Litigation + Valuation Perspectives

Demystifying Valuation, Economic Damages + Forensic Accounting

Determination of Income for Child Support: Consider Income Control When A Parent Holds an Interest in a Closely Held Business

When a parent has income generated from an ownership interest in a closely held corporation or partnership, it is important to determine how the earnings of the entity flow through to the parent.   Both Subchapter S-Corporations and Partnerships are pass-through entities.   The income or loss from operations flows through to the parent’s individual return based on the percent ownership interest the parent has in the entity.   However, the income or loss does not reflect the cash distributed or paid to the parent.  The annual “distributions” or “draws” to an owner may be less or more than the owner’s share of income from the company.

Forensic accountants will consider whether the appropriate amount of income for child support is the pass-through income from the entity, or the distributions paid to the parent.   In addition, the forensic accountant may determine an appropriate compensation for the parent, based on his/her position, skills and responsibilities in the company.   In establishing income, an important aspect experts keep in mind is the degree of control that the parent has in determining his/her compensation and distributions.  The understanding of income control is integral to the income determination to ensure that parents do not manipulate earnings or distributions in order to shield income from child support.

For example, assume that Sarah is the sole owner of an S-Corporation.  Sarah can set her wage at $24,000 per year or $60,000 per year.  Sarah will also be in control of the distributions that she receives from the company.  Therefore, she has substantial control over how much income may be presented for the determination of child support.  A forensic accountant is aware of this and will ensure that Sarah does not improperly state income for child support.   The forensic accountant may adjust wages to a reasonable market wage, as well as make other adjustments to income.  In this case, the forensic accountant will likely use the adjusted income from operations, rather than distributions in establishing income, since the amount of distributions can be manipulated by Sarah.

However, if a parent has no control over the distribution of earnings, the possibility of earnings manipulation is reduced.    Therefore, as the degree of control decreases, the forensic accountant may consider using distributions to the parent as income for support purposes rather than the parent’s share of operating income.  The forensic accountant also may not make adjustments to wages and other expenses of the company that the parent cannot control.   Consider the case of five brothers who own a very profitable restaurant.  Max (Husband) owns a 20% interest in the S-Corporation.  From review of the tax returns, annual income averages approximately $250,000 allocated to each brother.  However, each brother receives approximately $125,000 each year in distributions.  Each brother also received a below market wage of $25,000. The brothers agreed to limit the amount of wages and distributions in order to invest into the company and grow a chain of restaurants.  For child support purposes, it may be more reasonable to use actual wages and distributions rather than net income in this case.  The Court may determine that there is a legitimate reason for keeping the earnings in the business and not include it as income for child support.   (However, Max’s wife may petition for an increase in child support in later years, when the business has grown and Max has increased cash flow.)

These two cases illustrate that every income determination case has unique aspects.  When a parent has an ownership interest in a closely held business, one of the important factors to consider is the degree of control that parent has over the operations and can influence the income available for child support.