Imputing business income can often be a complicated calculation since business owners often receive multiple types of income; including wages, guaranteed payments, distributions, and personal expenditures that could be charged through the business. This article will provide practitioners and attorneys with a suggested step-by-step process on how to appropriately capture spouse’s business income to assist in imputing income for alimony purposes when dealing with a closely held company.
Step 1 –Wages
Taxable wages will be reported on the owner spouse W2 in Box 1. The W2 can be very helpful in determining whether the owner spouse receives any benefits, such as 401(k) contributions or medical benefits to name a couple.
Step 2 – Net Income and Distributions
Too often we have seen where the full amount of net income is used to impute a business owner’s income. However, the net income that is reported on the owner’s K1 may not be the actual amount that should be imputed for alimony purposes. Other factors must also be considered including whether the company has enough working capital (that is current assets less current liabilities) to sustain operations. If not, then the additional needed working capital should be removed from net income since those funds will be needed to keep operations ongoing.
Another factor to consider is whether the entity took accelerated depreciation[1] to lower net income for tax purposes. An adjustment may need to be made if more-than-normal depreciation was taken in a single period. Business owners will often attempt to reduce their taxable earnings by fully depreciating an asset in the same year it was purchased.
Distributions received by a business owner may also not accurately reflect a business owner’s true income for alimony purposes. Many questions need to be answered regarding an owner’s distributions including comparing net income to distributions. One example is when an owner purposefully withholds distributions attempting to reduce cash available for support. On the other side, we have also seen an owner take too large of distributions, thereby not leaving the entity with enough working capital or funds for expected capital expenditures to maintain operations. This could also have a negative effect on the owner’s basis, which could result in a capital gain needing to be reported on their personal tax returns.
Step 3 – Personal benefits and expenditures charged through a business.
Some business owners may receive personal benefits or charge non-operating expenses through the business. As mentioned in Step 1, the benefits should be reported on the owner’s W2 but may not be included as taxable wages in Box 1. Therefore, these benefits should be added back as additional income received by the owner, not subject to taxes.
If the business tax returns have not yet been prepared, a review of the company’s financials will need to be undertaken to determine whether the business financials are reasonable and normal. Tax returns that have already been prepared in prior years by a qualified tax or CPA firm should already have made these adjustments and appropriately reported these non-operating expenses as distributions. If those returns have not been reviewed or prepared then it is up to the forensic accountant to normalize the expenses. Therefore, one may need to addback those expenses to arrive at income available for support.
Step 4 – Balance Sheet Adjustments
Business owners may also transfer or loan funds to another related entity in an attempt to lower their cash balance that is reported on the business tax return. We want to always review all entities involved to ensure that the due to/from are in line. Adjustments may need to be made to account for those transfers, adding/subtracting them as potential distributions/contributions a business owner could have received had the transaction been properly recorded.
Step 5 – Calculate Cash Income Before Taxes
Gross Income Available for Support is calculated by adding all the income and adjustments that were performed in Steps 1-4.
Step 5 – Tax Effecting Cash Income Before Taxes to Obtain Cash After Income Taxes
Tax effecting an owner’s wages and adjusted net income will have a dramatic effect on an owner’s income that is available for alimony or other support. Instead of simply using the IRS’ tax bracket, calculations must be made to determine what the effective tax rate. The effective tax rate is calculated by taking the total taxes the individual was required to pay and divide it by the adjusted gross income. Obtaining the effective tax rate will adjust for any capital losses or other deductions the taxpayer was able to take advantage of in a single period. The result will be obtaining the business owner’s Net Income Available for Support.
Step 6 – Take the average Cash After Income Taxes
Example – Below is a very simplified example for calculating After-Tax Income Available for Support. Assume for our example that tax returns were used for years 2018 and 2019, and interim financial statements were reviewed as discussed in step 3 used for 2020.
[1] Also known as Section 168(k) depreciation.
Any advice contained in this article, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion. If desired, we would be pleased to perform the requisite research and provide you with a detailed written analysis. Such an engagement may be the subject of a separate engagement letter that would define the scope and limits of the desired consultation services.