CORPORATE OR PARTNERSHIP RETAINED EARNINGS AS INCOME UNDER CHILD SUPPORT GUIDELINES
Laura W. Morgan
The determination of each parents income is the primary focus of all states child support guidelines, for it is the determination of income that dictates the presumptive child support award. 45 C.F.R. § 302.56(c)(1) (child support guidelines must be based on, at least, income and earnings of absent parent).
As stated by one authority,
Child support guidelines presumptively establish a childs needs based on the childs parents income. Thus, the guidelines have shifted the evidentiary focus from proving the needs of the children to establishing the parents income.
Laura W. Morgan, Child Support Guidelines: Interpretation and Application § 2.03[a] at 2-7 (Supp. 2001). See also Lynn Gold-Biken & Linda Ann Hammond, Determination of Income, in Child Support Guidelines: The Next Generation 29 (U.S. Department of Health and Human Services, Office of Child Support Enforcement 1994) (The most important piece of information is the income of the party. The definition of what constitutes income is crucial to the development of an accurate and equitable formula); Center on Child and the Law of the American Bar Association, Evaluation of Child Support Guidelines, Volume I: Findings and Conclusions (Executive Summary) at ES-2 (Office of Child Support Enforcement, Dept of Health and Human Services 1996) (One of the first steps in any child support case is the determination of income); Center on Children and the Law of the American Bar Association, Evaluation of Child Support Guidelines, Volume II: Findings of State Guideline Reviews, State Guideline Studies, and Unstructured Interviews (Executive Summary) at ES-3 (Office of Child Support Enforcement, Dept of Health and Human Services 1996) (Income is the driving factor behind every child support calculation, and accurate information is vital to arriving at an appropriate order).
Because income is the driving force behind child support guidelines calculation, much attention has been paid to how income is defined. All state child support guidelines have defined income with a number of underlying principles in mind. The most important of these principles is that the definition of income must be as expansive as possible, taking into consideration all available funds.
Consonant with the principle that income for child support guidelines must take into consideration all available funds, all state guidelines determine a parents income not only on what the parent actually earns, but on the parents earning capacity. See generally L. Morgan, Child Support Guidelines: Interpretation and Application § 2.04[a] at 2-46 (Supp. 2001) (Every child support guideline has a provision that allows the court to consider the earning capacity of a party where that party is voluntarily underemployed or unemployed. Such consideration of earning capacity in the absence of true earnings is termed imputing income).
Child support guidelines generally define income for a self-employed person as follows:
For income from self-employment, rent, royalties, proprietorship of a business, or joint ownership of a partnership or closely held corporation, gross income means gross receipts minus ordinary and necessary expenses required for self-employment or business operation.... Income and expenses from self-employment or operation of a business shall be carefully reviewed to determine an appropriate level of gross income available to the parent to satisfy a child support obligation. In most cases, this amount will differ from a determination of business income for tax purposes[.]
Clearly, then, all income from a closely held corporation is income to the support obligor. That income is defined as gross receipts less ordinary and necessary expenses. Further, income for child support is not necessarily the same as income for taxes. In the case of closely held corporations, subchapter S corporations, and partnerships, do retained earnings that appear as income on a tax return but are not collected by the parent still income for child support?
The overwhelming majority of states that have addressed this issue have applied held that when the parent is a minority shareholder in a closely held or subchapter S corporation, and therefore does not control the decision on distribution of earnings, then the retained earnings of the corporation cannot be attributed to him/her as income. The rationale behind these decisions is that parents should not be allowed to manipulate corporate assets and earnings to shield legitimate income from child support. Anderson v. Anderson, 60 Ark. App. 221, 963 S.W.2d 604 (1998) (allowing a deduction from income for retained earnings of subchapter S corporation would encourage shareholders to favor their own long-term financial interests in their corporations over their childrens need for support by keeping most of shareholder income as retained earnings); Kelley v. Kelley, 656 So. 2d 1343 (Fla. DCA 1995) (parent cannot avoid child support by being under compensated by closely held family business); Riepenhoff v. Riepenhoff, 64 Ohio App. 3d 135, 580 N.E.2d 846 (1990) (retained earnings should not be used as a subterfuge to avoid obligations). See generally L. Morgan, Child Support Guidelines: Interpretation and Application § 2.03[e][i] at 2-52 to 2-54 (Supp. 2001); Annotation, Divorce and Separation: Attributing Undisclosed Income to Parent or Spouse for Purposes of Making Child or Spousal Support Award, 70 A.L.R.4th 173 §§ 4-7 (1989 & Supp. 2002).
If, however, a parent has no control over the distribution of earnings, then obviously the possibility of this kind of manipulation is not present. In that case, the court will not consider the retained earnings as income to the parent. Anderson v. Anderson, 60 Ark. App. 221, 963 S.W.2d 604 (1998) (appellate court affirmed chancellors decision to exclude from income retained earnings where father was 25% owner); McHugh v. McHugh, 702 So. 2d 639 (Fla. 4th DCA 1997) (husband as 10% shareholder did not have control over decision to retain earnings); In re Marriage of Heck, 2000 WL 1724588 (Iowa Ct. App. November 20, 2000) (fathers role as 25.5% minority shareholder does not permit him to determine whether corporate earnings are retained or distributed; it would not be equitable to attribute those earnings to the father in these circumstances); In re Marriage of Waite (Greenlee), 21 Fam. L. Rep. (BNA) 1529 (Mont. Sup. Ct. September 8, 1995) (profits retained by partnership to pay debt would not be considered, where there was no evidence father had choice of use of funds); Fennell v. Fennell, 753 A.2d 866 (Pa. Super. 2000) (fathers proportional share of retained earnings of subchapter S corporation were not income for child support, where father was minority shareholder who could not control whether profits were retained or distributed); Laird v. Laird, ___ N.W.2d ___, 2002 WL 1813377 (S.D. August 7, 2002) (ex-husbands retained earning from bank, of which he was shareholder and director, were considered asset rather than income, since decision of whether to pay dividends from retained earnings was not made exclusively by husband and all of banks retained earnings were not available for distribution by law); Mitts v. Mitts, 39 S.W.3d 142 (Tenn. Ct. App. 2000) (retained earnings of gold and country club in which husband was minority stockholder would not be calculated as income for support, where husband did not have ability to manipulate his reported income as a sole shareholder would, because distribution of corporations income was within control of majority shareholder). See also Lee v. Lee, 2000 WL 1459825 (Va. Ct. App. October 3, 2000) (refusing to create hard rule on retained earnings, instead holding each case would be considered on its facts); Weis v. Weis, 215 Wis. 2d 135, 572 N.W.2d 123 (Ct. App. 1997) (retained earnings would not be considered where father had no control over their distribution).
Further, some cases have held that where there is a legitimate business reason for the retention of the earnings, then the retained earnings will not be considered. Roberts v. Wright, 117 N.M. 294, 871 P.2d 390 (Ct. App. 1994) (mothers corporate earnings retained by company would not be income where they were used for normal operating costs); Taylor v. Taylor, 118 N.C. App. 356, 455 S.E.2d 422 (1995); Fitzgerald v. Sharum, 857 P.2d 92 (Okla. Ct. App. 1993); Labar v. Labar, 557 Pa. 54, 731 A.2d 1252 (1999); Muir v. Muir, 841 P.2d 736 (Utah Ct. App. 1992); Lendman v. Lendman, 157 Wis. 2d 606, 460 N.W.2d 781 (Ct. App. 1990).
Where a party is a majority shareholder and thus has control over the distribution of profits, or where there is simply no business explanation for the retained earnings other than to increase personal assets at the expense of income, then the retained income of a corporation can be considered income. Pannell v. Pannell, 64 Ark. App. 262, 981 S.W.2d 531 (1998) (retained earnings were income because father had 100% control); Merrill v. Merrill, 587 N.E.2d 188 (Ind. Ct. App. 1992) (retained earnings of pharmacy owned 100% by father was income to him); Campbell v. Campbell, 682 So. 2d 312 (La. Ct. App. 1996) (husband was 100% shareholder of construction company); Roth v. Roth, 406 N.W.2d 77 (Minn. Ct. App. 1987) (chiropractor was 100% shareholder); Morgan v. Ackerman, 964 S.W.2d 865 (Mo. Ct. App. 1998) (husband owned 100% of closely held corporation); Boudreau v. Benitz, 827 S.W.2d 732 (Mo. Ct. App. 1992); Kuhn v. Bovier, 268 A.D.2d 806, 701 N.Y.S.2d 748 (3d Dept 2000) (imputation of income to former husband was warranted, where corporation had retained earnings for which there was no explanation); Cauble v. Cauble, 133 N.C. App. 390, 515 S.E.2d 708 (1999) (retained earnings considered, where father held 51% of stock and profits were available); Quamme v. Bellino, 540 N.W.2d 142 (N.D. 1995) (husband was majority shareholder and retained earnings as salary to new wife); Williams v. Williams, 74 Ohio App. 3d 838, 600 N.E.2d 739 (1991) (50% shareholder voluntarily reduced salary to accumulate earnings; retained earnings would be attributed as income); Ochs v. Nelson, 538 N.W.2d 781 (S.D. 1994) (80% shareholder); Sandusky v. Sandusky, 1999 WL 734531 (Tenn. Ct. App. September 22, 1999) (solely owned companys accumulation of retained earnings can be considered when setting support); Bailey v. Bailey, 954 P.2d 962 (Wyo. 1998) (100% owner).
In a minority of decisions, the courts have refused to apply the control/legitimate reinvestment test, and held that retained earnings are income. Hubband v. Hall, 739 So. 2d 498 (Ala. Civ. App. 1999); Martinez v. Martinez, 761 So. 2d 433 (Fla. 3d DCA 2000); In re Perlenfein, 316 Or. 16, 848 P.2d 604 (1993).
The rationale for the majority rule distinguishing between retained earnings that are income for income for tax purposes on the one hand and income for child support purposes on the other hand was explained recently in In re Marriage of Brand, 44 P.3d 321 (Kan. 2002):
Few courts rely solely on personal income tax returns to determine the amount of income available for purposes of calculating support. Taxable income of a Subchapter S corporation which is attributable to a shareholder does not reflect actual income received as a cash distribution.... There is no presumption that an individuals share of a Subchapter S corporations income should be included as income for purposes of calculating child support. Individual inquiry on a case-by-case basis is necessary to ensure that the appropriate amount of income is considered received when determining Domestic Gross Income for the self-employed.
44 P.3d at 328. Consequently, it would be inequitable to attribute to the shareholder income that he did not receive and had no choice of receiving.
While there is general agreement that retained earnings are not income to a minority shareholder, there is little agreement as to who holds the burden of proof on this issue. In one case, the court suggested that when one parent is a minority shareholder or partner, it is the other parents burden to show that the earnings are not retained for a legitimate reason. Bleth v. Bleth, 607 N.W.2d 577 (N.D. 2000). There is, however, law to the contrary, that it is up to the shareholder to show that the earnings were reinvested for a legitimate purpose. Hubbard v. Hall, 739 So. 2d 498 (Ala. Civ. App. 1999); In re Marriage of Stenshoel, 72 Wash. App. 800, 866 P.2d 635 (1993).