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Income – Why the Tax Return Doesn’t Paint the Whole Picture

6 Oct 2021 4:06 PM | Anonymous

By John O’Grady, CVA, MSA – Eisner Advisory Group LLC, AAML NJ Gold Sponsor

Often times we are told “just look at the tax return” when it comes to determining a party’s joint or individual income.  The reality is that the tax return does not paint the whole picture.  In this blog, I will explain what is presented on the tax return, what else should be considered, and what other documents and information should be obtained in order to determine the party’s true income/cash flow available to them.

What information is presented on the tax return?

Income information that is typically presented on a personal income tax return includes:

  1. Salaries and wages – Form W-2 wages earned by one or more of the parties.

  2. Interest and dividend income – information regarding both taxable and non-taxable (such as on municipal bonds, etc.) interest will be contained on the tax return.  

  3. IRA, pension, or annuity distributions – not all distributions are taxed, however; taxable and non-taxable portion amounts will be presented on the return.

  4. Social security benefits.

  5. Capital gains or losses.

  6. Sales of business assets or ownership in business entities.

  7. Business income or losses reported on Schedule C.

  8. Pass-through income for rental real estate, partnerships, S corporations, trusts, etc. (Schedule E income).

Most of these items are straight-forward and represent true income received by the parties.  However, pass-through income needs to be discussed a bit further. 

What is pass-through income and why is it misleading?

Pass-through income, especially from partnerships, S corporations, trusts, etc., represents an individual’s share of the entity’s income based upon ownership interest.  The term “pass-through” indicates that the taxes are paid by the individual owner(s), not by the entity.  For example, if a party owns 50% of a business that is organized as an S corporation, that party will report 50% of the business’s net income on their individual tax return; the entity itself will not pay any income tax.  This income (or loss) could be misleading in that it doesn’t necessarily mean that the party received that income personally.  Many times, entity income that is reported on a pass-through basis is retained in the entity, and the owners instead receive distributions.  In some situations those cash distributions can be significantly less than the income reported on the party’s Schedule K-1.  Owners are not taxed on distributions, therefore, they are not included in the calculation of taxable income on their individual tax returns.  Distribution totals can be found on the Schedule K-1 that the entity includes with its tax returns and issues to the owner(s).  Therefore, it is important to reconcile the income reported on the K-1 with any distributions received to arrive at the actual cash flow received by the parties.

What else is not included on a tax return?

There are other items that could be additional income available to a party that may not be reported on the party’s tax return.  For example, a business owner may have sold their ownership interest to another individual or a trust, and rather than take a one-time payout for their ownership interest, the business established a note payable to the selling owner.  Many times, when this situation arises, the selling owner may have the business pay expenses directly or receive funds from the business and the business treats these expenses or transfers as pay-down of principal and interest on the note payable to the owner.  This activity would not be reflected on the tax return of the individual and would require review and analysis of the books and records of the business, primarily on any transaction activity in the notes receivable/shareholder loan accounts on the balance sheet.

Additionally, as we see with many closely held businesses, the business pays various perquisites on behalf of the owner(s).  These could include such items as cell phone expenses, automobile insurance, meals and entertainment, travel expenses, etc.  However, there are many instances when the perquisites paid on behalf of the owner(s) include many more items.  Often times, these items are not included in distributions or taxable compensation to the owner(s).  In order to quantify the total amount of perquisites paid, thorough review of the general ledger of the business is required, as well as potentially a review of the bank account and credit card account statements of the business.

Other potential income items that should be evaluated include deferred compensation, stock options, inheritances or gifts, or additional income received from third parties not listed in the categories discussed.  The parties’ personal bank accounts should be reviewed to determine if any other income sources may exist.  

Summary

In summary, when determining the income of the parties in a divorce proceeding, it is critical to look beyond the federal income tax returns as there could be a number of income categories that are not presented on the returns.  At a minimum, information to review to determine available income should include bank statements (personal and business), credit cards statements, business tax returns, and general ledgers of the business.

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