We summarize select cases addressing the inclusion of S corporation “pass-through” earnings in the context of an award of child support.

March 01, 2015

Overview

Various courts have addressed the treatment of undistributed earnings of an S corporation that are attributable to the parent-shareholder for income tax purposes but may or may not be available to pay child support. The courts have considered relevant factors, based on the particular circumstances of each case, for the determination of the appropriateness of inclusion or exclusion of the “pass-through” income in setting child support. The following are summaries of selected cases addressing the inclusion of S corporation “pass-through” earnings in the context of an award of child support.

In re Marriage of Brand, 44 P. 3d 321 – Kan: Supreme Court

Facts of the Case

The parties were divorced on November 19, 1996. As a part of the property division, Mr. Brand (Father) was awarded, among other assets, the interest in a corporation owned by members of Father’s family, Brand Plumbing, Inc. (Plumbing). Child support was based on Father’s salary from Plumbing. No self-employment income or distributions from the Subchapter S corporations were included in the income computation.

In 1998, Plumbing converted to Subchapter S status, and the taxes due on income of the corporation were then “passed through” to Father as a shareholder responsible for paying the taxes. Father could not elect to take distributions of corporate assets independently and the shareholders did not always make distributions in the amount requested. In fact, Plumbing had not made distributions in excess of the amount necessary to cover the shareholders’ respective tax liabilities on the S corporation income in any given year. Sufficient operating capital was retained so that the corporation could continue to purchase material, purchase vehicles, and finance a possible relocation.

In 2000, Mary Brand (Mother) filed a motion to modify child support, claiming that Father’s “income” from Plumbing should be included as income for purposes of calculating child support.

Trial Court Decision

The district court determined that the distributions were not income as defined in the Kansas Child Support Guidelines and once again set child support based only on Father’s salary from Plumbing.

Mother appealed, arguing that the district court erred in determining that Subchapter S income is not income of the taxpayer and that the court should have at least considered the distributions for the purposes of paying his share of the income tax on the corporations’ income.

Appellate Court Decision

The Appellate Court upheld the trial court decision finding that “there are many factors to be considered when determining what amount of a Subchapter S corporation’s income should be included as income for purposes of calculating support,” including past earnings history of the corporation, ownership share, and the shareholder’s ability to control distribution or retention of the net profits of the business.

Under the facts of this case, the court found no indication that Father had manipulated income for the purposes of avoiding support obligations and, further, he had no ability to control the distribution of corporate assets.

JS v. CC, 454 Mass. 652 – Mass: Supreme Judicial Court 2009

Facts of the Case

The parties, who never married, had one child born in 1997. Father was the chief executive officer and 65% owner of a closely held S corporation (SCorp). On his financial statement filed with the court, Father indicated that his gross income for 2005 was $92,001.65, consisting largely of salary or wages paid to him by the corporation. Although Father did not list any other earnings from the corporation, he did state that he rarely received distributions from the corporation other than in the amount required to pay any tax liability attributable to the pass through of 65% of the corporation’s income for income tax purposes. The trial court heard testimony that the SCorp profits for the current year were likely to be between $400,000 and $500,000, and that Father would report 65% of that figure, or between $260,000 and $325,000, on his individual tax return.

Trial Court Opinion

The trial court determined that based on his 65% ownership in the SCorp, Father’s income was likely to be at least $352,000 ($92,000 from salary and at least $260,000 from earnings or income attributable to him).

Father appealed, arguing that the court erred by including undistributed earnings of the SCorp in the computation of his income available for support.

Supreme Judicial Court Decision

The Court remanded the matter to the Probate and Family Court for further consideration solely on the issue of ability to pay child support. In its opinion, the Court concluded that the trial court judge erred in treating all of the S corporation’s retained earnings as income available to Father for purposes of paying child support.

The Court ruled that “a determination whether and to what extent the undistributed earnings of an S corporation should be deemed available income to meet a child support obligation must be made based on the particular circumstances presented in each case.” The Court directed the trial court to consider Father’s level of control over corporate distributions, to evaluate the legitimate business interests requiring the retention of corporate earnings, and to evaluate evidence of any attempt to shield income by means of retained earnings, placing the burden of proof on Father to present evidence that he did not have access to retained earnings.

Haefele v. Haefele, 837 NW 2d 703 – Minn: Supreme Court 2013

Facts of the Case

When the parties divorced in 2000, Mother had 20% interest in Dura-Supreme (Dura), a family-owned manufacturing business taxed as an S corporation. In 2008, Mother’s family formed TK Investments, LLC (TK) to self-finance the expansion of Dura and agreed that the owners of Dura would fund TK with distributions from Dura. From 2007 to 2009, Mother received $4,994,000 in distributions from Dura, $2,690,000 of which were used to fund TK and $1,559,000 to pay taxes.

In 2010, after amendments to the Minnesota child support statutes, Father moved to modify his child support obligation, arguing that the distributions paid to Mother as a shareholder of a closely held subchapter S corporation should be included in her “gross income,” for the purpose of calculating the child support amount.

Trial Court Decision

The trial court agreed with Father and granted his motion, including the distributions in Mother’s income for purposes of calculating child support. Although the court found that Mother was not attempting to hide money in the family companies or avoid her child support obligation, the “availability of income received is not mentioned in the statutes.” The court also ruled that the funds distributed to pay income taxes must be included because the statutes require that child support be based on gross income.

Mother appealed the ruling.

Court of Appeals Decision

The court of appeals reversed, concluding that the distributions either were not available to Mother or were designated to pay her income tax obligation, and therefore did not constitute gross income within the meaning of the statutes.

Father appealed the decision.

Supreme Court Decision

The Supreme Court reversed the Court of Appeals, finding error in the determination that the income tax payments should be excluded from the calculation of income for support. The court concluded that, in order to give effect to the term “gross income,” it was necessary to deny a deduction for any amounts used to pay income taxes. Moreover, Father’s pretax salary was the basis for his gross income, and using pre-tax figures for Mother’s income would treat the parties equally.

With respect to the distributions to fund TK, the court acknowledged that the Minnesota statute extends the definition of gross income for child support purposes to reach funds that the corporation has not distributed and are not available to the parent. Further, the court recognized that “strict application of the rule could have significant potential for unfairness, including in cases in which the parent is a minority owner of the business and has no power to control when or how much of her share of the earnings the business distributes to her.”

This issue was remanded to the trial court to consider whether to deviate from the guidelines. The Supreme Court observed that gross income is only the starting point for a child support analysis, and the obligation calculated by applying gross income to the child support guidelines is a rebuttable presumption. Under Minnesota statute, courts are required to look beyond the definition of gross income to consider such things as “all earnings, income, circumstances, and resources of each parent, including real and personal property,” and “the standard of living the child would enjoy if the parents were currently living together.”

In summary, the Supreme Court found that the trial court may depart from the guidelines in appropriate cases based on the unavailability of money included in gross income, or based on other facts or considerations that suggest that the guidelines do not accurately represent the amount of the child support obligation for which a parent should be responsible.

Diez v. Davey, Mich: Court of Appeals 2014

Facts of the Case

Father is the president and sole shareholder of Supreme Gear Company (“SGC”), an S corporation for tax purposes. The parties never married but had three children together. In April 2010, Mother filed a motion with the court requesting child support. The matter was referred to a Friend of the Court (FOC) referee who held a three-day evidentiary hearing on the topic of child support.

The referee heard testimony from three CPA experts regarding the actual income available to Father for the payment of child support in 2008 through 2011. The experts each offered differing opinions, but when determining Father’s income, the referee relied on the opinion of the expert he found to be most credible. The expert considered Father’s W-2 income, interest and dividends, actual distributions, perks, and “additional monies available for income, or for payment of child support that aren’t in any of the other four categories.” The expert calculated the amount that in his judgment was “excess working capital,” defined as the amount in excess of money required to pay for the operations of the company. Based on his analysis, the expert testified that it was his opinion that excess working capital was $300,000 in 2010 and $797,000 in 2011. Further, he estimated that it was reasonable to assume that 60% to 65% of excess working capital would be available for distribution.

Father objected to the FOC recommendation and the matter was heard by the trial court.

Trial Court Decision

Based on the FOC report and further testimony, the trial court included a portion of “excess working capital” retained in SGC in determining Father’s income available for support. The trial court ruled that “Michigan law treats the income of an S corporation as the income of the S corporation’s shareholders”.

Father appealed, arguing that the trial court erred in relying on an expert’s determination of “excess working capital” in the S corporation as a basis for attributing income to him and further, that distributions used to pay taxes on the SGC income should not be considered available to pay child support.

Court of Appeals Decision

The Court of Appeals reversed the trial court, holding undistributed earnings of an S corporation should not be considered income available to pay support absent evidence of a reduction in distributions compared to historical practices. The court found that “provided that the operation of a parent’s business is in keeping with historical practices, that those practices can be described as the reasonable exercise of business judgment, and that there is no evidence of an improper effort to make funds unavailable for child support,” undistributed earnings are not for income available to pay support. Further, a parent’s historical business practices should be given considerable weight in assessing the parent’s income from a business.

With regard to the funds distributed for the payment of taxes, the court found that tax distributions are not a true measure of the funds a parent has, or should have, available for child support. Thus, tax distributions should not be included in the calculation of income available for support.

In a concurring/dissenting opinion, one of the justices wrote as follows:

"I would adopt a case-by-case, fact-specific inquiry that is not limited to situations where there is evidence of reduction in distributions compared to historical practices. It is clear that, particularly where a parent is the sole owner of an S corporation, a parent has complete control to determine their own salary, when to take distributions, and how much money to leave in the corporation. To ignore this fact would allow a sole shareholder, such as plaintiff, to determine his own income for child support purposes. Further, I would place the burden of demonstrating that earnings are necessarily retained in the corporation on plaintiff in this case.”

Conclusion

The determination of income a parent has available to pay child support varies from state to state according to statutes, guidelines, and relevant court opinions. As seen in the limited examples above, the treatment of S corporation income can vary significantly from jurisdiction to jurisdiction.