spent to extinguish some of the debt. At the end of the 5-year period, credit card debt had ballooned to over $160,000, including interest incurred at a rate of 19%.

The moral is that tax returns do not just report income; they tell a story. If analyzed critically, they can present a picture of lifestyle and spending habits.

'Imputed Income' of Business Owners

All business tax returns, regardless of their structure, must be thoroughly examined for “imputed income,” better known as benefits derived from the company by its owner. Without seeing the underlying accounting records, one does not truly know what benefits sit in “office expenses” or other expense categories. The tax return is often the beginning point for identifying such benefits. It is beneficial to review the business tax return with a client, regardless of whether he or she is the owner of the business. The client often knows where the weaknesses lie or if income is understated or expenses overstated.

The most obvious expenses that would constitute additional income to the owner fall into the categories of meals and entertainment, automobile, travel, home office deductions, and promotion and employee benefits, such as medical and pension benefits. The nature of the entity determines if certain deductions are allowed for tax purposes. For example, a sole owner of a “C” corporation, with no employees but himself, can have a medical reimbursement plan for his and his family's medical expenses, including health insurance. In contrast, a sole proprietor of a single-member limited liability company with no employees is not allowed to take a deduction for these expenses against business income. For the “C” corporation owner, the medical expense deduction should be treated as “imputed income” and added to his or her wages.

For illustration, let's take the example of a man who has a net income of $63,722. Although on his federal Form Schedule C: Profit or Loss from Business, for a Self-Employed Individual he has taken 100% of his automobile expenses – totaling $5000 on line 10 and $9600 on line 20a – we know from speaking with our own client that he rarely uses the car for business. We also know that “travel” expenses totaling $7760 were mainly for personal trips abroad, and most of his meals and entertainment expenses, reported as $5576, involved dining out with friends. The home office expenses of $5502 would have been incurred even if he were not self-employed.

Adding these expenses back to his original net income of $63,722, his income increases to $97,160. The additional imputed income of $33,438 could have a significant impact on the value of the business. It could also cause child support and maintenance payments to increase significantly.

If the business is a cash business, other strategies need to be developed to obtain a true picture of income. One true-life case I was involved with concerned a hot dog vendor in New York City. In order to properly evaluate this case, it was necessary to hire independent people to watch and count the number of sales he transacted over the course of a week. Needless to say, income imputed from this exercise, and extrapolated over a full year, resulted in much higher income than he had reported. This case was settled out of court, for obvious reasons.

Tracing Assets

It is very common for one spouse to manage the finances, including preparation of the tax returns. The other spouse often signs the returns without bothering to review them. Only years later, usually during divorce, does this spouse learn that an asset no longer exists or that debt is higher than expected.

The tax return can help us trace the existence of some of these assets, because they often generate income, eg, interest from savings accounts and bonds and dividends from stocks and mutual funds that appear on federal Form Schedule B: Interest and Ordinary Dividends; rental income from real estate and royalties from intangible assets that appear on federal Form Schedule E: Supplemental Income and Loss; and Business Iincome from Partnerships; and “S” corporations that also appear on federal Form Schedule E. Assuming that income from these assets had been reported on the tax returns, we should be able to see the sale of these assets, except for bank accounts, on the federal Form Schedule D: Capital Gains and Losses. If the sale does not appear on Schedule D, further investigation is needed. Perhaps the asset was “gifted” without your client's knowledge.

Income from assets reported on the tax return also needs to be compared to assets reported on the “Statement of Net Worth” prepared specifically for the divorce by both parties. In addition, if the parties have applied for loans and mortgages over the years, income from assets should be compared with the “Statement of Assets and Liabilities” that is prepared for these applications. When people seek loans, they naturally want to present their own financial picture in the best light, so all assets should thus be listed on this document. Since most of us rarely keep copies of these applications, you might need to request them from the lending institution. (The state of California has been known to obtain mortgage applications and compare them with tax returns for the express purpose of discovering unreported income.)

Tax returns are critical documents for gathering financial information to ensure that the divorce results in an appropriate financial settlement and protects both spouses and their children. They are useful in isolation, but identifying trends and inconsistencies is also important. To this end, in addition to obtaining copies of tax returns from clients, you might want to consider obtaining copies filed with the taxing agencies directly. For example, this may help determine whether “innocent spouse” protection may be an issue during the divorce proceedings. The copies one spouse has may not be the ones actually filed.

Conclusion

The creative and knowledgeable professional does not stop at the obvious facts but looks to ensure that underlying data are consistent with assets, income and lifestyle. It's always important to look for the story behind the numbers.

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The primary purpose of a tax return is for government entities to assess income taxes on the earnings of a business or individual, but in divorce, the role of the tax return is much broader and serves various purposes. Business and personal tax returns should be thoroughly analyzed before marital assets are divided and before income is set for the purpose of determining spousal maintenance and child support. If analyzed properly and creatively, they can help show whether: 1) there was financial irresponsibility; 2) income is much greater than appears on the surface; or 3) assets no longer exist that one spouse assumes still do exist.

Financial Irresponsibility

I was recently approached by a divorce attorney who was handling a litigated divorce that involved a custody battle for two small children. In addition to developing a picture of the husband's inadequate parenting, she wanted to make a case for his financial irresponsibility as well. He was the primary breadwinner and made most of the financial decisions in the marriage. The only documents I had available were 5 years of personal tax returns, the W-2 forms and the Statement of Net Worth. The husband and wife were both wage earners. They had been renting their apartment and were barely able to make ends meet. When her generous parents gifted them a sizeable amount of money to be used as a down payment on a home, they purchased an expensive residence, taking on a very high mortgage. This spiraled them into enormous debt, which they could not sustain. The final result was that both spouses had to file for personal bankruptcy.

A Hypothetical Case Study

The case study that follows closely mimics this case. The first step we took in analyzing the husband's finances was to develop an Excel spreadsheet (see exhibit in Sidebar, below) detailing “cash inflow and cash outflow” for the five most recent consecutive years for which I had tax returns. Gross income items are at the top, in the same order in which they appear on the tax return.

The first thing to note is that taxable wages are not necessarily the same as gross wages. The W-2 form is very helpful in this regard. Line 7 of the federal 1040 personal tax return reads, “Wages, salaries and tips, etc.” In our example, without the actual W-2 form for the husband for the year 2000, his wages appear to be $80,100. However, analysis of his entire W-2 form and, if available, the “Employee's Reference Copy” with the “Earnings Summary,” shows that his actual gross wages are $95,000, because he received other benefits of value, such as life insurance premiums of $100, paid by his company, for insurance exceeding $50,000; $700 of transit checks; a $9000 401(k) plan contribution; and flexible spending plans for medical insurance premiums of $300 and dependent care of $5000. Dependent care, transit checks, medical insurance and life insurance affect the FICA tax calculation, which is critical for calculating child support. The first three benefits decrease FICA income, while the fourth — life insurance — increases it.

Deducting the total tax liability for FICA and federal and state income taxes for each year, yielded “disposable income,” ie income after taxes. Additional “outflow” items came from “itemized expenses,” as detailed on Schedule A of the subject's federal tax return, the detail of the W-2 form, the “Statement of Net Worth” and client discussions. By subtracting the outflow from disposable income, it became obvious that the inflow was not able to support the needs of the family, even though the family was modest in its spending habits.

In 1999, prior to buying their home, the couple in question was barely able to make ends meet. By the end of that year, they had increased credit card debt from zero to $8855. After buying their home in 2000, their finances went totally out of control. They could no longer contribute to their pension plans, and their small amount of savings had to be spent to extinguish some of the debt. At the end of the 5-year period, credit card debt had ballooned to over $160,000, including interest incurred at a rate of 19%.

The moral is that tax returns do not just report income; they tell a story. If analyzed critically, they can present a picture of lifestyle and spending habits.

'Imputed Income' of Business Owners

All business tax returns, regardless of their structure, must be thoroughly examined for “imputed income,” better known as benefits derived from the company by its owner. Without seeing the underlying accounting records, one does not truly know what benefits sit in “office expenses” or other expense categories. The tax return is often the beginning point for identifying such benefits. It is beneficial to review the business tax return with a client, regardless of whether he or she is the owner of the business. The client often knows where the weaknesses lie or if income is understated or expenses overstated.

The most obvious expenses that would constitute additional income to the owner fall into the categories of meals and entertainment, automobile, travel, home office deductions, and promotion and employee benefits, such as medical and pension benefits. The nature of the entity determines if certain deductions are allowed for tax purposes. For example, a sole owner of a “C” corporation, with no employees but himself, can have a medical reimbursement plan for his and his family's medical expenses, including health insurance. In contrast, a sole proprietor of a single-member limited liability company with no employees is not allowed to take a deduction for these expenses against business income. For the “C” corporation owner, the medical expense deduction should be treated as “imputed income” and added to his or her wages.

For illustration, let's take the example of a man who has a net income of $63,722. Although on his federal Form Schedule C: Profit or Loss from Business, for a Self-Employed Individual he has taken 100% of his automobile expenses – totaling $5000 on line 10 and $9600 on line 20a – we know from speaking with our own client that he rarely uses the car for business. We also know that “travel” expenses totaling $7760 were mainly for personal trips abroad, and most of his meals and entertainment expenses, reported as $5576, involved dining out with friends. The home office expenses of $5502 would have been incurred even if he were not self-employed.

Adding these expenses back to his original net income of $63,722, his income increases to $97,160. The additional imputed income of $33,438 could have a significant impact on the value of the business. It could also cause child support and maintenance payments to increase significantly.

If the business is a cash business, other strategies need to be developed to obtain a true picture of income. One true-life case I was involved with concerned a hot dog vendor in New York City. In order to properly evaluate this case, it was necessary to hire independent people to watch and count the number of sales he transacted over the course of a week. Needless to say, income imputed from this exercise, and extrapolated over a full year, resulted in much higher income than he had reported. This case was settled out of court, for obvious reasons.

Tracing Assets

It is very common for one spouse to manage the finances, including preparation of the tax returns. The other spouse often signs the returns without bothering to review them. Only years later, usually during divorce, does this spouse learn that an asset no longer exists or that debt is higher than expected.

The tax return can help us trace the existence of some of these assets, because they often generate income, eg, interest from savings accounts and bonds and dividends from stocks and mutual funds that appear on federal Form Schedule B: Interest and Ordinary Dividends; rental income from real estate and royalties from intangible assets that appear on federal Form Schedule E: Supplemental Income and Loss; and Business Iincome from Partnerships; and “S” corporations that also appear on federal Form Schedule E. Assuming that income from these assets had been reported on the tax returns, we should be able to see the sale of these assets, except for bank accounts, on the federal Form Schedule D: Capital Gains and Losses. If the sale does not appear on Schedule D, further investigation is needed. Perhaps the asset was “gifted” without your client's knowledge.

Income from assets reported on the tax return also needs to be compared to assets reported on the “Statement of Net Worth” prepared specifically for the divorce by both parties. In addition, if the parties have applied for loans and mortgages over the years, income from assets should be compared with the “Statement of Assets and Liabilities” that is prepared for these applications. When people seek loans, they naturally want to present their own financial picture in the best light, so all assets should thus be listed on this document. Since most of us rarely keep copies of these applications, you might need to request them from the lending institution. (The state of California has been known to obtain mortgage applications and compare them with tax returns for the express purpose of discovering unreported income.)

Tax returns are critical documents for gathering financial information to ensure that the divorce results in an appropriate financial settlement and protects both spouses and their children. They are useful in isolation, but identifying trends and inconsistencies is also important. To this end, in addition to obtaining copies of tax returns from clients, you might want to consider obtaining copies filed with the taxing agencies directly. For example, this may help determine whether “innocent spouse” protection may be an issue during the divorce proceedings. The copies one spouse has may not be the ones actually filed.

Conclusion

The creative and knowledgeable professional does not stop at the obvious facts but looks to ensure that underlying data are consistent with assets, income and lifestyle. It's always important to look for the story behind the numbers.

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