Dissipation of marital property will most likely be defined by your state statutes and case law, but it generally can be defined as occurring after one spouse uses marital property, frivolously and without justification, for a purpose unrelated to the marriage and at a time when the marriage is breaking down1. Expenditures that were typical or commonplace during the marriage will be difficult to prove as dissipation, especially when the other spouse acquiesced in them. The timing of the expenditure or transaction can be extremely relevant along with the transparency of the dissipating party's actions. Did he/she seemingly intend to hide, deplete, or divert a marital asset? The major problem in proving dissipation is the subjectivity and the interpretation as to what was typical or acceptable during the marriage and what was condoned by the other spouse.
According to the Tennessee Code Annotated ("T.C.A."), the factors for a court to consider when equitably dividing the marital estate include "[t]he contribution of each party to the acquisition, preservation, appreciation, depreciation or dissipation of the marital or separate property."2 Black's Law Dictionary defines dissipation as "[t]he use of an asset for an illegal or inequitable purpose, such as a spouse's use of community property for personal benefit when a divorce is imminent."3 In Tennessee, after the party alleging dissipation establishes a prima facie case that marital funds have been dissipated, the burden shifts to the party who spent the money to prove that the challenged expenditures were appropriate. The Ward4 case in Tennessee outlined a measured and logical approach for proving or disproving allegations of dissipation, which are now known as the "Ward Factors". Ward directed that trial courts must distinguish between the marital expenditures that are wasteful and self-serving and those which are not so far removed from "normal" expenditures occurring previously during the marriage. Ward stated:
In determining whether dissipation occurred, we find trial courts should consider the following: (1) whether the evidence presented at trial supports the alleged purpose of the various expenditures, and if so, (2) whether the alleged purpose equates to dissipation under the circumstances. Id. at 420-421. The first prong is an objective test. To satisfy this test, the dissipating spouse can bring forward evidence, such as receipts, vouchers, claims, or other similar evidence that independently support the purpose as alleged. The second prong requires the court to make an equitable determination based upon a number of factors. Those factors include: (1) the typicality of the expenditure to this marriage; (2) the benefactor of the expenditure, namely, whether it primarily benefited the marriage or primarily benefited the sole dissipating spouse; (3) the proximity of the expenditure to the breakdown of the marital relationship; (4) the amount of the expenditure. Id. at 421.5
Exhibit 1 was derived from an actual case and contains a table of what the Wife (my client) alleged were highly questionable, frivolous and wasteful expenditures that were not typical during the marriage of the "Smiths". Through the Request for Production of Documents, the Wife's attorney had requested bank account statements, canceled checks, and credit card statements for the two years before the marital problems surfaced. The cash ATM withdrawals were atypical for the Husband during the marriage as were the travel and meals expenditures since he enjoyed a generous expense account from his employer and rarely incurred personal expenses of this nature. The Husband also initiated numerous new loans around separation time which encumbered debt-free vehicles and we provided evidence that he had no apparent need for the proceeds at the time. Although some of Exhibit 1 has been altered for confidentiality purposes, the Husband actually did incur fees for the cosmetic dentistry and the hair plugs in February 2006, which, we surmise, allowed or prompted him to purchase the $20,000 diamond ring for his paramour in May. The loans, cosmetic expenses and jewelry typify the types of expenses contemplated in the Ward Factors.
An organized table, such as that presented as Exhibit 1, along with properly referenced copies of checks, receipts, deposition and interrogatory excerpts, etc., is a powerful tool to use in presenting the prima facie case and attempting to satisfy Prong 1 of the Ward Factors. Prong 2 will probably require additional proof through documentation of typical expenditures made during the marriage that were not dissipation, along with live testimony. The total balance of dissipated funds should be placed on the Marital Balance Sheet as an asset as if the expended funds still exist, and the non-dissipating spouse will receive an offset of another marital asset. If marital funds were spent on a frivolous or wasteful tangible asset that still exists, such as the diamond ring, or the funds are suspected of being diverted to a previously undisclosed bank account; consider placing the asset as a single line item on the Marital Balance Sheet6 rather than on the dissipation schedule since dissipation is often viewed as subjective by a judge.
1Altman v. Altman, No. M2003-02707-COA-R3-CV, 2005 Tenn. App. LEXIS 207, at *5-6(Tenn.Ct.App. Apr. 7, 2005) (perm. app. denied).
2 T.C.A. § 36-4-121(c)(5) (2005).
3 Black's Law Dictionary 486 (7th ed. 1999).
4 Ward v. Ward, No. W2001-01078-COA-R3-CV, 2002, WL 31845229 (Tenn.Ct.App. Dec. 19, 2002).
5 Lee R. Russ, Annotation, Spouse's Dissipation of Marital Assets Prior to Divorce as a Factor in Divorce Court's Determination of Property Division, 41 A.L.R. 4th 416 (1985).
6 A Marital Balance Sheet is a listing of separate and marital assets and debts in a single table representing the entire estate with a proposed division of each item. The table "balances" the net estate into one version of a proposed equitable division.
Expert Alphabet Soup – Jumble of Letters Represent Significant Expert Titles for Litigants and Judges
As Published in Memphis Business Journal, Special Litigation Section, June 12, 2009
The financial forensic1 experts of today possess a litany of credentials and licenses that are intended to promote and define their particular expertise. This article provides attorneys and clients the recipe for the “alphabet soup” that follows the name of an expert in order to assist in their hiring or cross examination in litigation. Simplified explanations, commentary and web page references are included for the most common and widely-held litigation-oriented credentials2.
FINANCIAL: The CPA, Certified Public Accountant, is a state-issued license that is well known and respected by judges and juries. Currently, the CPA license requires a five-year college degree, passing what is perceived as one of the most difficult of professional exams plus two years of supervised experience. CPAs are governed by the holder’s state board of accountancy3 and the AICPA, American Institute of Certified Public Accountants4. CPAs must obtain forty hours of continuing professional education per year and must adhere to a strict code of ethics. CFAs, or Chartered Financial Analysts, 5 are focused on investment analysis and valuation. The designation requires an intensive educational course, passing a rigorous exam and three years of experience, but requires no continuing education. The CFP, Certified Financial Planner6, is oriented towards personal financial planning, requires passing a comprehensive exam and completion of thirty hours of continuing education every two years. CFAs and CFPs, along with CPAs, must adhere to strict ethical and competency guidelines. The CDFA, Certified Divorce Financial Analyst7 is a credential which requires passing an on-line exam.
BUSINESS VALUATION: Valuation credentials have become more prevalent in the last fifteen years and are essential if one is attempting to qualify as an expert witness. The ABV, Accredited in Business Valuation8, and CVA, Certified Valuation Analyst9 are issued by the AICPA and National Association of Certified Valuation Analysts, respectively. The CVA requires an intensive valuation course or holding of another valuation credential and passing a rigorous exam. The ABV requires a similar exam and valuation experience. Both credentials require the holding of a valid CPA license, therefore the ethical and continuing education requirements apply. The American Society of Appraisers issues the ASA, Accredited Senior Appraiser10, which requires a college degree, passing a comprehensive exam, five years of experience and obtaining forty hours of continuing education very five years. ASAs are usually not CPAs therefore they generally have less of a background in accounting and tax issues.
FORENSICS: A relatively new but rapidly expanding designation is the CFF, Certified in Financial Forensics11, which is issued by the AICPA. The CFF requires holding a valid CPA license, a minimum of one thousand hours of work experience and seventy-five hours of education in forensic-related disciplines. Since the CPA is required, the ethical and continuing education requirements apply. Almost all serious fraud investigators hold the CFE, Certified Fraud Examiner12. The CFE is issued by the Association of Certified Fraud Examiners and requires a bachelor’s degree, two years of experience, passing a comprehensive exam and completing twenty hours of continuing education per year.
REAL ESTATE: Commercial litigation and divorce often require a real estate appraisal. Two very respected appraisal credentials are the MAI and SRA, both of which are issued by The Appraisal Institute13. The SRA is more residential-oriented. The two credentials are not acronyms like the others described in this article. Current requirements for the MAI and SRA include completing rigorous education requirements, submitting specialized experience descriptions and receiving credit for a demonstration appraisal report. The MAI additionally requires passing a comprehensive exam. Holders of both designations must adhere to a strict code of ethics and are subject to a peer review process.
In the litigation context, how does one score the relevance of a set of letters? In addition to the education, years of experience and testing required to obtain a credential, the question of relevance is answered by the professional standards, ethics and continuing educational requirements of the credentialing organization. The most respected organizations require continuing education in their specific discipline and have procedures in place for public complaints and disciplinary proceedings that can subject an expert to legal and monetary consequences by way of suspending a credential. Most of the above-described organizations have disciplinary mechanisms in place, but all of the credentials requiring the CPA license as a prerequisite have the full force and effect of state statutes enforced by a government agency, each state’s board of accountancy.
The “alphabet soup” of credentials can be a jumble, but these letters can help the litigants and judges separate the wheat from the chaff. A practitioner attempting to qualify in court as an expert should hold a recognizable and respected credential if one exists in that niche. The CPA is essential for all things financial since judges recognize and respect the license. The CFA and CFP are essential designations in investment-related matters and both boost the expert’s credibility in divorces due to the personal nature of the finances involved. The CFF represents longevity and a commitment to forensic accounting and litigation support and the CFE represents intensive training for fraud-related engagements. A business valuation expert must have a CVA, ABV or ASA in order to demonstrate competency in this niche and a real estate appraiser’s credibility is boosted greatly if he/she has earned the MAI and/or SRA.
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1Black’s Law Dictionary defines “forensic” as belonging to courts of justice.
2Other very credible credentials that are less widely held exist, but were not included due to space limitations.
3www.state.tn.us/commerce/boards/tnsba/
4www.aicpa.org
5www.cfainstitute.org
6www.cfp.net
7www.institutedfa.com
8http://fvs.aicpa.org/
9www.nacva.com
10www.appraisers.org
11http://fvs.aicpa.org/
12www.acfe.org
13www.appraisalinstitute.org
Visit the LBMC Valuation Web Page here: www.lbmc.com/valuation_services
Breakin' Up Is Hard To Do
As Published in Tennessee Bar Journal, August
2009
In a divorce engagement, attorneys strive to discover methods of dividing the ma-rital estate in their client’s favor and justify an alimony figure that is low if they represent the obligor and high if they represent the obligee. Explaining either side to the trier of fact is best accomplished with a straightforward, logical and business-like approach, rooted in facts, with documentation and analysis to support the positions. From my understanding, most states that allow alimony typically base awards around one spouse’s reasonable need and the other spouse’s ability to pay, with Tennessee following this premise1. The proposed equitable division of the marital estate should be a central factor before alimony is considered as this will affect the need.
The article features two methods or “steps” that assist in the division of the marit-al estate and figure alimony need and the ability to pay that alimony. The steps follow a case study that illustrates the primary factors the attorney should be considering and the knowledge and services that should be expected from a forensic accountant (hereinafter “expert”). Step 1, Dividing the Marital Estate, describes a method to facilitate marital es-tate division in an understandable manner while highlighting several common issues that typically arise during the process, such as the valuation of pensions and other retirement assets, the value and nature of separate property, documenting dissipation and factoring in the tax characteristics of assets. Step 2, Figuring Reasonable Needs and the Ability to Pay Alimony, introduces a method to calculate and justify the reasonable need for alimo-ny (or lack thereof) and the ability to pay alimony (or lack thereof). The alimony analysis is based upon both spouses’ income, proposed child support, personal living expenses, taxes, retirement draws and future income generated from the divided assets. The analysis illustrates a simplified lifetime financial plan for all of the remaining years of each spouse’s life expectancy so the court can understand the impact of a proposed settlement on each spouse’s cash flow and the ability to accumulate wealth as the years pass.
Hiring Experts
An expert can be hired by both parties as a mutual expert with the settlement de-tails being negotiated and contributed by both parties. The mutual expert method is the wave of the future since it offers the ability to reduce conflicts and professional fees. Of course, an expert is most often consulted by an attorney who asks that the parties’ finan-cial situation be reviewed in order to frame a favorable settlement for their client and then present that at mediation or trial. In those situations, the expert must have cold, hard facts to support the position so as not be labeled a complete partisan or hired gun. In highly complex matters or in cases with opposing experts holding polar opposite opinions, the court can appoint an expert as its own witness or as a special master. In all three types of employment, the expert’s analytical and communication skills are critical.
Case Study
This article features a case study that illustrates the concepts discussed. Mr. Smith (“Husband” and “money spouse”) and Mrs. Smith (“Wife” and “non-money spouse”) have two children, ages 15 and 13, and seek to end an eighteen-year marriage. Both spouses are financially conservative and have amassed a sizable amount of investments and retirement savings with the net marital estate exceeding $2.2m. Alimony is a definite possibility due to the length of the marriage, disparity in each spouse’s future income earning capacity and Husband’s admitted fault. Husband, age 48, is an airline pilot with income greatly exceeding that of Wife, who is also age 48 and works at a non-profit agency.
Wife desires to stay in the Tennessee marital residence which has 20 years re-maining on the mortgage. The Smiths own an expensive rental house that is listed for sale which was the former marital residence located in the Washington D.C. area. Husband is vested with a defined benefit pension from his current employer and the military, but he joined the military several years before marriage, thus claims some of that pension to be his separate property. Husband spent significant assets on a paramour, along with other questionable financial transactions and transfers, but claims none of it to be dissipation.
Step 1-Dividing the Marital Estate
The attorney or expert usually begins with the classification and organization of the assets and debts into a spreadsheet known as the Marital Balance Sheet (“MBS”). In the property division context, “balance sheet” refers to the listing of separate and marital assets and debts in a single table representing the entire estate with a proposed division of each item. The table “balances” the net estate into one version of an equitable division and serves as the foundation for an alimony needs analysis. See Exhibit 1.
In a perfect world, a proposed division would be based upon reasonable and sens-ible factors. Of course, “reasonable” is defined in the mind of the one proposing the idea. Some sensible factors include the spouses’ desire for a particular asset (e.g., mother wants to stay in the house until children go to college), the practicality, legality or necessity of one spouse owning an asset or owing a debt (e.g., Wife is a dentist thus cannot split ownership of the practice or its line of credit with her husband), the tax consequences (e.g., an IRA is taxable if withdrawn but a money market is not) and the future income earnings from an asset (e.g., the cash and IRA settlement may be large enough to generate enough income to cancel the alimony need). The proposed settlement does not have to be equal, only equitable; however, neither party is served well if a proposal is rendered dead-on-arrival by containing extreme assumptions or positions.
The MBS is a flexible presentation. The MBS should be constructed using formu-las in an electronic spreadsheet, such as Excel, which allows an attorney or expert to easi-ly make changes and adapt to new scenarios and proposals. Several scenarios may be needed on hand during negotiations. Including the following features in the MBS will allow it to be more useful: 1) relating debts to secured assets and showing the net equity as in Exhibit 1 line #s 1-5; 2) displaying property claimed as separate in whole or in part so as to establish the separate claim; 3) offsetting the present value of a pension or fair market value of a small business with other estate assets; 4) grouping asset and debt cate-gories such as real estate and investments; and 5) displaying the proposed division of each and every item along with the total net percentage to each spouse. Judges often rule directly from an MBS and attach it as an exhibit to the decree since they find it to be sim-ple, concise and unambiguous. Occasionally, a judge will ask for a blank copy of the spreadsheet template so as to fill in the division pursuant to the ruling.
What sort of supporting documentation is needed? The expert and attorney must collaborate to gather the supporting documents that evidence each line item in the MBS. One or the other should accumulate a document or work paper representing backup for each listed asset and debt, dated as close as possible to the date of the final divorce hear-ing2. Exhibit 2 provides a basic list of documents or analysis needed for the most common MBS items. If the case is continued, a discovery request for updated documents should be issued if allowable.
Request for Production of Documents (“RPD”) and Other Discovery Tips
Account numbers and the name of the asset or debt should be included in an RPD if known. Using a truncated version of those numbers on the MBS allows for easier iden-tification. For mediation and trial, the documents that identify and value the assets and debts should be labeled with exhibit numbers that correspond with the line numbers in the MBS and then placed in a three-ring binder with several identical copies. If an expert is to be hired, he should be engaged early in the divorce process and used to assist in formu-lating the RPD. In the case study, Wife’s attorney sent an RPD which resulted in produc-tion of monthly or quarterly statements for most, but not all, of Husband’s accounts con-taining cash, investments, retirement and debts. Wife’s attorney had hired an expert who reminded her to request the couple’s tax returns for the last five years. The expert discov-ered dividend income on the tax returns that identified an on-line brokerage account that Husband failed to “remember” in the RPD and Interrogatories. A subpoena was issued for this account and it was discovered that, during the months leading up to separation, Husband made several large profitable trades of stocks and wired the proceeds to another unidentified account.
When requesting personal tax returns, always specify five years of Form 1040, in-cluding all schedules since Form 1040 is actually only two pages in length. If the spouse is also a small business owner, request five years of that business’ tax returns
with all schedules. The form numbers are Form 1065 for a partnership or LLC, Form 1120 for a corporation and Form 1120S for an S corporation. The owner’s income reporting form known as Schedule K-1 from a 1065 or 1120S, unlike a W-2, will not be attached to an individual form 1040. Request the K-1s for all business owners of the entity even if dis-covery of the full business returns is denied. A K-1 can reveal valuable information such as changes in ownership percentages, non-taxable cash distributions and capital contribu-tions that can be used as a method of “parking” or hiding funds until the divorce is final.
The attorney should consider sending a subpoena to all banks that a spouse may use, especially if that person owns a small business and must periodically renew loans and substantiate good credit. Request the entire loan file, including personal financial statements (“PFS”) and loan applications. In a PFS, owners often list their “estimate” of the value of a small business and are required to list details of all assets and debts. Assets might appear in a PFS that might be unknown to the other spouse and are often valued higher than that claimed for divorce purposes since the loan applicant is motivated to in-flate values in order to renew the loan. In Tennessee3, a person can be held to values listed in a PFS issued to a bank since it is a document that is generally subject to federal bank fraud provisions.
The RPD should also request electronic file copies or access to all electronic ledgers, including passwords, maintained by the spouse or the business, such as Quicken for personal records and QuickBooks for business records. Access to electronic files al-lows the expert to easily and inexpensively sort data a number of ways, discover pre-viously unknown activities of the spouse and extract the true income, expenses, and fringe benefits from the data.
Pensions and Other Retirement Assets
The most common types of retirement assets are Defined Benefit Plans, Defined Contribution Plans and Individual Retirement Accounts.
Defined Benefit Plans. These types of plans do not usually have an investment “balance” that can be withdrawn and are often characterized as the classic pension whe-reas the spouse accruing the benefit, the employee-spouse, vests in the plan over time and draws a monthly benefit for life during retirement. The nonemployee-spouse can often request, through a Qualified Domestic Relations Order (“QDRO”), that an account be segregated or monthly payments allocated to him/her, often with many of the same rights as the employee-spouse.
What if the pension cannot be divided? The future monthly pension benefit stream can be discounted to present value by an expert and placed on the MBS as if a lump-sum, cash-equivalent balance existed in an account. The present value can then be offset against other estate assets. See line item #17 on the MBS, Exhibit 1, for the present value conclusion of Husband’s defined benefit plan. Husband’s military pension was also present-valued and placed on the MBS as line item #18.Tennessee, like many other states, has allowed present value pension offset in property divisions4. Offset may be the most practical and the only legal remedy to deal with a pension division, assuming other assets of equal value exist to offset the hypothetical pension balance.
The attorney will want to know the monthly pension benefit amount that is vested and accrued to date whether or not the plan is present-valued. When this document is ob-tained through RPD or subpoena, remember to order the vested benefit assuming a hypo-thetical retirement
as of the required valuation date near the divorce; not a projection of the benefit to retirement age. Post-divorce future vesting of benefits is not usually availa-ble as marital property to the nonemployee-spouse. If the pendency of the divorce is drawn out, pension benefits may increase; therefore, the attorney should obtain an up-dated benefit statement.
Unvested Pension. In some cases, a coverture fraction is an acceptable method to value the marital portion of unvested pensions which may require the court to retain ju-risdiction so as to divide the monthly payment once the employee vests and begins to draw on the plan. The marital property interest is often expressed as a fraction or a per-centage of the employee-spouse's monthly benefit. Under one variation, the percentage may be derived by dividing the number of months of the marriage during which the bene-fits accrued by the total number of months during which the retirement benefits accumu-late before being paid.
Defined Contribution Plans and Individual Retirement Accounts (“IRAs”) These types of assets do have a tangible investment balance that can be withdrawn (usually with tax and penalty if age and other requirements are not met) and are comprised of contribu-tions made by the individual. The 401(k) is the most well known defined contribution plan which is often matched or contributed to by an employer. Note that an IRA is the investment “vehicle” that receives a rollover balance from a defined contribution or de-fined benefit plan; therefore, IRAs can be created by the traditional annual contribution of $5,000 (2009 limit) or from a rollover.
Both types of assets generally do allow for division in divorce and can be trans-ferred or rolled over tax free to an IRA in the other spouse’s name. Note that in line #19 and #20 of the MBS, two of Husband’s retirement assets are proposed to be transferred to Wife through a rollover. The assets do not become taxable to Wife until she begins to draw funds from the accounts.
The attorney or expert must confirm that the retirement plan allows for segrega-tion or distribution and will accept a QDRO. Avoid being caught in the malpractice web of negotiating a deal with the client receiving some of the benefit plan, but the plan itself does not allow for the provisions of the negotiated deal. Read the plan organizing docu-ment! Private and union plans are usually covered by ERISA, thus are subject to QDROs. Government, public schools and the military are generally not subject to ERISA and do not accept QDROs, but may have developed their own version.
Separate Property Issues
Tennessee defines marital property to include “income from, and any increase in value during the marriage of, property determined to be separate property…if each party substantially contributed to its preservation and appreciation.”5 The courts have generally determined that a spouse can contribute to the preservation and appreciation of the other spouse’s separate property through a number of ways, including running a household as a homemaker, payment of property taxes by one spouse on property owned separately by the other, filing a joint tax return with one spouse paying federal income taxes through withholding or paying estimated tax payments on the other’s separate income, one spouse “allowing” the other to contribute marital income to a separate, pre-marital retirement account, and one spouse operating a farm or small business owned separately by the oth-er, among many others. Tennessee courts do not generally allow purely market-driven separate property appreciation to become marital6.
When figuring the pre-marital separate portion of a pension account, consider the fact that a valuation that uses a monthly retirement benefit that was derived based on a plan’s prescribed compensation formula may render a result that is dramatically different than applying a coverture fraction based on the months married. The facts of the situation may give guidance as to which method to use. Note the military pension on line #18 has a separate element since the Husband joined the military three years before the marriage and military pensions vest after twenty years, thus the pension was fully vested after year seventeen of the eighteen-year marriage. The calculated present value using the plan’s own compensation formula to figure the hypothetical monthly benefit accrued at date of marriage was $20,000 and the date of divorce value was $190,000, resulting in a $170,000 marital value appreciation. Had the coverture fraction been used, the separate value would have been $28,500 ($190,000 x 3/20).
Commingling and Transmutation. Concepts that are often difficult to illustrate in-clude identifying property acquired in exchange for separate property and determining whether funds have been commingled and/or transmuted. Exchanges of assets occurring over multiple financial accounts and multiple years can be especially confusing. A typical example might involve a pre-marital 401(k) plan that was rolled over into an IRA that is with a brokerage house that has merged and changed names a few times. The attorney should avoid assuming an account or other asset that exists today that seemingly did not exist at marriage is automatically marital property. An expert can create a schedule that traces the flow of separate funds over time in order to demonstrate if separate funds were used to purchase other separate assets or whether or not separate funds that may have been deposited with marital funds are still identifiable or inseparable so as to prove or disprove commingling and transmutation.
Proving Dissipation
Dissipation of marital property occurs when one spouse uses marital property, fri-volously and without justification, for a purpose unrelated to the marriage and at a time when the marriage is breaking down7. The factors that Tennessee courts frequently con-sider when determining whether a particular expenditure or transaction amounts to dissi-pation include whether the expenditure benefited the marriage or was made for a purpose entirely unrelated to the marriage, whether the expenditure or transaction occurred when the parties were experiencing marital difficulties or were contemplating divorce, whether the expenditure was excessive or de minimis, and whether the dissipating party intended to hide, deplete, or divert a marital asset. The timing of the expenditure or transaction is extremely relevant. Expenditures that were typical or commonplace during the marriage will be difficult to prove as dissipation, especially when the other spouse acquiesced in them8.
After the party alleging dissipation establishes a prima facie case that marital funds have been dissipated, the burden shifts to the party who spent the money to prove that the challenged expenditures were appropriate. Exhibit 3 illustrates a table containing a list of what Wife alleges were highly questionable, frivolous and wasteful expenditures that were not typical during the marriage of the Smiths. Through the RPD, Wife’s attor-ney had requested checking account statements, with canceled check copies, along with credit card statements for the two years before the marital problems surfaced. The cash ATM withdrawals were atypical for Husband during the marriage as were the travel and meals expenditures since he enjoyed a generous expense account from his employer and rarely incurred personal expenses of this nature. Husband also incurred numerous new loans around separation time with no apparent need for the proceeds.
An organized table, such as that presented as Exhibit 3, along with properly refe-renced copies of checks, receipts, deposition excerpts, etc., is a powerful tool to use in presenting the prima facie case. The total balance of dissipated funds should be placed on the MBS as an asset as if the funds still exist and the non-dissipating spouse will receive an offset of another marital asset. A similar asset offset can be used to obtain credit for marital funds used to pay divorce attorney fees since this could be considered a form of dissipation. Line item #29 of the MBS, Exhibit 1, represents the total dissipation as a sin-gle figure as if the funds still existed.
If marital funds were spent on a frivolous or wasteful asset that does still exist, such as a car for a girlfriend, or the funds are suspected of being diverted to an unknown account; consider placing the asset as a single line item on the MBS rather than on the dissipation schedule. Dissipation is often perceived as subjective in the eyes of the Court, thus minimizing the entries and dollar amounts on that schedule is often more beneficial.
Tax Characteristics of an Asset
Assets of similar gross fair market value may result in different amounts of tax due if sold and, therefore, have different net intrinsic values, i.e., an asset with a higher tax basis9 will result in lower taxes. When dividing up the marital estate, the attorney or expert should consider whether or not a particular asset is of a taxable nature and, if so, determine the tax basis. Some assets, like checking accounts, would not be taxable if spent, but a mutual fund may be taxable if sold. The personal residence may or may not be taxable if sold, but most retirement accounts will be taxable if liquidated.
In the Smith MBS, the proposed division transfers item #9, ABC Corporation Stock-200 shares, with a value of $20,000 to Husband, and #10, Amer. Century I (a mu-tual fund), with a value of $20,000 to Wife. Husband purchased ABC five years ago at $20 per share, thus his tax basis is $4,000 and will have a $16,000 capital gain if sold. Wife purchased the Amer. Century I fund last year for $22,000, thus it will have a $2,000 capital loss if sold. Husband would owe $2,400 in capital gains taxes and Wife would owe nothing, therefore, Wife’s asset possesses a higher net intrinsic value.
Step 2-Figuring Reasonable Needs and the Ability to Pay Alimony
A property division must be considered before figuring one spouse’s needs and the other spouse’s ability to pay alimony since the divided assets and debts each carry their own future cash flow implications. Attorneys need a method to calculate and justify the reasonable need for alimony (or lack thereof) and the ability to pay alimony (or lack thereof) after a working property division is on their table. The Alimony Needs and Ability to Pay Analysis illustrates a simplified, lifetime financial plan covering all of the remaining years of each spouse’s life expectancy. The court and the parties can use the analysis to understand the impact of the proposed settlement on each spouse’s cash flow, along with the accumulation or dispersion of wealth as the years pass.
Foundation for Alimony
Tennessee’s statutes and case law provide for and define the foundation for ali-mony based upon the nature of the case and circumstances of the parties. The courts must consider many factors in setting alimony, but generally it is appropriate when one spouse is economically disadvantaged relative to the other spouse.10 No absolute formula exists; however, numerous cases and the T.C.A. provide that, “The court shall consider the fi-nancial needs of each spouse and the financial ability of each spouse to meet those needs…”
11
The Tennessee Supreme Court expounded upon the T.C.A. and set out several guiding principles regarding the foundation for alimony, including: 1) the real need of the spouse seeking the support is the single most important factor, 2) in addition to the need of the disadvantaged spouse, the courts most often consider the ability of the obligor spouse to provide support, 3) further, the amount of alimony should be determined so that the party obtaining the divorce is not left in a worse financial situation then he or she had before the opposite party's misconduct brought about the divorce,12 and 4) while alimony is not intended to provide a former spouse with relative financial ease, we stress that alimony should be awarded in such a way that the spouses approach equity. Thus, need, ability to pay, status, and fault are the primary considerations.13
Standard of Living. As the courts assess the real or reasonable need of a non-money spouse, most attempt to make the post-divorce standard of living reasonably com-parable to that experienced during the marriage, while considering the standard that the money spouse will enjoy post-divorce. Standard of living is broadly defined as “a level of material comfort as measured by the goods, services, and luxuries available to an indi-vidual, group, or nation”.14 Considerations can include the value and furnishings of the marital residence, models of cars driven, schools attended by the children, social or club memberships, types of vacations enjoyed, etc. I generally define the term as the level of expenses that a family could afford to enjoy during their marriage, not necessarily what they did enjoy, since many families today spend more than they make and pile on the credit card debt.
Figuring Reasonable Needs
A majority of attorneys I encounter use a single-month financial statement format for “proving” alimony need or ability to pay since most people tend to think in terms of monthly budgets, thus it is easier to comprehend. Additionally, many courts require this type of monthly income and expense illustration in the form of an affidavit. The article presents an alternative solution since single-month formats are often flawed for these rea-sons: 1) use of a single month representing a snapshot in time, not a realistic, forward-looking projection of the actual incomes and expenses the spouses expect over their re-maining lifetimes, 2) gross understatement of income by self-employed and commission or bonus-dependant spouses,15 3) use of expense figures that appear to be an accurate ac-counting of the historical standard of living, however the future expenses will inevitably be different due to new housing arrangements, additional child care expenses, duplica-tions, etc., 4) failure to incorporate the use of investment earnings available from the di-vided property, 5) failure to incorporate the use of retirement assets or pensions at retire-ment date or for use immediately if necessary, 6) overstatement of monthly expenses due to a lack of knowledge of the real details, and 7) overstatement of monthly expenses after listing those ordered to pay as temporary support such as the house note, utilities and car note; these expenses may be misleading as to the money-spouse’s future ability to pay if they will transfer to the non-money spouse or change to a new amount after the divorce is final.
A forward-looking projection. The goal in “proving” alimony need should be to illustrate the non-money spouse’s real and reasonable need based on a forward-looking projection of income and expenses. A logical and business-like analysis resembling a lifetime financial plan is very useful if the marital estate contains diverse financial and retirement assets, the assets need to be present-valued or appraised and used as offset, or each spouse’s income and expense affidavit displays great disparity or negative cash flow (which frequently occurs).
The future income should reflect a realistic earning capacity along with a reason-able return on retirement and investment accounts distributed in the property settlement. The future expenses should reflect those that the spouse actually expects to incur. The court needs to be informed of the possibility that a spouse might become destitute by re-ceiving too little support, or by paying too much, or that one spouse may have the ability to accumulate a considerably larger amount of future wealth and therefore experience a greatly superior post-divorce standard of living to that of the other spouse.
Steps for Figuring Reasonable Needs
Calculate the remaining life expectancy of each spouse based upon age and other fac-tors. An often cited source is the United States Life Tables, National Vital Statistics Re-ports, compiled by the National Center for Health Statistics.
For alimony and child support purposes, generally use earnings from W-2s or the tax return, or determine the true income of the self-employed and commission or bonus-dependant money spouse through forensic examinations of tax returns, company books, bank statements, etc. A multiple-year average may be appropriate along with cost-of-living adjustments. Consider hiring a vocational expert to examine the unemployed or underemployed spouse to determine a fair and attainable future earning capacity, if any.
Allow for contributions to retirement plans and/or IRAs based on past practices. One or both spouses will most likely need to rebuild retirement assets post-divorce. Incorpo-rate an investment rate of return on the retirement assets from the proposed settlement in the MBS thereby allowing for an accumulation of funds until retirement age at which point the assets should be drawn down. The availability of retirement assets and Social Security as a future source of income is often a forgotten aspect, or at least one that is dif-ficult to quantify, unless a lifetime illustration is presented. A reasonable return based upon financial planning portfolio theory should be used.
Incorporate an investment rate of return on the non-retirement financial assets like brokerage accounts, money market accounts, cash and rental properties from the proposed settlement in the MBS. The accumulation becomes the “go to” or emergency fund if cash flow is negative in a particular year. A reasonable return based upon financial planning portfolio theory should be used.
Factor in the receipt of child support. Note that child support is often the element that produces the short term façade of well being for the obligee and pain for the obligor. The attorney must consider and be prepared to illustrate what occurs to each spouse once the obligation ceases.
Since at least one of the spouses will be moving to a new residence, figure the new mortgage note or rent based on an approximation of the pre-divorce standard of living while being realistic as to the proposed new home(s). In today’s economy, many couples are house poor in that they are “upside down” in the marital residence equity and have too few financial and retirement assets. Affordable future housing plays much better with a judge than the same old financial irresponsibility that probably contributed to the mar-riage breakdown in the first place.
Analyze the personal living expenses from the bank statements, canceled checks and credit card statements. Having a detailed accounting or general ledger of actual historical expenses is a powerful rebuttal to an over-stated expense affidavit. Inflation is another element of the future expenses that should be factored into any projection, that, when ignored, can produce a façade of future well being for both spouses. Beware of the double-dip expense list or affidavit that details routine expenses, like, clothing replacement, groceries, entertainment, gas, etc., along with the nebulous item: “credit card payments”. Who pays cash or writes checks for clothing, groceries and gas these days?
Calculate federal and state taxes on the projected earnings, other taxable incomes, itemized deductions and the tax consequences for paying/receiving alimony. Avoid the mistake of using the withholding amounts from the spouses’ pay checks or the tax liabili-ty from the latest tax return as these tax amounts will change with the new deduc-tion/inclusion of alimony.
Explanation of Wife’s Need for Support Analysis
The Needs Analysis, Exhibit 4, represents the result of scientific and methodical calculations and analysis using the same process as in the section, “Steps for Figuring Reasonable Needs,” from above. The table is constructed with the lines representing years of remaining life expectancy and the columns representing the incorporation of various incomes, deductions, expenses, etc. The figures add or (subtract) going from left to right with a subtotal of Total Income in column J, a subtotal of Net Disposable Income in col-umn L, and the ultimate goal of figuring the Annual (Deficit) or Surplus in column O. The Annual (Deficit), if any, is divided by 12 to result in the Monthly (Deficit) or Surplus which approximates the spouse’s monthly need.
The following steps explain the process for compiling the need for support of Wife from the case study. These steps are embodied in Exhibit 4 with incomes illustrated as positive numbers and expenses as bracketed or negative numbers.
Wife is forty-eight years old and in good health. Women in her family tend to live in-to their mid-eighties. The life table suggests a thirty-five year remaining statistical life expectancy, thus Exhibit 4 contains thirty-five lines for each year of Wife’s estimated remaining life which are reflected in Columns A and B.
Wife is primarily a homemaker, but has worked a part-time job for a non-profit agency for the past ten years of the marriage earning around $18,000 per year. Husband’s at-torney received a court order to have Wife tested by a vocational consultant in order to determine if her income earning potential was higher, but in today’s economy, the ability to even obtain a new job could be questionable. She has a master’s degree in finance and scored high in intelligence and vocational abilities on the test, thus the consultant deter-mined her earning ability to be $45,000 per year. Wife corroborated in her deposition tes-timony that this income level was achievable. Column C reflects the $45,000 earnings with a 2% cost-of-living/raise adjustment per year with the mandatory FICA withhold-ings deducted in column D.
Wife will need to maximize her retirement contributions as reflected in Column E. These contributions are added to the “pool” of other retirement assets she is proposing to receive in the property settlement (lines 17-24 in the MBS, Exhibit 1). The term “pool” is used to describe the various retirement assets, like 401(k)s, 403(b)s, IRAs and other simi-lar accounts that either remain in the spouse’s name as originally titled or are rolled over from the other spouse’s ownership into an IRA. Although not illustrated here, all of the accounts are pooled together in a single table as if all of the assets were invested in one generic account for ease of explanation to the court.
As illustrated in Column G of Exhibit 4, the plan calls for Wife to begin drawing $150,000 annually from the retirement assets (which could all be in one IRA or in several different accounts) at age 59 ½. The Social Security income is estimated and presented in Column H. Without illustrating the compounded earnings on the investments in the re-tirement accounts in a table, it might be difficult to imagine that Wife could draw $150,000 per year for 23 ½ years. Had the impact of this element been ignored, Wife might have seemed to have a need for long-term or lifetime alimony.
Column I illustrates draws of earnings and principal from the non-retirement invest-ment asset pool Wife is proposing to receive in the property settlement (lines 6-16 in the MBS, Exhibit 1). In this particular case, the draw amount was crafted so that Wife’s total investment balance would not dip below its original principal balance. Although not illu-strated here, all of the accounts are pooled together in a single table as if all of the assets were invested in one generic account, just as with the retirement assets above, for ease of explanation to the court. A separate calculation of this sort is also useful when attempting to illustrate the impact of a non-recurring item, such as the sale of the Smiths’ rental property and splitting of the net proceeds (line 3 in the MBS). Wife will have an addi-tional $175,500 to invest after the sale of the property and the availability of the earnings on this new investment principal should not be ignored.
The child support income presented in Column F was calculated pursuant to the state child support guidelines. Additional child-related expenses paid by Husband will be re-flected in his personal living expense schedule and identified specifically in the parenting plan.
Wife desires to remain in the marital residence since it is the only house the children have ever known and it provides for less disruption to their lives. The principal and inter-est of the fixed-rate mortgage is presented as a deduction in Column M for the twenty years remaining on the note and were separated from the other personal living expenses since they will not inflate. The escrowed property taxes and insurance will inflate, thus they are included with the other personal living expenses. Husband will have a new mortgage on his proposed new residence, and this will be reflected in The Ability to Pay Analysis, Exhibit 5.
Wife’s personal living expenses were compiled and documented from her bank statements, canceled checks and credit card statements since historical figures should usually be the starting point from which to project the future expenses. Adjustments will need to be made for changing expenses, like those of the children that will be paid by Husband, new health insurance, different expenses reflecting a change of residence (tax-es, insurance, utilities, etc.), vacations, etc. Although not illustrated here, the personal liv-ing expenses were summarized in a table and are totaled in Column N along with an an-nual increase of 2.5% for inflation. Note the drop in expenses after year three which represents the decrease as the children emancipate and leave the household.
Finally, Column K reflects the federal and state income taxes, calculated on a year-by-year basis, that Wife will pay with the newly-projected employment earnings, retire-ment deductions while employed, retirement and Social Security income once retired, earnings from investments, itemized deductions and exemptions and, of course, the ali-mony income.
The alimony “need” is reflected as a (deficit), or shortfall, in Column O and is simply the result of adding and subtracting the elements from 1 - 8 above (i.e., Columns C - N in Exhibit 4) as if it were a formula. Courts tend to award alimony as a monthly figure, so Column P reflects one-twelfth of Column O, with the figure rounded to $5,000 per month in Column Q. The table illustrates the need or shortfalls throughout the lifetime of the non-money spouse which helps the court to understand whether or not the non-money spouse will enjoy a reasonable post-divorce standard of living or become destitute after child support and alimony end.
Local jurisdictional custom may dictate the length of time alimony is paid – or it can be based in economic reality. In Wife’s case, the proposed alimony (i.e., the need) ceases after year twelve as this coincides with Husband’s mandatory retirement age of sixty and Wife commencing to draw on the rolled-over retirement accounts. Husband was very clear that he did not want to pay alimony after he retired. In order to eliminate a “drop dead” argument from Husband, Wife was allocated more investment assets that could be drawn upon (Column I) while alimony was being paid so that she could enjoy a reasona-ble standard of living similar to that experienced during the marriage, while still allowing for alimony to cease at Husband’s retirement.
Explanation of Mr. Smith’s (Husband’s) Ability to Pay Support Analysis
An equally important flip side of the non-money spouse’s need is the money spouse’s ability to pay. A need can be very real, but the money spouse must be able to meet that obligation. An attorney should not seek alimony based on false or rosy assump-tions that the obligor simply cannot pay unless the client wants to spend time and money in court for a round of contempt or change-of-circumstance hearings.
The “formula” used in Exhibit 5 clearly shows that Husband does have the ability to pay alimony of $5,000 per month, or $60,000 per year for twelve years. This table con-tains a deduction for the alimony (Column F) and child support (Column G) that Wife shows as income items in Exhibit 4. Similar to Wife’s needs analysis, Husband’s ability to pay analysis contains projections of his future employment income less FICA, deductions for contributions to his 401(k) plan, the eventual draws from the 401(k), two pensions and Social Security upon retirement, draws from investment earnings, taxes (after paying and deducting alimony), a new mortgage and personal living expenses. Note that Hus-band is to receive 100% of his two future pension payments since they were both present-valued on the MBS and Wife is proposed to receive an offset of assets of equivalent value of the property division.
Use of a Lifetime Net Worth Accumulator Graph
The non-money spouse’s attorney will probably want the court to be informed as to the ability of each spouse to accumulate post-divorce wealth. Exhibit 6 illustrates the values of the marital estate assets and debts that are proposed to be divided to each spouse at the date of divorce and the values at the statistical dates of death. Using a sim-ple graph, the disparities in lifetime earning ability are much more evident and can be es-pecially useful when proposing an estate division that is not equal and weighted more heavily to the non-money spouse.
Wife proposed a 55% or $1,242,400 net property division in her favor plus $5,000 per month in alimony. The graph illustrates that Husband will accumulate much more wealth than Wife during their expected remaining lives, even after paying her alimony for twelve years. Wife’s accumulation assumes she will obtain the new job and work until retirement, which may not happen, thus it is probably a best-case scenario. Husband may actually spend his assumed accumulation rather than save it as the graph depicts, but he has the luxury of making that choice.
Conclusion
The first half, or Step 1, of the article highlights a method known as the Marital Balance Sheet that attorneys can utilize to facilitate the asset and debt division of the ma-rital estate. The second half, or Step 2, introduces a method known as the Alimony Needs and Ability to Pay Analysis that attorneys can use to calculate one spouse’s reasonable need and the other spouse’s ability to pay alimony based upon the remaining lifetime in-comes and expenses of the parties after accounting for the asset and debt division. The Needs Analysis allows attorneys to avoid presenting a potentially misleading financial snapshot of one year or one month to a judge or mediator while educating all parties as to the accumulation or dispersion of wealth using the post-divorce standard of living for each side. Attorneys should use these analyses at trial or mediation to prove the viability of their proposal or the unreasonableness of the opposition’s offer, or to move a client away from unfounded or entrenched positions before mediation.
1T.C.A. § 36-5-121(b).
2T.C.A. § 36-4-121(b)(1)(A).
3Powell v. Powell, 124 S.W.3d 100 (Tn. Ct. App. 2003).
4Cohen v. Cohen, 937 S.W.2d 823, 830-832 (Tenn. 1996).
5T.C.A. § 36-4-121(b)(1)(B).
6Langschmidt v. Langschmidt, 81 S.W.3d 741, 747 (Tenn. 2002).
7Altman v. Altman, No. M2003-02707-COA-R3-CV, 2005 Tenn. App. LEXIS 207, at *5-6(Tenn. Ct. App. Apr. 7, 2005) (perm. app. denied).
8Halkiades v. Halkiades, No. W2004-00226-COA-R3-CV, 2004 WL 3021092, at *4 (Tenn. Ct. App. Dec. 29, 2004).
9Tax basis-the cost of the asset; when subtracted from the sale price, the result is the taxable gain.
10Aaron v. Aaron, 909 S.W.2d 408 (Tenn. 1995).
11T.C.A. § 36-5-121(b).
12Burlew v. Burlew, 40 S.W.3d 465, 469 (Tenn. 2000) citing Aaron v. Aaron.
13Aaron v. Aaron, 909 S.W.2d 408 (Tenn. 1995).
14www.answers.com.
15If I had a dime for every time I heard the statement “business is way-off this year” during the pendency of a divorce, I would be a rich man.
What’s Your Life Worth?
As published in the Memphis Business Journal, June
23, 2006
Attorneys must know the “replacement value” of a life in order to
formulate a damage claim in personal injury, wrongful death and wrongful termination litigation. Forensic accountants calculate life worth based on the remaining
work capacity that is lost after the damaging event in order to illustrate to a jury that a damage claim was formed in economic reality. A case can pivot on the
calculation alone. This article explains some of the basic concepts of economic damages for individuals and illustrates a quick method to figure life worth.
Damages are generally considered to be a lump-sum amount for
judgment or settlement purposes. The losses are typically calculated from the date of the damaging event and compounded with interest to the present date, then
projected into the future and discounted back to present value. Individuals that can continue to work in a limited fashion produce mitigating dollars that are
subtracted from a total loss.
How does one cram a lifetime of lost earning potential into a
neat, single figure? The general answer includes:
1) Projecting
the expected yearly future earning capacity, over the work life expectancy. The earnings can be based on the working status at the time of the damaging event,
or, if the situation warrants, based on reasonable alternatives such as allowing for job promotions and attainment of higher education.
2) Estimating
associated employer-provided fringe benefits, over the work life expectancy. Lost benefits can represent a large portion of the damages suffered. A recent
U.S. Chamber of Commerce study reports that Social Security taxes, paid holidays and vacations, medical insurance and 401(k) plan (typical large company benefits)
can be worth up to 26% of earnings.
3) Figuring
the yearly value of household services that can no longer be performed over the life expectancy. The services include the unpaid tasks that maintain and
enhance the lives of those that occupy the household, such as food preparation, laundry, cleaning, auto and yard maintenance, and child care. The loss of the
production, even though not directly compensated like regular employment, has value to the household nonetheless since the tasks will: a) not be done at all or not
as often, b) be done by someone else in the household (at the expense of other things the "someone else" might have been doing), or c) require outside assistance
which may have to be compensated. Since most individuals do not keep hourly logs, published studies, like “The Dollar Value of a Day,” help to quantify the hours
that typical Americans spend performing the unpaid household tasks and present an hourly rate to measure the value. This loss category is usually considered in a
personal injury and wrongful death case and applies to the employed, the unemployed and homemakers.
4) Discounting
the annual sums for earnings, benefits, and services to a single present value for the desired lump-sum number.
Many analysts grow the earnings figures each year to account for
merit raises using a “real” wage growth rate of around 1% and discount to present value using a “true” interest rate of around 3%. Why such low rates? A method
accepted by the U.S. Supreme Court known as “constant-dollar” is often used by analysts to estimate future lost earnings and interest by removing inflation from
current rates. Removing inflation, which has hovered around 3% in recent history, eliminates the nearly impossible task of predicting future inflation rates and
gives the dollars to be received in the future the same average purchasing power as dollars received today.
The concepts discussed can be best explained with an illustration. In order to simplify the
calculations, the earnings are not grown for merit raises and only the future damages are considered. The merit raise growth is accomplished, however, by using a 2%
discount rate derived from subtracting the real wage growth rate of 1% from the true interest discount rate of 3%. The Tables referenced allow the reader to
calculate his or her own life worth and can be downloaded from
www.valuationlitigation.com/downloads.asp.
Sarah, a forty-year old, white, female engineer is permanently injured in a car accident and will be
unable to work on the job and perform regular household chores and family duties for her husband and two children. She was earning $80,000 annually at the time of
injury and enjoyed all of the fringe benefits listed above at 26% of pay, or $20,800 annually (no Table to download for fringe benefits, so use between 20-26% for
your own calculation). Sarah’s pre-injury life expectancy (see Table 1) is 42 years, thus she would have statistically been expected to live until age 82. Her
pre-injury work life expectancy (see Table 2a) is 21 years, thus she would have statistically been expected to work until age 61. Since Sarah did not keep
records of time spent with household chores (and who does?), Table 3 shows that someone with Sarah’s family makeup would typically have worked 32.5 hours per week in
the household, valued at $9.97 per hour, or $16,849 annually.
The goal is to figure the yearly future losses and discount them to present value. Table 4 lists
factors for the 2% discount rate that will transform an annual payment into a single, lump-sum present value figure. Add together Sarah’s lost earnings and benefits
for a total of $100,800. Multiply that figure by the present value factor of 17.011 found in the 21 year row of Table 4 to equal $1,714,708. Multiply Sarah’s lost
household services of $16,849 by the present value factor of 28.235 found in the 42 year row to equal $475,731. Add the two figures together to arrive at the total
economic damages for Sarah’s lost earning and production capacity of $2,190,439. If you have a financial calculator, solve for present value by entering a payment of
$100,800 at 2% for 21 periods, then a payment of $16,849 at 2% for 42 periods. What’s your life worth? Using the Tables, find your own life and work life
expectancies, household service hours and rate, and present value factors, then plug your numbers into the “formula” found in the illustration.
Fair or not, the “replacement value” of some individuals is worth more than others due to the loss of
a greater working capacity. No one can state with absolute certainty that an individual would have earned “X” amount of dollars for “Y” amount of years, however, if
a person is unable to fully work or has died, a forensic accountant can reasonably estimate the life worth by using known facts, statistical estimates and
professional judgment.
CPA CSI: Creatively Searching for
Income
As Published in
Memphis Business Journal, February 2004
By Robert Vance,
CPA, CVA, CFP
Why would
anyone have a need for Creatively Searching for Income on a
tax return? Everyone is always honest and straightforward in a business
acquisition, loan application, divorce or lost profits lawsuit – aren’t
they? Forensic CPA work may not be as exciting as watching the team on
Crime Scene Investigation solve a murder, but we can often find the
missing piece of the puzzle that solidifies your decision-making process or
proves your case. The forensic CPA can assist the buyer, seller or litigant in
proving or disproving the existence of income, validating claims of separate
property, determining disposable income, verifying the standard of living and
identifying transmuted property.
This
article will focus on techniques used by forensic CPAs to identifying income
using the form 1040, U.S. Individual Income Tax Return as the starting point.
The 1040, however, is not always a completely accurate reflection of a subject’s
true income. The individual may legitimately report a lesser amount of taxable
income and draw a considerably larger amount of cash than that reported. I have
used the following tax return CSI methods on many forensic engagements,
but they can be used by anyone trying to make sense of facts and figures in
common business and litigation situations.
Start with the basics on the form 1040
The starting point for most forensic
investigations involving individuals begins with reviewing several years of the
1040 in order to gauge the level and consistency of income and deductions.
Income miraculously tends to fall in the periods preceding an event like a
divorce, and income tends to rise in those preceding a business sale or major
loan application.
Form
W-2 Examine the Line 1 “Wages” and Line 5 “Medicare Wages” for a
difference. Observe the box 13 check boxes for “Retirement Plan.” If this box is
checked or a difference exists between Lines 1 and 5, then the employee probably
has a retirement or 401(k) plan or other salary reduction benefit. State income
taxes withheld in excess of 6-8%, or by a person who does not live or work in
that state, or federal income taxes withheld in a larger percentage than the tax
bracket the person would likely fall within, may indicate this person is
intentionally over withholding and parking funds to hide from the lawsuit.
Another related hiding technique involves overpaying estimated taxes, which is
reported on the second page of the 1040. This transgression is not obvious and
would require direct information from the IRS or examination of bank records.
You should
not always necessarily assume that the W-2 is prepared correctly since many
errors and omissions occur on them. I have been told many times that a
divorcing spouse is “in cahoots” with the business owner, or the subject
prepares the W-2s himself. Try to obtain corroborating information like a
paystub or payroll summary from the employer if the information seems suspect.
Schedule A (Itemized Deductions) An astute individual can hide assets
(cash) in prepayments for his future benefit. These prepayments can often be
detected on Schedule A. Analyze the property taxes that should be due annually
to see if substantially more is deducted than in the past. Prepayment of a year
or two of taxes can add up. Perform the same check on mortgage interest. An
increase in interest deduction from one year to the next could indicate
prepayment of a few mortgage payments, and, conversely, a large decrease in
deduction could indicate a refinancing or large principal pay-down. Payments of
an unusual or extraordinary nature can usually be found by examining the bank
records, but can often be lost in the maze of bank accounts or check volume.
Schedule B (Interest and Dividends) If interest and dividends are reported,
then an investment asset is generating the income. If the person owns growth
stocks or other non-dividend producing assets, then little or no income will be
reported. Although nontaxable municipal interest is supposed to be reported,
many filers omit this since tax-exempt income is not reported to the IRS. Be
aware that assets may be transferred to a child through an UGMA, to another
person by “gift”, to a trust or to a corporation. The IRS reporting is on that
other entity’s SSN or EIN, thus disguised.
Schedule C (Sole Proprietorship) A sole proprietor does not have to keep a
balanced, double-entry accounting system, i.e., many owners keep their records
in a coffee-stained spiral notebook. Since the income statement and balance
sheet are not required to be reported and reconciled together on the return, as
is the case with a corporation, partnership or LLC, manipulation can occur. Most
Schedules C are reported on the cash basis, thus receivables and inventory may
exist but are not recorded anywhere. If possible, inspect sales tax returns,
customer invoices or cash register tapes to ensure that all income is reported
and not pocketed. Watch for excessive vehicle, travel, meals and miscellaneous
expenses. Depreciation can be manipulated legitimately for tax reporting by
writing off the full value of assets under IRC Sec. 179 and other newer
expensing provisions. These artificially high depreciation deductions allow
write-offs that distort the true income picture of a business.
Schedule E, (Rental, Partnership/LLC and S Corporation) A common,
legitimate tax dodge allows small business owners to pay themselves rent for
buildings they own in lieu of a larger salary or draw. The rent expense is
deducted on the business return, but the reportable income is sometimes
mysteriously absent on the individual’s 1040 rental income Schedule E, thus
tracing is required.
Profit or
loss for a partner, LLC member or S corporation owner is reported to them in the
form of a Schedule K-1, which is an attachment to a business tax return. A
partner or LLC member should not receive a W-2 to report his income since
he is not a legal employee, and an S corporation owner should receive a
W-2. When inspecting the partnership/LLC and S corporation income section on
page 2 of Schedule E, scrutinize the income/loss reported. This does not
necessarily reflect the actual income received by this owner. An S corporation
owner will commonly take compensation in the form of “S corporation draws”,
which is essentially a non-reported return of capital likened to a dividend, in
place of or in addition to his W-2. If the K-1 is correct, the draw figure will
appear on the second page. If not reported there, check the corporate tax return
balance sheet on page 4 for the distributions. In a recent divorce case, I
observed an owner’s S corporation K-1 that reported income of $49,250. The owner
took no W-2, but rather took all of his compensation, $78,500, as an S
corporation draw (which is against IRS rulings because it avoids payroll taxes).
The K-1 was in error and did not report this draw, but found it on the corporate
tax return.
The
partner/LLC member receives most of his compensation by taking draws, not
“payroll” per se. The draws should be reported on the K-1 and on the business
return, form 1065, page 4. Be aware that both LLCs and partnerships file on form
1065, the partnership tax return. Another form of compensation, likened to a
salary, is called a “guaranteed payment” and should be reported on that
partner’s/member’s K-1. A common error (or deception) is the failure to report
the guaranteed payment (salary) on the K-1 and bypass paying tax on it. Once
again, income reported on the K-1 does not necessarily reflect the owner’s
actual income received.
Another
aspect to consider is the amount of capital or loans a small business owner may
invest in or loan to his company, thus parking cash out of the way of prying
eyes. Owners can easily bury capital on a tax return. Track the retained
earnings or partners equity from year to year. The basic formula is beginning
(prior year) balance plus net income earned less draws equals ending balance.
Analyze the total capital and owner-related loans. If these balances seem high
for the type of business, ask yourself if this business needs a large amount of
accumulated capital to operate.
Forensic Techniques After the Tax Returns
Autopsy
Dead men don’t talk, and sometimes tax
returns don’t either. Forensic CPAs will often be called upon to conduct an
“autopsy” to determine the cause of discrepancy in income claimed versus
reality. Assuming no personal or business financial statements are available and
the tax returns are silent, then where do you look? Five basic methods are
available to prove unreported income: the Transaction Method, Net Worth Method,
Expenditures Method, Bank Deposit Method and Percentage Method.
Transaction Method This is the easiest method to employ since it involves
identifying a specific item or transaction that was not properly reported on a
tax return such as a real estate sale or securities sale. Most financial
transactions and earnings are reported to the IRS on some type of form, like a
1099. An individual may fail to identify to the court or report on the tax
return items that are recorded on a 1099-S, from a real estate sale, or 1099-B,
from a broker sale of securities. This is discussed as a general concept above
in relation to erroneous K-1 reporting. A business might also inflate inventory
values or create fictitious payables in order to depress reportable income. In
this case, a thorough fraud audit may need to be conducted on the business’
books.
Net Worth Method
Many civil and criminal tax cases use this
method to determine unreported income and to support findings from other methods
employed. The concept is simple - if an individual’s net worth from one year to
the next increases beyond the reported income, then unreported income probably
exists. Outside of a form 1040, records of assets can be obtained from county
assessors, bank and brokerage accounts, federal estate and gift tax returns and
loan/credit card applications. After an unsubstantiated increase in net worth is
established, a likely source for this income must be determined other than from
accumulated cash, loans, inheritances, gifts, insurance proceeds, etc. If the
individual claims the likely source was from accumulated cash, you need to
establish the unreasonableness of this by searching for checks returned for
insufficient funds, bankrupt filings, offers in compromise or installment
agreements with the IRS, Social Security and employer records showing low
income, deposition answers about cash on hand, etc.
Expenditures Method This method
is very simple to understand and apply and is useful when the individual spends
most of his income and does not save much. Establish annual expenses through
affidavits, checkbooks, bank statements, canceled checks, etc. If the expenses
exceed the reported income and it can be established that the gap was not
bridged with accumulated cash, loans, inheritances, gifts or insurance proceeds,
you probably have found unreported income.
Bank
Deposits Method The IRS commonly uses this method to catch tax cheats. All
deposits recorded in all banks and other institutions are totaled, cash received
by the individual that was not deposited and used to pay expenses is added,
deposits that do not represent already reported and known taxable income are
subtracted and business expenses paid by check or cash are subtracted. Finally,
the standard or itemized deductions and exemptions, as reported in the 1040, are
deducted to arrive at taxable income. If more taxable income is found with this
formula than was reported on the 1040, the individual probably has unreported
income.
Percentage Method Not used as often, but this is a good method for
supporting findings from other methods when investigating a business. An
established and reliable profit percentage, typical of that business, is
multiplied by a reported income base, such as sales or gross profit, to
determine net income. The formula net income is compared to that reported on tax
returns or financial statements to establish an underreporting of income.
I used a
variation of this method combined with the business valuation method of
capitalized returns a few years ago in a divorce. The case involved a family
that owned the local cable company and several other businesses in the small
town. The husband owned a separate property minority share of the businesses and
had successfully stalled producing financial statements and tax returns, but we
did have all of the 1040s for the duration of the marriage. The attorney that
employed me had been assigned this case a few days before trial and needed me to
very quickly establish an increase in value of the separate property since an
antinuptial agreement was signed. I established a value of the businesses in
each year of the marriage by taking his minority reported income on the 1040s
and “grossing it up” to a full value using his ownership percentage and a
reasonable rate of return. This gross up provided me with a figure for goodwill,
which I added to the “hard assets” he had reported on an affidavit. Together,
the goodwill and hard assets established a value that the wife was able to show
had increased substantially during the marriage. The judge approved the
easy-to-understand methodology and awarded a decent property settlement, despite
the antinuptial agreement.
Conclusion Hiding income and assets is routine and seemingly easy for a
litigant. The transfer of income between an individual’s 1040 and his business
return, and visa versa, is easily manipulated and can go undetected without the
proper scrutiny. Tax returns are often the first, best shot at Creatively
Searching for Income, so hire an experienced CPA to read between
the lines and keep an eye on the cash flow. Forensic accounting isn’t flashy and
fancy, but it is often as important to a lawsuit as the CSI team is to a
murder investigation.
Surely You Jest While
I Vest
Pension Valuation In
A Tennessee Divorce
As Published in Memphis Lawyer,
January/February 2003
The Magazine of the Memphis Bar
Association
By Robert Vance, CPA,
CVA, CFP
A pension plan can be the most significant
asset that accumulates during a marriage. Couples often forego other forms of
savings while vesting in an employer-sponsored plan since it is a “free” fringe
benefit. The term, vested, means, “the degree to which an employee-participant
owns the benefits which have been accrued on his or her behalf.”(1) It stands to
reason that a pension, whether vested or not, should always be considered a
valuable marital asset in a divorce. The Court of Appeals of Tennessee at
Knoxville agrees with this premise. The Court ruled April 23, 2002 on the
divorce case of Curtis Michael Daniels v. Mary Freels Daniels. The parties
appealed several issues, one of which was whether the Trial Court erred in
failing to award Mrs. Daniels any share of Mr. Daniels’ pension benefits. This
article will focus on the Daniels decision and the methods the Court restates
are to be used in valuing vested and unvested (or undetermined)
defined benefit pensions in Tennessee divorces, however, different cases and
circumstances may require different methods and techniques.
Daniels v. Daniels
As of the trial date, Mr. Daniels had been
an employee of the Tennessee Valley Authority (TVA) for over twenty years. At
trial, an affidavit from Robert J. Vaughn, manager of Retirement Services at
TVA, was presented stating that if Mr. Daniels retires from TVA after five or
more years of creditable TVA service, he may be eligible to receive a pension
based solely on TVA’s contributions. He also stated, “the amount of any pension
to which Mr. Daniels may become eligible has not been determined by TVARS and is
not contained in any record maintained by Retirement Services.” The Trial Court
apparently took this statement to mean that the pension was unvested
and even used that particular term in describing the pension. This case,
however, appears to center around undetermined benefits, not unvested.
In researching this article, I spoke with
Mr. Vaughn at TVA. He issues the pension affidavits almost daily and assures me
that in a situation as seen in this case, a TVA employee with twenty years of
creditable service would be vested in the TVARS pension. He said that any vested
employee could easily obtain a statement from TVARS estimating his monthly
retirement benefit based on service already performed. TVA’s standard affidavit
states that an employee’s eligible pension has not been determined and TVA does
not maintain a record of it. Mrs. Selma Paty, attorney for Mrs. Daniels, told me
this is technically true since TVA outsources the generation of the statements
to a private firm and does not actually keep copies in their files. She agrees
that the pension benefit information could have been easily obtained, but the
Trial Court would not compel Mr. Daniels or TVA to produce the document.
In the appeal, Mrs. Daniels argued that
the TVA pension is marital property pursuant to T.C.A. §36-4-121(b)(1)(B), which
states:
“Marital property” includes income from,
and any increase in value during the marriage of, property determined to be
separate property in accordance with subdivision (b)(2) if each party
substantially contributed to its preservation and appreciation, and the value of
vested and unvested pension, vested or unvested stock option rights, retirement
or other fringe benefit rights relating to employment that accrued during the
period of the marriage.
Mrs. Daniels also asserted and that the
Trial Court abused its discretion in failing to award her any portion of the TVA
pension that accrued during her husband’s twenty year career with TVA. Mr.
Daniels argued that his potential collection of the unvested pension is based
upon a number of future events and that Mrs. Daniels failed to produce any
evidence as to the value of the pension or that he will even receive the
pension. Mrs. Paty asserts that many attempts were made to produce the evidence
of value, but Mr. Daniels would not cooperate and the Trial Court did not compel
him to do so.
The Appeals Court found the pension to be
a marital asset because of T.C.A. §36-4-121(b)(1)(B). The Court stated that,
while Mr. Daniels’s pension is contingent upon several factors including but not
limited to his retirement from TVA, the pension is a valuable marital asset
assuming he qualifies for it upon retirement. They further found that the Trial
Court did not divide the pension and it erred in failing to award Mrs. Daniels
any portion of it. Although the Trial Court referred to the pension as
unvested, it is actually undetermined since it apparently is vested
based upon TVA parameters, but was simply left unvalued at trial.
The Appeals Court cited Cohen v. Cohen,
937 S.W.2d 823, 830-832 (Tenn. 1996). In Cohen, the Supreme Court stated
that the difficulty in determining the value of pension or retirement benefits
should not affect the classification of the property. Having held that unvested
retirement benefits are marital property under the Tennessee statute, the Court
in Cohen listed principles that may assist trial judges in valuing these
benefits. The Court then went on to cite observations made by the Court of
Appeals in Kendrick v. Kendrick, 902 S.W. 2d 918, 922 (Tenn. App.
1994) as follows:
1. Only the portion of retirement
benefits accrued during the marriage are marital property subject to equitable
division,
2. Retirement benefits accrued
during the marriage are marital property subject to equitable division even
though the non-employee spouse did not contribute to the increase in their
value,
3. The value of retirement benefits
must be determined at a date as near as possible to the date of the divorce.
Cohen v. Cohen specifically directs
the Trial Courts as to possible methods of dividing an unvested or
undetermined pension.
Vested
"The first approach, known as the present cash value method, requires the trial
court to place a present value on the retirement benefit as of the date of the
final decree…To determine the present cash value, the anticipated number of
months the employee spouse will collect the benefits (based on life expectancy)
is multiplied by the current retirement benefit payable under the plan…This
gross benefit figure is then discounted to present value allowing for various
factors such as mortality, interest, inflation, and any applicable taxes…Once
the present cash value is calculated, the court may award the retirement
benefits to the employee‑spouse and offset that award by distributing to the
other spouse some portion of the marital estate that is equivalent to the
spouse's share of the retirement interest…The present cash value method is
preferable if the employee‑spouse's retirement benefits can be accurately
valued, if retirement is likely to occur in the near future, and if the marital
estate includes sufficient assets to offset the award."(2)
Unvested/Undetermined
"In other circumstances in which the vesting or maturation is
uncertain or in which the retirement benefit is the parties' greatest or only
economic asset, courts have used the "deferred distribution" or "retained
jurisdiction" method to distribute unvested retirement benefits. This method has
distinct advantages when the risk of forfeiture is great…Under such an approach,
it is unnecessary to determine the present value of the retirement benefit.
Rather, the court may determine the formula for dividing the monthly benefit at
the time of the decree, but delay the actual distribution until the benefits
become payable…The marital property interest is often expressed as a fraction or
a percentage of the employee spouse's monthly benefit. The percentage may be
derived by dividing the number of months of the marriage during which the
benefits accrued by the total number of months during which the retirement
benefits accumulate before being paid. One advantage to the deferred
distribution method is that it allows an equitable division without requiring
present payment for a benefit not yet realized and potentially never obtained…
Another advantage to the approach is that it equally apportions any risk of
forfeiture…While the parties are entitled to an equitable division of their
marital property, that division need not be mathematically precise…It must,
however, reflect essential fairness in light of the facts of the case."(3)
The Daniels Appeals Court stated that both
the Supreme Court in Cohen v. Cohen and their Court in Kendrick v.
Kendrick had already addressed the unvested pension issue in both cases. The
Court therefore remand to the Trial Court to choose one of the two
aforementioned methods of valuation found in Cohen in order to obtain an
equitable division.
Using the Present Value Method To Value An Interest In A Defined
Benefit
Pension Plan (Vested Benefits)
Many businesses, large and small, sponsor
retirement plans that can be classified into generic categories as defined by
the retirement plan industry and the Internal Revenue Code (IRC) as defined
contribution plans and defined benefit plans. Participants in
defined contribution plans (including IRA, 401(k), and Keogh accounts)
usually receive periodic statements of their accounts that detail vested and
non-vested balances. It is usually a simple matter to determine the values of
investments in such plans since these are contributory accounts having a
definite dollar figure “deposited” or contributed to the account owned by the
employee.
A more challenging endeavor is determining
the value of an employee's interest in a defined benefit plan since the
value of the participant’s interest in such a plan must be calculated by
determining the present value of the expected future monthly pension payments,
as prescribed in Cohen. The concept of present value must be understood
in order to appreciate the pension valuation process. Present value embodies the
concept that a dollar in hand today is worth more than a dollar a year from now,
or many years from now. One would rather receive a lump sum of money now rather
than waiting for it to be paid over a period of months or years. This preference
lies in the time value of money, and, in order to receive a lump sum now
rather than throughout the future, one must be willing to receive a reduced or
“discounted” amount. The future benefits are discounted back to the present
value using a number of variables that include a time period (the participant’s
life expectancy) and an assumed rate of return on the money (the discount rate).
The valuation process usually
follows these general steps:(4)
1.
Establish the vested monthly
retirement benefit as close to the Divorce Date as possible,
2.
Determine the age and life
expectancy of the participant,
3.
Determine the appropriate
discount rate to be applied,
4.
Calculate the present value
of the future benefit payments at the Retirement Date,
5.
Discount the present value
of future benefits at the Retirement Date (as computed in Step 4) back to the
Divorce Date (a.k.a. valuation date),
6.
Determine what percentage of
the computed pension value qualifies as marital property.
Pension Plan Valuation
Timeline
Discount Present Value of
Calculate Present Value of
Future Benefits at Retirement Date
Future Benefit Payments at
Back to Divorce Date
Retirement
Date
Divorce
Date
Deferral Retirement
Payout Maximum
(Valuation Date)
Period Date
Period Life Expectancy
(Present
Value)
(Death)
Payout period - Life
Expectancy at Divorce Date minus age at Retirement Date
Deferral period -
Age at Retirement Date minus age at Divorce Date
Step 1 - Establish the vested monthly
retirement benefit as close to the divorce date as possible
Most companies have an in-house pension
administrator or outside administration firm that can readily calculate the
expected monthly or annual benefit a participant will receive upon retirement,
based on the benefit formulas established by the company. As previously stated,
the value of a participant’s interest in a pension plan is determined, for
divorce purposes, by calculating the present value of the expected future
monthly pension payments based on a life expectancy assumption. Quite often the
benefit will be presented on a company-generated form as a dollar figure to be
received monthly upon retirement at a normal retirement age and sometimes as a
reduced amount upon early retirement (if that is an option in the plan). The
statement may further break down the figures as a single life annuity (payments
for the employee’s life only) and a joint life annuity (payments for the lives
of both spouses). For divorce purposes, only the single life option is used
since a divorce is imminent and the joint life option will not be relevant (at
least not for this spouse).
Step 2 - Determine the age and life expectancy of the participant
The participant’s life expectancy is a figure in years that is
calculated generically based on national statistics. The figures can be obtained
from many sources. A commonly used source is the National Vital Statistics
Report, from the Centers for Disease Control and Prevention. This application is
quite simple. For example, a white male the age of 46 today, can be expected to
live another 31 years to age 77, according to the tables. If he is to retire at
age 65, the payout period is assumed/estimated to be 12 years (77-65) and the
Deferral Period would be 19 years (65-46), for a span of 31 years (12+19).
Step 3 - Determine
the Appropriate Discount Rate To Be Applied
In determining the
appropriate discount rate, the following two components are considered:
1. The rate of return on risk-free
investments, plus
2. An additional percentage of
return intended to compensate the “investor” for risk over and above the
risk-free investments, if any, associated with the specific pension plan being
valued.
Risk-free Rate of Return
The risk-free rate
refers to the investment return on a “perfectly safe” investment under current
market conditions. This return and its underlying investment are based on the
current yield of long-term U.S. Government bonds as of the valuation date. The
maturity of the bonds should approximately match the total period over which
benefits will be discounted (the combined deferral and payout periods previously
discussed).
Additional Risk Component
Many pensions are considered to be
risk-free based on the size and success of the sponsor company, and those of the
U.S. Government. The valuer may believe, however, that a risk may exist that the
promised future benefits could be less than expected. The higher the perceived
risk that payments will not be paid in full, the higher the discount rate should
be. In other words, if more risk were involved with the cash flow being
discounted, one would require a higher rate of return on the money to compensate
for the potential default. As the discount rate goes up with the risk
assessment, the present value will go down. The inverse effect occurs because
one is “trading” away the risk into the future by “receiving” a lump sum now.
The primary factors to consider in assessing the additional risk for a
particular plan are as follows:
1. Is the plan covered under the
Employee Retirement Income Security Act of 1974 (ERISA)?
2. Is the plan over or under-funded
by the company based on the projected future obligations?
3. Is the company financially strong
and currently successful?
Step 4 - Calculate the present value of
the future benefit payments at the Retirement Date
Review the timeline presented above once
more. The discounting of the present value of the future benefit payments begins
to the right, in the Payout Period. The payments to be received monthly during
this time period are to be calculated into a single lump-sum figure at the
Retirement Date using a computer program. The future payments to the right are
“pulled back” to the left closer to present day.
Step 5 - Discount the present value of
future benefits at the Retirement Date (as computed in Step 4) back to the
Divorce Date
Using the Deferred Distribution Method To Value An Interest In A
Defined
Benefit Pension Plan (Unvested Benefits)
The W-2 as Roadmap for Tennessee Child
Support Guideline Income
As published in the August 2002 issue of
Family Practice,
The Newsletter for the Family Law Section of the Tennessee
Bar Association
By Robert Vance, CPA, CVA, CFP
The IRS
form W-2, Wage and Tax Statement, can often prove to be a simple roadmap for
determining an employee’s income for Tennessee Child Support Guidelines
purposes. However, don’t be fooled by its apparent simplicity. The W-2, if not
read correctly, does not always reveal the unknown and known
sources of employment “income” as defined by the Guidelines. Per the Guidelines,
the definition of “income” is:
Gross income
shall include all income from any source (before taxes and other deductions),
whether earned or unearned, and includes but is not limited to, the following:
wages, salaries, commissions, bonuses, overtime payments, dividends, severance
pay, pensions, interest, trust income, annuities, capital gains, benefits
received from the Social Security Administration, i.e., Title II Social Security
benefits, workers’ compensation benefits whether temporary or permanent,
judgments recovered for personal injuries, unemployment insurance benefits,
gifts, prizes, lottery winnings, alimony or maintenance and income from
self-employment. Income from self-employment includes income from business
operations and rental properties, etc., less reasonable expenses necessary to
produce such income. Depreciation, home offices, excessive promotional,
excessive travel, excessive car expenses, or excessive personal expenses, etc.,
should not be considered reasonable expenses. “In kind” remuneration must also
be imputed as income, i.e., fringe benefits such as a company car, the value of
on-base lodging and meals in lieu of BAQ and BAS for a military member, etc. (1)
“All
income from any source (before taxes and other deductions),” would seem to be a
no-brainer - an all-encompassing definition of a person’s cash inflow. But, the
term “income” can mean one thing to a CPA and W-2 preparer and another to an
attorney trying to interpret the document in order to set child support. Income
is conventionally thought by CPAs to be taxable compensation or earnings of some
type. Attorneys and the Guidelines generally consider the term “income” to be
cash flows available to the employee regardless of the purpose for payment.
W-2’s report gross income in one of it’s boxes, and can document other payments
made to the employee for items like business expense reimbursements and moving
costs.
Practice Tip -Because the W-2 is a much more complex reporting document than
it appears, understand that employers or their accountants in preparation make
many unintentional errors. Do not necessarily rely upon the form as presented.
For employees with a more complex compensation structure, an attorney should
discover the expense reimbursement policies and retirement plans available to
the employee, then trace those items to the W-2.
Start your
analysis with the most commonly used items on the W-2 – Boxes 1, 3 and 5, Wages
Tips and Other Compensation, Social Security Wages and Medicare Wages,
respectively. Box 1 reports the taxable wages, salary, commissions, certain
expense reimbursements, etc. (hereinafter wages) the employee will be required
to report on his form 1040 as income for that year. It will not include any
amounts for elective salary deferrals, (i.e. pre-tax deductions.) The
most common examples of elective salary deferrals are contributions to 401(k) or
Simple IRA plans. Note that most companies match some percentage of an
employee’s pay or contribution to a retirement plan and deposits the cash or
company stock into the employee’s separate account. This type of fringe benefit
does not have to be reported on the W-2, although it may appear in Box 14. The
match could also be considered Guideline income since it is a monetary balance
the employee can access usually after a vesting period.
Practice Tip – Social Security Tax (6.2% rate) and Medicare Tax (1.45% rate)
are collectively known as FICA (total rate of 7.65%), not one or the
other separately. These taxes are deducted from an employee’s pay at these
rates, subject to certain limits as explained below. An employer matches the
withheld tax dollar-for-dollar for a total tax paid in of 15.3%. The W-2 will
only report the employee’s withheld portion.
Box 3
reports the wages subject to Social Security Tax withholding at the 6.2% rate,
up to the maximum wage base. For 2001, the wage base is $80,400 for a maximum
tax of $4,984.80; for 2002, the base is $84,900 for a maximum tax of $5,263.80.
Generally, Box 3 reports all of the items found in Box 1, but does not deduct
the elective salary deferrals. Note that certain government employees and clergy
are not subject to Social Security tax and will not have an amount reported in
Box 3.
Box 5
reports the wages subject to Medicare Tax withholding, which are generally the
same as those in Box 3, without the maximum wage base. The elective salary
deferrals are not deducted from Box 5 and, since there is no maximum Medicare
wage base, Box 5 is the most accurate of the three boxes in determining the
employee’s gross income from employment. An employee’s Box 5 will be higher
than Box 3 and possibly Box 1 if his wages exceed the maximum wage base
and he participates in a 401(k)-type plan.
A
simple example will illustrate all of these points. An employee, Joseph
Jones, earned $140,000 in 2002 and elects to have $5,000 deducted and
contributed to his 401(k) plan. He has no federal tax withheld (he lives
dangerously.) No fringe benefits.
The W-2
reporting is as follows:
Box 1
$135,000.00 (Wages)
Box 3
$84,900.00 (Soc. Sec. Base)
Box 4
$5,263.80 (Soc. Sec. Tax)
Box 5
$140,000.00 (Mcare Wages)
Box 6
$2,030.00 (Medicare Tax)
Box 12
$5,000.00 (401(k) code D)
In this
example, Joseph’s net “take home” pay is $127,706.20
($140,000.00-5,263.80-2,030.00-5,000.00); the Guideline income is $140,000. The
elective salary deferrals should be considered part of Mr. Jones’ gross income
since the deduction was elective and would have been included in gross
taxable income if Congress had not decided to make this particular paycheck
deduction a pre-tax item.
Practice Tip –Photocopy both sides of a W-2. The backside may include
instructions and explanations of any codes that might appear in Box 12. These
codes can provide a wealth of information about income, reimbursements,
deductions and fringe benefits that may or may not be included in Boxes 1, 3 and
5.
The Trouble with Fringe Benefits and
Expense Reimbursements
An employee fringe benefit increasing in
popularity is the §125 “Cafeteria Plan.” This IRS-qualified paycheck deduction
allows for a pre-tax deduction from income for particular personal expenses that
would probably otherwise not be tax deductible to the employee. A typical
cafeteria plan deduction is medical insurance, which could add up to several
thousand dollars. The amount of the Plan deducted from pay will generally not be
found in Boxes 1, 3 or 5, (or anywhere else for that matter) and could be
considered Guideline income since it is also elective.
Employer
expense reimbursements and allowances can also be a source of income for
Guideline purposes. An employee’s out-of-pocket business expenses and employer
paid moving expenses may be reported in Boxes 1, 3 and 5, however, the payments
may qualify for non-reporting on the W-2 depending on the method of payment and
documentation. In most circumstances, the obligee spouse will know if the
obligor makes a “profit” on expense reimbursements.
Practice Tip-The reporting of expense reimbursements and allowances is a
source of confusion, thus many employers fail to include them properly on the
W-2. A quick call or a subpoena issued to the company’s benefits department will
reveal their reimbursement and W-2 reporting policies.
Reimbursements could also satisfy the “all income from any source” Guideline
criteria. Under certain conditions, the IRS considers these payments to be
taxable income includable on the W-2 depending on the discretion the employee
has over the use of the funds. Since the dollars are paid to the employee to
reimburse him for ordinary and necessary business expenses or for moving, which
could be quasi-business related, many practitioners might not consider them as
income. To illustrate, a salesman may use her car to travel from customer to
customer and she is reimbursed for the mileage costs, but does an attorney
usually receive a stipend for his expensive business suits or commuting costs to
and from home? All are necessary to conduct business. All persons that work
incur some sort of personal expense as a condition of employment. Will the
attorney be hit for support on income that he ultimately will use to buy a new
suit and tie? Yes. Should the salesman be hit for support on reimbursed mileage
payments she will ultimately use to buy gas? Perhaps.
The W-2
can be an effective roadmap that summarizes income for Tennessee Child Support
Guideline purposes and other important measures in a divorce – but you can make
a wrong turn and end up in a bad neighborhood if you read it incorrectly. Of
course, there is no substitute for a thorough interview and full financial
analysis of the subject, along with a little common sense. The W-2 is a roadmap
that can lead the attorney to the right side of the tracks, but it also contains
alleys and side streets just waiting for a missed turn.
Summary of W-2 Reporting
|
|
Box 1 |
Box 3 |
Box 5 |
|
Includes |
-Taxable Wages, Salary, |
-Income subject to Social Security |
-Income subject to Medicare |
|
|
Commissions |
Tax withholding |
Tax withholding |
|
|
-Certain Expense Reimbursements |
-All items from Box 1 |
-All items from Box 1 |
|
|
|
-Elective Salary Deferrals |
-Elective Salary Deferrals |
|
Does Not |
-Elective Salary Deferrals |
-Income above maximum wage |
-No maximum wage base cap |
|
Include |
-Cafeteria Plan Deductions |
base; reporting "caps out" and |
-Cafeteria Plan Deductions |
|
|
|
does not report Guideline income |
|
|
|
|
over the maximum wage base |
|
|
|
|
-Cafeteria Plan Deductions |
|
|
Notes |
|
-Some government employees and |
Most accurate Box to use for |
|
|
|
clergy are not subject to SS |
Guideline income |
(1) Rules of Tennessee Department
of Human Services Child Support Services Division, Chapter 1240-2-4
Child Support Guidelines, ¶1240-2-4-.03 (3)(a), Oct. 1989 (Revised)
Professional Practice
Valuation in a Tennessee Divorce
As Published in Tennessee CPA Journal, June 2001
A Publication of the Tennessee Society of CPAs
By Robert Vance,
CPA, CVA, CFP
The process of
valuing a business is more art than science and depends on the circumstance
or event causing the valuation. The fundamental concept common to most business
valuations is that the value of an entity is equal to the present worth of the
future benefits of ownership at a single point in time. Economic benefits to
an owner ultimately must be derived from the generation of ongoing income from
operations or investments, liquidation of the underlying assets or sale of the
entity. Fair market value (FMV) is the value standard to be used in most cases,
with a few notable exceptions, such as in some divorces or dissenting shareholder
lawsuits. FMV is defined as the amount at which the property would change hands
between a willing buyer and a willing seller, neither under compulsion to buy
or sell, with both parties having reasonable knowledge of relevant facts. Believe
it or not, the Internal Revenue Service created this definition in 1959 in Revenue
Ruling 59-60, which, even today, is still considered a bedrock of valuation
text.
In a divorce, an
actual transfer of the business to a third party is not usually planned or even
possible, thus does not involve a willing buyer and willing seller in an arm's
length deal (i.e., no FMV). Jurisdictions, like the State of Tennessee, often
impose further limitations or restrictions based on their belief that, in certain
cases, the expectation of future earnings is not an asset for property division.
The following article focuses on three divorce cases decided in the Tennessee
Court of Appeals. These cases highlight three situations commonly argued when
professionals divorce - existence of goodwill for a sole practitioner, existence
of goodwill in a large practice and binding valuation formulas found in buy-sell
agreements. All three cases deal with medical practices, although the same theories
apply to other professions.
In a Tennessee
divorce, a sole practitioner licensed professional, such as a physician, dentist,
accountant, attorney, engineer, etc., would generally not be subject to having
the practice valued at FMV. Only the value of the net assets could be considered
with no allowance for an expectation of future earnings (i.e. goodwill), such
as in Hazard v. Hazard, 833 S.W. 2d 911 (Tenn. App. 1991). Net Assets is defined
as the total non-intangible assets (cash, accounts receivable, work in progress,
inventory, equipment) less the payables and debts. Professionals with larger
practices that do not depend on the sole reputation or efforts of the individual
have often been likened to going concern, closely held corporations, such as
in Witt v. Witt, 17 TAM 15-6 (M.S., Tenn. App. 1992). The valuation allowed
in Witt more closely resembles FMV and did allow for goodwill. Another interesting
twist was decided in Harmon v. Harmon, 25 TAM 15-22 (W.S., Tenn. App. 2000).
Harmon established that a spouse, who is not a party to a buy-sell agreement,
is not bound to the artificially low valuation method specified in the agreement.
Sole Practitioner
(No Goodwill)
In Hazard, the Western Section of the Tennessee Court of Appeals affirmed that
a sole practitioner professional practice is to be valued using the "net
tangible assets with ascertainable value." The court stated that goodwill,
which is usually based on some function of future, potential income, is not
to be considered based on the personal nature of a professional practice and
the speculative nature of future income which may or may not materialize. Dr.
Hazard was a physician in his final year of fellowship training in pulmonary
medicine. He established a private practice that employed one associate physician,
two nurses and two other employees. The court found the value of the practice
to be based upon a total of the cash on hand, accounts receivable, equipment,
fixtures, supplies and medical charts. No provision for goodwill was allowed.
The wife argued that the practice was a going concern, separate entity, and
should be valued accordingly. The court determined that the practice was highly
specialized and, apparently, very dependent upon the services of Dr. Hazard.
The court said:
In Smith v. Smith, 709 S.W. 2d 588 (Tenn. App. 1985), the…Court, in dealing
with a law practice, said:
The next question is what elements of a profession are taken into account in
arriving at the value of that profession for purposes of making an equitable
division. The physical assets, of course, such as the furniture, buildings,
library, etc., are things that have an ascertainable value and should be taken
into account. The accounts receivable, properly weighted, should have a definite
value. The most troublesome question involves the goodwill of the firm. Is that
an asset that can be considered part of the marital property? Other states are
split on the question, although a clear majority hold that the goodwill of the
firm should be considered and evaluated in making a division of the marital
property.
We are not persuaded,
however, that this state should adopt the rule that professional goodwill is
a part of the marital estate. We find the position taken by the Wisconsin Court
of Appeals in Holbrook v. Holbrook, (Wis. App. 1981) to be persuasive. The court
said:
The concept of
professional goodwill evanesces when one attempts to distinguish it from future
earning capacity. Although a professional business's good reputation, which
is essentially what its goodwill consists of, is certainly a thing of value,
we do not believe that it bestows on those who have an ownership interest in
the business, an actual, separate property interest. The reputation of a law
firm or some other professional business is valuable to its individual owners
to the extent that it assures continued substantial earnings in the future.
It cannot be separately sold or pledged by the individual owners. The goodwill
or reputation of such a business accrues to the benefit of the owners only through
increased salary.
There is a disturbing
inequity of compelling a professional practitioner to pay a spouse a share of
intangible assets at a judicially determined value that could not be realized
by a sale or another method of liquidating value.
The Holbrook opinion
is one of the most often cited involving professional goodwill (or the lack
thereof).
Closely Held Corporation (With Goodwill)
Exceptions do apply to the "no goodwill," net asset value divorce
rule. For example, in Witt, the court found that Dr. Witt's outpatient diagnostic
clinic had a value over and above the net asset value (i.e. it had goodwill.)
The court said:
We are convinced,
however, that excluding the professional goodwill, (Husband's) practice has
a value over and above the net asset value. The clinic employs eight people
providing CT scans and MRI examinations. (Husband) works a full day at the VA
Hospital and then goes to the clinic to apply his expertise to the work performed
during the day by technicians. (Husband's) professional fees are billed separately
from the technical fees generated by the technicians....The trial judge found
that the net asset value of the clinic amounted to $950,000. The evidence does
not preponderate against that finding....The trial judge set a value on the
medical practice at $1,300,000, i.e., $350,000 over and above the net asset
value. We think the part of the business that does not include (Husband's) professional
goodwill has a substantial value and that the trial judge's valuation of $350,000
for that portion of the business is supported by the evidence.
In other words,
the clinic was found to have separate goodwill that was not directly related
to the Husband's professional or personal goodwill, and thus the overall value
was increased accordingly to include the intangible value.
Spouse Not Bound to Buy-Sell Agreement
In Harmon, the wife was not bound to the valuation method (formula) mandated
in the buy-sell agreement in effect in her physician-husband's medical practice.
The wife was not a party to the agreement and had not signed it.
Husband owned 10
shares (1.17%) of stock in the Jackson Clinic (Clinic), a very large, multi-location
medical association. He had signed an employment contract that contained a non-compete
clause, which further subjected him to a buy-sell agreement. The agreement bound
him to a predetermined formula for valuation of the shares if he were to attempt
to sell them. The formula specified that no allowance could be made for goodwill,
supplies or accounts receivable, except upon dissolution.
Prior to trial,
the parties stipulated that the current net asset value of Husband's interest
in the Clinic at that time was $250,000. At trial, Wife asserted that the trial
court should use the parties' stipulated net asset values. She argued that Husband's
buy-sell agreements with the Clinic were designed to discourage physicians from
leaving the clinic, and therefore set an artificially low price per share. She
asserted that the share price set by the clinic did not reflect the actual value
of Husband's interest because it did not include the accounts receivable or
the inventory. Husband argued that the clinic should be valued in accordance
with the buy-sell agreement because he would be bound to that price if he sold
his shares. The trial court found the stipulated value of the Clinic was the
value to be used if the practice liquidated. Since there was no plan to liquidate,
the trial court stated that Wife was bound to the value set by Husband's buy-sell
agreement.
Upon appeal, Wife
first argued that appropriate value was the net asset value of $250,000 as stipulated
by the parties. She stated that this value looks to the net assets of the practice
as a going concern, taking into account the value for items such as accounts
receivable and supplies. Even though Wife argued that net asset value was the
FMV, she did not request a provision for goodwill, which would have been closer
to the true FMV. She noted that she was not a party to the buy-sell agreements,
and disputes the trial court's legal conclusion that she was bound by the value
set in the agreements. Husband argued that the trial court's valuation of his
interest in the Clinic is correct because his interest cannot be valued at more
than the price he would receive for the sale of his shares.
The Harmon appellate
court noted that both Smith and Hazard involved professional practices in which
the value as a going concern and its business reputation was inseparable from
the professional reputation of the practitioners. The court stated that, in
a larger professional setting that does not depend on the reputation or services
of a single practitioner, such as in Witt, Tennessee courts have not limited
the valuation to the physical assets and the accounts receivable and have included
goodwill.
In Harmon, the
court relied upon a 1992 case, York v. York 17 TAM 34-1 (M.S., Tenn. App. 1992).
In York, the Court discussed at length the method for valuation of a divorcing
spouse's interest in a large professional practice. In York, the husband owned
an interest in a multi-employee, specialty medical group. The York Court found
the husband's medical practice to be more similar to the practice in Witt than
to a traditional solo medical practice. The trial court in York likened the
professional association to a closely held corporation and indicated that, while
future income projections would not be considered, other factors such as corporate
goodwill and the price at which other physicians had purchased stock would factor
into the valuation of the husband's interest.
The Harmon court's
research revealed no Tennessee cases addressing the issue of whether Wife was
bound by the value stated in the buy-sell agreement. The clear majority of courts
from other jurisdictions held that the value established in the buy-sell agreement
of a closely held corporation, not signed by the non-shareholder spouse, is
not binding on that spouse, but is considered, along with other factors, in
valuing the interest. The court found that the majority view is more consistent
with the valuation approach outlined in Tennessee decisions such as in York.
The York court rejected the notion of mathematical formulas for such a valuation
and emphasized that valuation of a professional corporation, such as Husband's,
is "a factually driven inquiry that requires the trial court to weigh and
evaluate all relevant evidence regarding value."
The Harmon court
adopted the view that buy-sell agreements may be considered along with any other
relevant evidence on valuation, but are not controlling, thus reversed the trial
court's holding on this issue. The cause was remanded to the trial court for
valuation of Husband's interest after consideration of all relevant evidence,
including, but not limited to, the parties' stipulated net asset value and the
values set forth in the buy-sell agreements. The trial court was told it may
consider how closely the factors for valuation in the buy-sell agreements correlate
with the factors mentioned in York and other applicable case law. The buy-sell
agreement of the Clinic specifically excluded items such as intangible assets,
accounts receivable and supplies. As in York and Witt, Husband's medical practice
is an incorporated medical group that does not depend solely on his professional
reputation for its value as a going concern. In fact, Husband's medical group
in this case dwarfs in size those considered in York and Witt. The court found
that since Husband will continue to experience the benefits of being a shareholder
and an employee, factors such as those deleted from the valuation in the buy-sell
agreement are pertinent to the valuation of Husband's interests for purposes
of the division of marital property. The issue is not the value the shareholder
spouse would receive if he sold his shares, but rather the current value to
the shareholder of his interest in the corporation.
Conclusion
The final chapter of the valuation of professional practices in Tennessee divorces
has certainly not been written. The courts are continuing to grapple with the
concept of professional versus practice goodwill and the point at which the
line is crossed and the practice becomes diverse enough to separate itself from
the professional. This article addressed three valuation issues commonly found
when professionals divorce - the non-existence of goodwill for a sole practitioner
in Hazard, the existence of goodwill for a large practice in Witt, and not binding
a non-party spouse to artificially low-yielding valuation formulas found in
a buy-sell agreement in Harmon. The courts are becoming more sophisticated in
their understanding of business valuation as evidenced in these cases, but they
continue to depart from many traditional valuation methods.
