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Three Common Approaches for Determining What Constitutes Legitimate Business Expenses for Child Support PurposesBy Vincent Mayo Nevada has a child support formula that makes it relatively easy to predict an obligor's child support obligation based on gross monthly income. NRS 125B.070. This simple formula, however, becomes much more difficult to calculate with self-employed parents. The problem stems from trying to justify a self employed parent's claimed business expenses. Many states have established laws in regard to what constitutes income for self-employed parents. Unfortunately, given the varied treatment of this principle from state to state, attempting to establish a national consensus in regard to valid business expenses is of little help. Worse yet, Nevada has not articulated what constitutes justifiable business costs. NRS 125B.070(1)(a) merely states that a business expense must be "legitimate" in order for it to be deducted from the computation of gross income. The Nevada Supreme Court has directly elaborated on this concept. Fortunately, a better understanding of the reasons why courts choose to accept one business expense as legitimate and another as not legitimate can make addressing these issues easier on the family law practitioner. A review of sister-state opinions reveals three factors, or approaches, commonly taken into consideration by courts when making their determinations on what constitutes a legitimate business expense. These factors are: (1) whether the business expense is necessary to produce income; (2) whether the business expense is primarily a payment of a personal expense; and (3) whether the business expense unnecessarily reduces the income available to support a child. Is the Business Expense Necessary to Produce Income?This factor is perhaps the most widely used. According to the "necessary to produce income" approach, if an expense is not necessary to generate income, it is not a legitimate business expense. This factor typically comes into consideration when dealing with deductions that exists "solely on paper" for tax purposes and do not directly reduce an obligor's available income. The most common "paper deduction" is depreciation of a business asset. Some courts recognize depreciation as a legitimate expense, depending on its purpose. For example, in Freking v. Freking, 479 N.W.2d 736 (Minn. Ct. App. 1992), a child support obligor sought to deduct accelerated depreciation (which allows greater deductions in the earlier years of the life of an asset) from his farm business. The Minnesota Court of Appeals permitted straight-line depreciation (which allows for a yearly deduction of the useful life of the asset) but not accelerated depreciation. The court reasoned that accelerated depreciation is in the nature of a tax fiction, unrelated to the useful life of an asset and intended only to generate tax savings. Id. at 740. See also Turner v. Turner, 586 A.2d 1182 (Del. 1991). Based on this reasoning, accelerated depreciation is not necessary to produce income. On the other hand, the court recognized straight line depreciation as being appropriate since it more fairly reflected the cost of producing income. See also In re Marriage of Davis, 679 N.E.2d 110 (Ill. App. Ct. 1997). Other courts have been more restrictive on the definition of "necessary" to produce income and have not permitted any expense that does not actually reduce the obligor's disposable income. The Supreme Court of Montana in Stewart v. Stewart, 793 P.2d 813 (Mont. 1990), held that depreciation losses could not be deducted as business expenses since depreciation for tax purposes is intended to assist an individual in regaining their expenditures. Therefore, it does not follow that it is a business expense necessary to produce income. Id. See also Asfaw v. Woldberhan, 55 Cal. Rptr. 3d 323 (Cal. Ct. App. 2007). In contrast, expenses that can be shown to directly result in the production of income are considered necessary and, therefore, are commonly allowed. In Bower v. Bower, 697 N.E.2d 110 (1998), the Court of Appeals of Indiana held that the obligor's promotional, travel, and accounting expenses directly resulted in an increase to his income. The Court reasoned that as the obligor's income would not have been what it was without the costs, it would be unjust to not allow the obligor to deduct them. Id. at 115. See generally In re Marriage of Davis, 679 N.E.2d 110 (Ill. App. Ct. 1997) (which considered, as part of evaluating whether an expense is necessary, whether the expense was also reasonable). Critical to the court's approach in Bower was the question of whether the expenses would not have been incurred "but for" the employment. Id. at 115. There are a vast array of other potential deductions to be claimed (business loans, principal and interest on mortgage and assets, initial acquisition costs of new venture, insurance premiums, etc.). Analyzing whether these, as well as other costs, are a legitimate deduction can be accomplished by use of a "necessary to produce income" approach. Is the Business Expense Essentially Payment of a Personal Expense?This factor is also widely recognized. The "personal expense" approach is similar to the "necessary to produce income" approach yet differs from it in that courts will focus on whom the deduction primarily benefits, not on how necessary it is to generate income. In other words, although a personal expense can also be used to generate income, if its use is primarily for payment of a personal expense, it is not considered an appropriate deduction of gross net income to the obligor. The Alaska Supreme Court's reasoning in Coghill v. Coghill is a classic example of this principle. In Coghill, the Alaska Supreme Court upheld the decision of the Superior Court when it found that business expenses were primarily for the benefit of the parent, not the business. 836 P.2d 921 (Alaska 1992). In Coghill, the obligor claimed his meals and clothing expenses were necessary to operate his business. The Alaska Supreme Court stated that although such costs can constitute a legitimate business expense, the obligor's expenses were not legitimate since the meals were consumed by the obligor alone and since the type of clothing purchased by obligor was not significantly different from the clothing purchased by most Alaskans. Id. at 926. Other states have compromised in determining whether such expenses are legitimate by approaching the deductibility of a personal expense from a comparative view point. In other words, if the personal expense benefits the obligor while simultaneously benefitting the company, it will be apportioned so part of the cost is deductible and part is not. This was the case in Reinhart v. Reinhart, 963 P.2d 757 (Utah Ct. App. 1998). In that case, the Court of Appeals of Utah allowed only half of the obligor's claimed educational and travel expenses as they significantly benefited the obligor himself in addition to the business. Id. at 759. This comparative reasoning, however, may not be deemed valid in Nevada based on the fact NRS 125B.070(1)(a) directs that personal expenses must be excluded from calculating gross income. Will the Expense Unnecessarily Reduce the Income Available to Support a Child?This factor tends to center on the overall fairness of the deductions to the child, not whether the deductions are necessary or personal in use. The "reduction of income available to support a child" approach focuses on the fact that although it may be fair to allow the deduction as necessary or that a personal expense also benefits the business, the overall effect is that the deductions come at the expense of the child's financial welfare. Use of this factor typically comes into play when an obligor has wide discretion in manipulating deductions to set their own salary or when deductions in essence leave little funds available for child support. In Rauch v. Rauch, 590 N.W.2d 170 (Neb. 1999), the Supreme Court of Nebraska recognized that although the obligor's farming losses and use of funds to reinvest in his farm could constitute a necessary expense, "It would be unfair for Donald [the obligor] to benefit from his choice to incur debt and build equity in his farm at the expense of his children." Id. The court stated that, "[t]he support of one's children is a fundamental obligation which takes precedence over almost everything else." This reasoning was also used by the Indiana Court of Appeals in Merrill v. Merrill 587 N.E.2d 1888, 189 (Ind. Ct. App. 1992). In Merrill, the court acknowledged that a self-employed obligor has the discretion to defer current income by incurring debt, and there could be situations in which there would then be very little income to be considered available for determining child support. Id. at 189. Although the foregoing three factors are far from all inclusive, they are the foundation upon which most requests for deductions are made. Being familiar with and further researching these approaches will typically result in requested deductions that are not only well-reasoned but the most just to self-employed obligors as well as to their children. Vincent Mayo, Esq. is an associate at Pecos Law Group in Henderson. Mr. Mayo represents clients in domestic relations law including divorce, complex custody disputes, relocation litigation, paternity, adoption, termination of parental rights, cohabitation, name changes and separate maintenance. Mr. Mayo can be reached at (702) 361-2318, or This e-mail address is being protected from spam bots, you need JavaScript enabled to view it . Estate Planning Considerations in DivorceBy Richard Cunningham When a client calls and tells you he or she will be getting a divorce, there are important estate planning considerations that should be addressed, including but not limited to: ethical considerations of whether you can represent the client; reviewing existing estate planning documents; reviewing beneficiary designations; understanding the tax consequences of property transfers; and handling special assets (such as business interests, irrevocable trusts, retirement plans, and the residence). Ethical ConsiderationsBefore you can even begin to analyze the other issues with respect to your client's divorce, the first thing to consider is whether you can represent that client. In many instances, you not only have represented the client in estate planning matters, but you have also represented the client's spouse in the same matters. On February 6, 2006, the Nevada Supreme Court adopted the Nevada Rules of Professional Conduct, which are substantially based on the American Bar Association's Model Rules of Professional Conduct. Rule 1.9 of the Nevada Rules of Professional Conduct precludes an attorney from representing a current client in a matter substantially related to the prior representation of a former client if the current client's interests are adverse to the interests of the former client, unless the former client gives consent in writing. If you have jointly represented spouses in estate planning matters, you should avoid counseling one spouse during divorce proceedings if matters involving the estate plan will be substantially related to the divorce proceedings, unless you have written consent from the soon to be former spouse. Generally, your client's spouse will not consent when the divorce is highly contested. However, if your client and his or her spouse are each represented by divorce counsel you may be able to obtain the spouse's consent in order to implement necessary changes to the estate planning that are consistent with the divorce proceedings or negotiations. Review Current Estate PlanAfter you have addressed the ethical considerations of the representation, the next step is to analyze your client's current estate plan to determine if it remains appropriate in light of the pending divorce. It may be problematic to revise the terms of a will or trust during divorce proceedings. All proposed actions should be analyzed under terms of the Uniform Fraudulent Transfer Act, NRS 112.140 et seq. Conveyances of your client's property for no consideration may be overturned. In such instances, your client's spouse may be able to rescind such transfers. In addition, upon discovering such action, the court may question whether your client is acting in good faith in the divorce proceedings. Usually, the client wants his or her spouse to be removed entirely. While this understandable, make sure that there are no existing marital agreements, such as a prenuptial agreement or postnuptial agreement, that may preclude the client from taking such action. In addition, determine if the client has any separate property. Has any commingling occurred? If not, establishing a separate property living trust, if one does not already exist, may be appropriate to segregate the separate property from the spouse and remove indices of ownership that could be made by the spouse. Clients should be advised regarding unintentional commingling of assets and the consequences of asset transfers if divorce becomes an issue. Keeping accurate records regarding the original character of an asset may facilitate a less contentious dissolution. In many cases, your client may be the recipient of annual gifting from his or her parents or other family members. Generally, a gift to one spouse is not community property. In order to avoid the spouse arguing that a gift was commingled with other community assets, your client may wish to request that these gifts be terminated until the marital issues are resolved. If family members are unable or unwilling to discontinue making the gifts during the divorce proceedings, the family members should directly transfer the gifts to an account or trust that your client cannot independently access and is segregated from community assets until the divorce is final. Finally, your client may wish to sever joint tenancies, or at the very least create tenancies in common so that one spouse is prevented from obtaining 100% of the joint property upon the death of the other spouse prior to divorce. Furthermore, if your client's spouse is a spendthrift, severing joint tenancies and removing one-half of the property from the spouse's reach may also serve to preserve assets during the pending divorce. Remind your client that there are certain assets, such as publicly traded securities, that cannot be severed without the consent of the client's spouse. Spouse as FiduciaryIn many instances, your client will have named his or her spouse as the fiduciary under the estate planning documents. Your client may want to change any such designations before the divorce proceedings commence. This will entail revoking and/or amending the will, living trust and powers of attorney. The client's divorce counsel should be consulted before any changes are made to ensure that the client's position is not adversely affected in terms of the divorce proceeding. Beneficiary designationsIt is very important to review the beneficiary designations. Your client may make any beneficiary changes for separate property life insurance policies and for retirement plans and other deferred compensation plans not qualified under the Employee Retirement Income Security Act ("ERISA"), such as individual retirement accounts and non-qualified retirement plans. However, your client will need his or her spouse's consent for any beneficiary change that will remove the spouse as a designated beneficiary under plans governed under ERISA. Income Tax ConsequencesThere are certain income tax-related issues which should be considered. Alimony. In general, payments of alimony in cash are generally taxable to the recipient spouse under Section 71 of the Internal Revenue Code (the "Code") and deductible by the payor spouse under Section 215 of the Code. What is considered "alimony" for federal tax purposes may differ from definitions under applicable state law. Under Section 71(b) of the Code, a payment is generally considered alimony when:
Section 71(b) does not require that payments be periodic in nature or even defined. An agreement that contains no specific amount but simply obligates the payor spouse to give the payee spouse an amount sufficient to maintain his or her prior standard of living may satisfy the requirements of this section. Additionally, the purpose of any payment is irrelevant, as long as the payment(s) meet the statutory requirements of Section 71. Section 71(c) states that payments to support children are specifically excluded as alimony payments. Payments representing child support are neither includible in the income of the payee nor deductible by the payor. Excess Alimony Recapture. Section 71(f) of the Code was passed to prevent spouses from characterizing nondeductible property settlement payments as deductible alimony payments. "Excess" alimony payments are re-characterized as property settlements and will require the payor spouse to recapture the amount of the alimony deduction attributable to any excess alimony payments. Accordingly, the payee spouse is also entitled to a correcting income deduction for the amounts recaptured. Section 71(f) looks at the first three calendar years after separation, beginning with the first year in which alimony payments are made (known as the first post-separation year). The sum of the alimony payments in the first and second post-separation years are subject to recapture, but payments made in the third post-separation year, and those thereafter, are not subject to recapture. The aggregate amount of alimony payments made in the third post-separation year is compared with the aggregate amount of alimony paid in the second post-separation year. If the payments in the second post-separation year exceed the aggregate payments in the third by more than $15,000, that excess is subject to recapture in the third post-separation year. The aggregate amount of alimony payments made in the first post-separation year is then compared with the average of the aggregate amount of the non-excessive alimony paid in the second post-separation year and the alimony payments made in the third post-separation year. If the first year payments exceed the average of the second and third years' payments by more than $15,000, that excess is subject to recapture in the third post-separation year. Section 71(f)(5) provides four circumstances in which excess alimony payments will not require recapture:
Care must be taken to avoid the imposition of these recapture rules in negotiating a settlement agreement. Child SupportA payment fixed as child support by the divorce or separation instrument will constitute child support for federal tax purposes. I.R.C. Section 71(c)(1). A spouse's payment(s) to the other spouse will be treated as "fixed" as child support if one of the following four tests is met.
Simply identifying all or part of a cash payment as child support in a divorce or separation agreement makes the designated amount child support for tax purposes. Payments that are designated for a child's support, even after the child reaches the age of majority, are treated as child support. Under Section 71(c)(1), the obligation to make the child support payment must be "fixed" in the divorce or separation agreement, but the total dollar amount to be paid for child support does not have to be fixed. This typically occurs when the agreement requires payment of a child's college tuition costs. Transfers of Property Other Than CashIn general, the tax treatment of transfers of property other than cash between spouses or former spouses incident to divorce is determined under Section 1041 of the Code. Section 1041(a) provides that no gain or loss shall be recognized on a transfer of property between spouses or former spouses if the transfer is incident to the divorce. Instead, the transfer is treated as a gift and will pass free of income tax, and the transferee receives the transferor's tax basis. I.R.C. Section 1041(b). A transfer incident to divorce is a transfer that occurs within one year after the date the marriage ceases, or that is related to the cessation of the marriage. I.R.C. Section 1041(c). Non-recognition treatment is mandatory if §1041 applies; the parties involved cannot opt to treat the transaction as a sale. Section 1041(e) provided an exception for recognition the gain on transfers that would otherwise be nontaxable under §1041(a), if:
Any gain recognized under §1041(e) is added to the transferee's carryover basis in the transferred asset. Because the transferor's adjusted basis in the transferred property is carried over, the transferee must include in his or her holding period the period during which the transferor spouse held the property. I.R.C. Section 1223(2). Section 1041 treatment applies to losses, as well as gains, incurred in connection with a transfer of property. An exception to the carryover loss rule under Section 1041, is for passive activity losses. In the case of a gift of an interest in a passive activity, suspended passive losses allocable to the interest increase the carryover basis, and are therefore not allowable as deductions under Section 469(j)(6) of the Code. Gift Tax IssuesAlthough there are no income tax consequences under Section 1041 of the Code, a transfer incident to a divorce may still be considered a taxable gift for purposes of the federal gift tax, which could have unintended gift and estate tax consequences. In general, under the current gift tax laws, a person may make lifetime gifts up to $1,000,000 free of gift tax. Currently, until 2009, a person may at death gift up to $2,000,000 free of estate tax. If a person uses his or her lifetime gift exemption, his or her estate tax exemption will be reduced accordingly. Therefore, if your client gifts $1,000,000 to his former spouse after the marriage (and the gift was considered to be taxable) your client would fully use his or her lifetime gift tax exemption and his or her estate tax exemption would be reduced by $1,000,000. Any future gifts made by your client during his or her life would be subject to the 45% gift tax. If your client and his or her spouse are married and have not initiated divorce proceedings they may be able to take advantage of the unlimited gift tax marital deduction under Section 2056 of the Code which allows transfers between spouses to pass free of gift tax. In order to allow transfers between divorced spouses to pass free of gift tax, Congress passed Section 2512(b) of the Code that provides that any transfer for "full and adequate consideration in money or money's worth" is not a gift for gift tax purposes. Certain transfers qualify:
Special AssetsIn light of the impending divorce, you and your client will want to look closely at assets that may require special consideration. Closely-held business interestsIt will be important to review any shareholder, partnership, or operating agreements for any closely-held business interests that your client may have. In many instances, these agreements include provisions giving other shareholders, partners, or members a right to purchase the interest of the spouse participating in the business if such spouse's interest passes to the non-participating spouse. Your client should consult with the other owners of the business to consider other arrangements to protect against the potential loss of his or her business interest that may result in the divorce context. If both spouses own interests in the business, look to see if there are other provisions in the agreements that may be exercised to allow one spouse to easily remove himself or herself from the business relationship. Valuation of closely-held businesses is difficult since usually there is no ready market available to sell the interests. It is important to use a reputable appraiser in obtaining a valuation. An equal division of closely-held business interests may not be the best solution in the divorce context. In such a situation, the spouse who actively participates in the business could lose control and the spouse that is not involved in the business has rights and obligations (such as voting and contributing additional capital) that may be undesirable. Your client should consider offsetting the value of the spouse's interest in the business with another marital asset, or purchasing the spouse's share of the business interest through an installment sale. Irrevocable trustsIn many instances your client may have already established irrevocable trusts. In analyzing the trusts, ask yourself what value do the trusts give to your client and/or his or her spouse? In some instances (such as a domestic asset protection spendthrift trusts), it may be best for your client's spouse to resign as trustee and be replaced by an independent trustee. Some irrevocable life insurance trusts have trust consultants or trust protectors that have rights to remove or otherwise change trust beneficiaries. If you are named a trust consultant or protector remember to consider the ethical implications before removing the spouse as trustee. In some instances, the client may want more significant changes made to the irrevocable spouse, especially if it holds a life insurance policy on your client. The problem is that the trust agreement is irrevocable and cannot be amended or changed. In the past, many clients were forced to lose the insurance policy and let the trust die, or in the divorce agreement, the spouse agreed to be treated as predeceased for purposes of the agreement (usually after a certain period of years). Under a new revenue ruling, there is another option if the irrevocable trust is a grantor trust for federal income tax purposes: establish a new irrevocable trust and have the new trust purchase the life insurance policy from the old trust. Rev. Rul. 2007-13, I.R.B. 2007-11. Ideally, the new trust should be funded with enough assets to purchase the life insurance for fair market value so that the trustee of the old trust does not breach any fiduciary duties to the existing beneficiaries under the old trust agreement. ResidenceUnder Section 1041 of the Code, the transfer of a share of a jointly-held residence generally is treated as a income tax-free gift. If your client should purchase his or her spouse's interest in the residence incident to divorce, the sale is disregarded under Section 1041 and your client will not be able to increase his or her basis in the residence by the amount of the purchase price. Should both spouses decide to sell the house there may be a way to exclude up to $500,000 of capital gain from income. Under Section 121, the first $500,000 of gain ($250,000 for each married individual filing separate returns) is not recognized from the sale of a principal residence when both spouses own and use the property as their principal residence for two years during the five-year period ending on the date of sale. Individual Retirement Accounts (IRAs)Section 408(d)(6) of the Code provides that the transfer of an individual's interest in an IRA to his or her spouse or former spouse under a divorce or separation agreement is not to be treated as a taxable transfer. The transferee spouse is to be considered as the owner of the account for tax purposes. Treas. Reg. Section 1.408-4(g)(1) clarifies that such a transfer is not a distribution from the transferor's account. Distributions from Qualified Retirement PlansThe assignee of qualified plan benefits under ERISA is called an "alternate payee." Section 402(e)(1)(A) of the Code provides that an alternate payee who is a spouse or former spouse of the plan participant will be treated as a "distribute" for purposes of Code Sections 402(a)(1) and 72. Furthermore, Code Section 402(a), which governs the taxation of qualified plan distributions to beneficiaries, implicitly uses the term "distribute" to refer to the plan beneficiary or participant. This means, with minor exceptions, that the assignee spouse or former spouse of the participant will be taxed on distributions from his or her assigned share of the plan as though he or she was the participant. This shift in liability for tax on distributions from the participant to the alternate payee only applies if the payee is a spouse or former spouse of the participant. If the alternate payee is a child or other dependent of the participant, the liability for tax on distributions made to the alternate payee remains with the plan participant. This shift usually is accomplished via a Qualified Domestic Relations Order (QDRO). A QDRO is a "domestic relations order" that relates to the provision of child support, alimony payments, or marital property rights to the "alternate payee" who may be a spouse, former spouse, child, or other dependent of the participant; and is made pursuant to a state domestic relations or community property law. The QDRO must clearly specify the name and the last known mailing address of the participant, the name and the last known mailing address of the alternate payee, the amount of the participant's benefits to be paid by the plan to the alternate payee, the number of payments to which such order applies, and each plan to which such order applies. ConclusionThis article hopefully provides a good overview of important estate planning considerations in the divorce context. There are, however, other issues that should be considered but could not be adequately addressed within the constraints of this article. These issues include, but are not limited to, how to handle obligations that may extend beyond death (perhaps use an irrevocable life insurance trust) or establishing annuity trusts under Code Section 682(a) (a trust structured to pay income to the former spouse)). Richard Cunningham has an LL.M in Taxation and is an associate at Lionel Sawyer & Collins where he focuses on wealth transfer, tax and business succession planning. |
© Originally published in COMMUNIQUÉ (June/July, Vol. 28, Nos. 6 & 7), the official journal of the Clark County Bar Association. All rights reserved.