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Don’t Let Retained Earnings in Your Small Business Overstate Your “Divorce Income”

 

Determining a business owner’s “divorce income” in Florida is more complex than for a W2 salaried employee.

This is not surprising.

But if you are a sub-chapter “S” business owner, you might have an additional income determination issue that you want to settle early in the case to prevent needless litigation.

That’s because sub-chapter “S” businesses pass through business income to its owners, even if the corporation retains the income.

And your spouse’s attorney might try to claim that the pass through income should be included when determining your total income for alimony and child support purposes — even if you never actually get to hold, touch, or use that money.

Assuming you were the breadwinner during the marriage, your income will be an important factor in alimony and child support calculations. In many cases, it is the most important factor.

Let’s take a second to discuss why pass through income retained by your company should not be counted against you and how to nip this issue in the bud early, so we can keep your divorce tightly focused on the real issues.

Florida Defines Income Differently Than the IRS

Generally, Florida’s definition of income for purposes of child support and alimony is more encompassing that the IRS’.

Non-taxed sources of income like military housing allowance or disability payments are considered income in the courts, even though the IRS does not take a cut.

Pass-through income retained by the corporation is the opposite scenario.  You are personally getting taxed by the IRS for income you don’t actually have at your disposal.

Because you don’t actually take possession of the income when your business needs it, the court should not hold that income against you.

But you need more than the Cliff’s Notes version to make sure the other attorney understands that 1. This is the rule and 2. The facts in your case suggest the rule applies to your divorce.

Rationale for Not Including S-CORP retained earnings in your “Divorce Income”

As a small business owner, you need to be able to pay your debts as they come through. Otherwise, bankruptcy will be around the corner.

Florida Business Law

When this issue comes up in our divorce cases, we want the opposing counsel to understand Florida’s Business Law on Subchapter S Corporations.

Florida business law recognizes that a business must pay its bills to be successful. The Subchapter S Revision Act in Florida actually forbids you from taking distributions from your corporation if the corporation can’t pay its bills.

To make sure a business can pay its bills when income fluctuates, its owners often try to keep three to six months (or more) of operating expenses in the business.

In other words, Florida business law recognizes it is perfectly reasonable for you as a business to retain earnings in your business for legitimate business purposes.

Or said another way, just because you are keeping money in your business does not necessarily mean you are trying to deflate income or shield profits from your spouse.

Now, we turn to Florida’s divorce-specific law to see how it handles pass through retained income.

Florida Divorce Law and Pass Through Retained Income

Florida law’s definition of income is focused on what is actually received.

Legally speaking, we want to point out to the other attorney the Florida Statute associated with income determination, which defines income as any form of payment to an individual, regardless of source.

If the money is not paid to you (or a third party under your control), how can that be considered a payment?

To help explain more thoroughly, we want to point the other attorney to a Florida Supreme Court case called Zold v. Zold.  Zold gives an in-depth analysis of the issue before codifying the following rule:  Pass through income retained by the corporation is not income for support purposes — as long as it has been retained for business purposes.

From a public policy standpoint, all of this makes sense. If you will be paying any support, whether it is alimony or child support, or servicing any marital debt, then you will need to be making income.

If your business closes because you stripped it of all cash, then everyone loses. Not just you and your employees.

The only complicated part about the Zold case is that, instead of having a bright line rule, the court said that we have to look at every case to see if this law really fits. Otherwise, a small business owner could abuse the process by retaining income that he or she really intends to distribute as income once the divorce is over.

So, the Zold case says this rule applies if you are acting appropriately and are only retaining earnings truly for the business, and not to screw your spouse over.

Handling The Issue With Your Spouse’s Attorney

We have found that educating the other family law attorney at the beginning of the disclosure process can minimize litigation costs and delays.

If your spouse’s attorney does not understand the law or the specific facts of your business, they will assume that your income is much larger than it is after seeing your business records.

And if they assume your income in artificially high, they will advise their clients of an alimony and support range that is too high.

Even worse, if they mistakenly believe you are concealing income or intentionally misrepresenting your income on your financial affidavit, they will start sending subpoenas to your shareholders and potentially the people you do business with.

And this is never good for business.

They say that 65% of cases are resolved at mediation.  I believe that this number would be much higher if both attorneys worked hard to thoroughly understand the law and the facts of a case before trying to settle.  A misunderstanding of the facts is certainly the biggest culprit in settlement negotiations. (Although one party being flat unreasonable and/or ridiculous is a close second.)

And because it is your business, you are the gatekeeper of the information.

So in most cases, we start by educating the other attorney.  We can:

  1. Show the law as discussed above.  Many divorce attorneys are not versed in business law. Heck, many divorce attorneys don’t know divorce law, so let’s educate them!
  2. Show your corporation bylaws and articles.  Are you a minority shareholder without control over retained earnings?  That would quickly nip this problem in the bud.
  3. If the other shareholders are leaving in equal parts retained earnings, we must show this.
  4. Show a business budget, so the other attorney understands what three to six months of operating capital actually looks like.
  5. Hire an expert accountant. In many higher dollar alimony cases, we will use an expert accountant to figure out your spouse’s standard of living.  The return on this investment can be huge.  Sometimes, we can use this same expert to do an income analysis on you, providing expert testimony for the court that is difficult to refute.
  6. In some cases, we can file a motion with the court asking for a summary judgment on the issue.There is nothing worse than a divorce that gets off track.  It is the tangential issues that get litigated that drive up costs and delay final resolution.
  7. But if you spot the issues that will cause problems in advance, and resolve them in a timely manner, you can focus your case on what matters and drive towards your goal.  This is especially true for small business owners.

Conclusion

There is nothing worse than a divorce that gets off track.  It is the tangential issues that get litigated that drive up costs and delay final resolution.

But if you spot the issues that will cause problems in advance, and resolve them in a timely manner, you can focus your case on what matters and drive towards your goal.  This is especially true for small business owners.

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