Small Business and Divorce: What You Don’t Know Can Cost You

If you own a small business, before you divorce, you need to know how your income would likely be determined.  Here, you’ll learn how and why and how you can save on legal fees in the process.

Alimony and child support are often issues to be resolved in divorce.  For instance, a business owner spouse might have a potential legal obligation to pay alimony to the other spouse. 

Also, both spouses have a legal obligation to support their children until each child is “emancipated,” which may extend beyond the age of 18 where, for instance, the children attend college full-time.

How business income is determined

The first step in determining how much alimony and child support would be appropriate would be generally to determine the amount of income that each spouse earns now and is capable of earning in the future.

This can be tricky where one or both spouses own a small business.  What many business owners don’t realize is that the way income is determined by the IRS is very different from that determined for calculating alimony and child support in divorce.

Therefore, the attorneys for each spouse would generally defer to a forensic accountant to calculate the business owner’s income.

Significantly, income reported on a personal or business income tax return is not reflective of the funds available to pay living expenses of the family.

The forensic accountant therefore generally adjusts the business owner’s tax returns and financial statements to take into account the following:

  1. Nonrecurring items such as sales of fixed assets, lawsuit settlements, and casualty losses;
  2. Non-operating items such as depreciation and related expenses for non-business real estate or personal property and investment income or expenses;
  3. Discretionary expenses such as personal automobiles, insurance policies, travel, and other personal “perks”;
  4. Investment tax credits;
  5. Home offices;
  6. Entertainment;
  7. Related party transactions that do not reflect market rates, such as leasing space from a building owned by the shareholder at above-market rates; and
  8. Compensation that does not reflect market rates.

The value of a business is often based on the earnings or the future earnings that the business is expected to produce.   The earnings stream or future benefits are converted to a present value by either capitalizing the current benefits using an appropriate capitalization rate or by discounting the future benefits earning stream using an appropriate discount rate. 

The capitalization of earnings method derives the company’s value by looking at a single period of normalized earnings stream. The discounted future earnings method is derived by looking at the company’s normalized earnings stream to be received over a number of years in the future.

Therefore, the starting point for a “cash-flow analysis” is generally the salary the business owner receives from the company, as well as distributions and/or loans the owner is taking. 

Also, there should be an analysis of the entity’s general ledgers to determine what perquisites may exist that should be included in the business owner’s cash flow. Any payment of items that are for the personal benefit of the business owner or the owner’s family is considered cash flow to him or her, including automobile expenses, travel and entertainment, mortgage or other personal obligation payments.

Cash flow analysis is therefore critical to an accurate valuation of a business, particularly with a closely-held business where there are many ways for the business owner to impact the reported income or cash flow. 

How to Significantly Minimize Fees for Attorneys and Forensic Accountant

Here are 3 things you, as the business owner spouse, can do to save money on attorney fees and accountant fees:

1.   Engage an accountant who is also a trained mediator. 

Much of the attorney fees can be avoided by simply allocating your financial resources to the professional who can get you the most bang for your buck.  Here, the forensic accountant can perform two vital roles, that of forensic accountant to calculate income and to facilitate a settlement.  I have also engaged the same forensic accountant to do cash flow analyses for both spouses to help us come up with viable solutions for monthly alimony payments; buyout of alimony obligation; and child support amounts.  These solutions take into account significant tax benefits to both spouses that they would not have otherwise known about.

2.   Ask the accountant to prepare a calculation engagement. 

Often, attorneys will engage an accountant to do a full blown forensic investigation and report which generally costs tens of thousands of dollars and can be cost-prohibitive, particularly since such reports are typically prepared in preparation for a trial.

When the spouses are committed to staying out of court, however, a calculation engagement is generally far less expensive in that it is prepared and used for settlement purposes only.

3.   Forego the use of a forensic accountant and “back into” an income figure for you that you can both agree upon.

This might be having the non-business owner spouse work with a financial professional to help calculate the expenses likely to be necessary after the divorce and how the expenses can best be made taking account future likely income while avoiding or minimizing any tax consequences.

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