Why should we request parties’ personal tax returns? Often, a case is starting from ground zero, with little to no information disclosed by parties in the process of litigation or divorce. Information contained in personal tax returns can confirm or unveil details about the parties, while also providing valuable insights into a party’s financial situation. Here, we will highlight and discuss the areas of federal Form 1040 and how this information can further assist attorneys.
Attorneys commonly request and receive personal tax returns in initial discovery requests. Through a review of these returns, one can answer or verify a number of questions by using the information further detailed in this article:
Confirming or reviewing this information can assist with discovery requests, determination of the scope of a project, and a general understanding of the parties’ estate.
Tax returns are readily available documents that are commonly retained for long periods. The information has an assumed level of accuracy because tax returns are signed under penalty of perjury, commonly prepared by a tax professional, and used to substantiate income to creditors. Personal tax returns are filed as Form 1040 and typically include a federal and state form.
The first page of the tax return details the parties’ names and filing status, which indicates whether the parties file separately or jointly. If the parties file separately, attorneys should request tax returns from each party to gain a full understanding of the estate. The parties’ main home residence is also stated, as well as any dependents claimed. This may reveal the names of the parties’ minor children. The second page includes the name of the tax preparer. If the signatory is an outside third party, this party likely holds supporting documents and could be a potential target to subpoena.
Line 1 of Form 1040 reports the total W-2 wages that the parties received from employers. Supporting schedules to the tax return may further detail wages by amount, company name, and spouse. The source for this figure is Box 1 of Form W-2 issued by the parties’ employers.
The difference between Box 1 and Box 5 is the deferral compensation amounts, such as 401k contributions by the parties, which are aggregated in Box 5. An attorney may consider including these deferred amounts when discussing the parties’ cash flow. Attorneys may further review Box 14 of Form W-2, as this may indicate the vesting of restricted stock units (RSUs) in that year, the amount of which is included in Box 1. This may signal the existence of future units that will vest and consideration to include these in the estate.
Interest and Dividend Income (Sched. B)
Total interest and dividend income are reported on lines 2 and 3 of page 1 of Form 1040, and further detail may be reported on Schedule B. Reviewing the financial institutions included on Schedule B may reveal a previously undisclosed bank and investment accounts held by the parties. If an undisclosed account is found, an attorney may consider issuing discovery requests to the institution or inquiring about the account.
Capital Gains (Loss) (Sched. D)
Capital gains (losses) are reported on page 1, line 6 of Form 1040. Schedule D further details the sale of an asset and whether the parties incurred a gain or loss after considering the cost basis and purchase price of the asset. Depending on the transaction amount, additional detail may be provided in Form 8949.
A capital gain or loss can signal an asset divestiture or that an asset was sold during the year. Divestitures can also be apparent by comparing tax returns year over year to identify the income source that no longer appears on Form 1040 (e.g., interests in businesses or properties, investment income, etc.). This comparison may shed light on whether a gain (or loss) was a one-time or nonrecurring event, such that the amount should be removed when determining the parties’ cash flow.
Business Income (Sched. C)
If the parties hold a sole proprietorship or single-member LLC, the company’s financial results are reported on Schedule C. Schedule C details: 1) the sole member of the company and whether this individual is “materially” involved in the company; 2) the name of the company and general company description; and 3) an income statement for the company, including the amount of revenue, expenses paid, and net profit generated, in addition to the accounting method applied. Schedule C does not, however, include a balance sheet, nor does it disclose the assets and liabilities of the company. This will need to be requested separately.
Attorneys can review Schedule C to identify the existence of interest-bearing debt and detect expense items that may need further discovery based on the magnitude and type of expense. Interest-bearing debt is likely if the company incurs an interest expense. The presence of interest-bearing debt may be of importance because the responsibility of the payment of debt is generally based on the corporation type, such that the sole proprietor is personally liable for the debt compared to the LLC being liable for a single-member LLC. However, many small business owners personally guaranty debt, regardless of corporate form. An attorney may also review the amounts and types of expenses included on Schedule C (e.g., travel, legal and professional fees, etc.) to question whether certain expenses are personal in nature and unrelated to the company.
Rental Real Estate and Royalty Income (Sched. E, Part I)
Part I of Schedule E details: 1) income and expenses from rental real estate held 100% by the parties (in addition to personal property leased with real estate) and 2) royalty income and expenses. The schedule provides a description or address of each property and the type of property (e.g., commercial property, land, royalties, etc.).
Similar to above, interest-bearing debt of the property can be identified by reviewing the amounts reported for mortgage interest or other interest paid. An attorney may also want to consider commissioning an appraisal.
Pass-Through Income (Sched. E, Part II)
If the parties hold an ownership interest in a partnership, S Corporation, or LLC, these entities are known as pass-through entities. Part II of Schedule E details: 1) the name of the entity; 2) the type of corporation; 3) whether it is a foreign partnership; 4) whether the investor earns passive or active income; and 5) the amount of taxable income for each interest. The supporting document for the amount of taxable income is a Schedule K-1. Schedule K-1s are prepared annually for each owner of a partnership, S Corporation, or LLC.
Attorneys should consider requesting Schedule K-1s, as they detail further information about the parties’ interest, including percentage ownership interest held and distributions received (which generally represent actual cash or in-kind benefits received by the parties), and they may also include capital contributions made by the parties to the company. A word of caution: if the parties hold an ownership interest in a C corporation, this interest is seldom indicated on the parties’ personal tax return. Discovering this interest will require disclosure by the parties or reference to the interest elsewhere.
Estate and Trust Income (Sched. E)
Income (loss) associated with the beneficiary of an estate or trust is reported on Schedule E. If the estate or trust files a separate tax return, the entity will be listed on Part III of Schedule E. The parties will receive a Schedule K-1 annually from the trust/estate tax return (Form 1041). Depending on the case and terms of the trust, one may request additional documents surrounding the trust’s holdings and rights.
Other Income/Miscellaneous Income (Sched. 1)
Line 8 of Schedule 1 reports the total other income the parties receive. Commonly, miscellaneous income relates to income a party receives as a result of services rendered as a nonemployee (e.g., consulting income received as a contractor). These figures are supported through copies of Form 1099-MISC for each separate service. An attorney may consider requesting documents surrounding the services provided depending on the amount and consistency of income generated each year. Further types of other income can include income from a pension and IRA distributions, among others.
Home Mortgage Interest and Points (Sched. A)
Parties may claim a deduction of mortgage interest (subject to eligibility and amount limitations). A home mortgage is any loan secured by your main home or second home, in addition to home equity loans and refinanced mortgages. A comparison of the amounts year over year may indicate a refinance or change in the balance of the loans. If there has been a recent refinance, it may be a good idea to request the loan application to review what assets, liabilities, and income the parties disclosed to the lender.
Total Tax (Federal)
Total tax is the actual amount of taxes owed by the parties to the federal government. The amount is calculated based on the parties’ reported taxable income and relevant federal tax bracket, adjusted for any qualifying tax credits.
Total Tax Payments
Total tax payments include the amount of federal taxes paid by the parties in a given year. Total tax payments primarily include actual payments made by the parties through the year, taxes withheld from a parties’ employer through a Form W-2 or 1099, adjustment for tax credits, and the application of a previous year’s tax overpayment to this year’s taxes (see page 1 of Form 1040 and Schedule 5).
Overpayment (Underpayment) of Taxes
The parties may be eligible for a tax refund or owe additional taxes after comparing the difference between the amount of taxes due and the amount of taxes paid. Parties either elect all or a portion of the overpayment to be: 1) refunded or 2) applied to next year’s estimated tax payments. If the parties select the latter, the amount is detailed on Schedule 5 of the following year’s tax return.
The tax refund amount and selection to apply this refund to next year’s taxes should be investigated if the balance has accumulated over time (see page 1, line 22 and Schedule 5). If there appears to be a sizable difference between the amount to be applied to next year’s taxes and the historical total tax payments, some or all of this balance may need to be considered in the parties’ estate.
Reported Total Taxable Income
The parties’ total income for tax purposes is presented on page 2 of Form 1040. While this figure represents amounts on which the parties are taxed, it does not necessarily reflect cash the parties received. As such, certain adjustments are likely required when determining the actual cash flow of the parties.
Calculate the Parties’ Effective Tax Rate
The parties’ effective tax rate can be calculated from the parties’ Form 1040. This rate captures the varying tax rates on different income sources and can be used as a proxy to calculate year-to-date tax estimates.
A review of the above information can assist in litigation or a divorce with discovery requests and an initial understanding of the parties’ financial holdings and income. However, the review of a party’s personal tax return can be complicated. By involving financial experts, we can answer questions and suggest the types of documents to request while highlighting areas of interest given the facts and scope of the case. An expert can help to narrow the scope and to field preliminary questions from the client.
Maggie Doman, CPA
Vice President, Valuation Advisory