The Business of Getting Divorced and Determining Self-Employment Income

June 24, 2019

How are child support and spousal support calculated in Wisconsin if you are self-employed and do not receive a paycheck?  Are retained income and business profits considered, even when they are not distributed to the owner?  Do courts only consider the owner’s regular draw?  What about distributions the owner receives to pay taxes or life insurance premiums related to the business?

The answers to these questions depend on the owner’s level of control over the business and whether there is a business-related reason for distributing or retaining the income.

When is undistributed income included?

Do not be fooled into thinking that you only have to pay child or spousal support (i.e. maintenance or alimony) from the distributions you pay to yourself from your business.  If an owner has a controlling interest in the business, then his share of the undistributed/retained income is also eligible for purposes of paying support, despite the fact that the owner doesn’t distribute this money to himself.  Courts are wary of an owner who has significant income on paper, but who shelters that money in the business in an effort to avoid paying support.  This is especially true when that owner has the authority to take a distribution or the discretion to decide what draw to pay himself.  When the owner does not have majority control to unilaterally decide when to access undistributed earnings, then it is less likely that the undistributed income will be considered.

Undistributed income of a business is calculated as the owner’s share of the federal taxable income of the business after deducting the straight line (not accelerated) depreciation.  The business’s taxable income may be adjusted to add back in expenses that the business deducted on its tax return, but which are arguably personal expenses of the owner.  Common examples include the owner’s cell phone or health insurance premiums.

Other adjustments to the business’s income may be made for debt service and principal payments on a loan, or any other legitimate business expense that is reasonably necessary for the production of income or operation of the business, even though these expenses are not tax deductible or reflected on the tax return.

Although retained/undistributed earnings are includible in the support calculation when the owner has a majority interest, there may be good reasons why those undistributed earnings should not be considered.  Perhaps the business needs to invest in capital improvements, equipment purchases, or expansions that will require additional cash on hand.  Or perhaps there are loan covenants that require the business to maintain a certain amount of cash on hand at all times.  Or perhaps the business has liabillity issues and needs to pay a settlement or judgment.  The owner will need to provide specific reasons why that money (which he has the legal ability to access and control) should not be included in a support calculation before the court will exclude it.

The “S” in S-corp does not mean simple

Most small businesses are structured as S corporations or LLCs due to certain favorable income tax rules. However, in the divorce arena this adds an additional layer of complexity. S corporation and LLC owners are taxed on the owner’s proportionate share of the business’ flow-through income, even if the business does not distribute cash representing this income to the owners. This is in contrast to the income tax treatment of a C corporation, under which the business pays tax at the corporate level. As a result of the flow-through income applicable to S corporation and LLC owners, an owner’s personal income tax return may have a sizeable tax liability. In many situations, the business distributes cash to each owner to cover his/her share of the company’s flow-through taxable income. These “tax distributions” can exceed the annual amount of the owner’s draw or salary. Unfortunately, some courts consider these tax distributions to be eligible for child or spousal support calculations, even though the owner does not pocket or have the ability to spend any of this money. For an individual who owns less than a controlling interest in a profitable business, and who receives a minimal draw or salary and who has no control over the amount of his/her distributions, large tax distributions could be a significant problem if used to calculate support. A good family law attorney can help to explain why certain pass-through (“phantom”) income and tax distributions should be excluded from support calculations, and why the owner’s actual cash flow is a more reasonable approach.