Divorce & Dollars: How Cash Flow Shapes Matrimonial Litigation

Determining an individual’s true historical income is a common task in the valuation, forensic, and litigation support industries. Family law attorneys’ arguments for child support and maintenance are molded by the amount of cash available to the parties. Figures reported on tax returns can serve as a base, but deeper analysis is required to determine cash flow accurately. Various tax benefits and rules can misconstrue a divorcee’s income, and proper due diligence must be conducted to separate tax-based income from true cash flow.

Cash flow can be loosely defined as cash that is available to spend. An individual’s tax-based income may differ from their actual cash flow in a few ways.

1. Wages

An individual’s wages, presented on line 1 of their Form 1040, are not wholly exhaustive of cash paid to them by their place of employment. To be more accurate, it is imperative to include any retirement plan contributions or deferrals when determining an individual’s cash flow. Many retirement plans offered by employers, such as 401(k)s and IRAs, withdraw pre-tax dollars, subtracted from wages, to fund them. This tax-deferred benefit of investing in retirement accounts is one of the reasons why cash flow trumps tax-based income. Dollars that go to fund retirement accounts, while not reflected on one’s tax return as income, are still wages earned through employment. Box 5 of an employee’s W-2 form illustrates the base wage used for Medicare tax and reflects one’s true cash flow from their employer by way of wages.

2. Pass-Through Entities

Pass-through entities, consisting of S-corporations, limited liability corporations, and partnerships, pass their income on directly to the owners, in which the company’s net income is paid on an individual level. Many small business owners find this attractive as they are not subject to double taxation at both the corporate tax level and on personal dividends. The tax basis for a company’s income is reflected on the Schedule E of an individual’s personal tax return. However, a company’s net income is not necessarily cash flow to the owner but rather their share of the company’s profits. This cash can be kept within the company for any number of business-related reasons, such as capital expenditures. Further investigation is required through the owner’s Schedule K-1 to determine how much cash is actually being paid from the company to the owner.

Distributions, shown in box 16D on a Schedule K-1, are the amount of money going to an owner out of the business, excluding their wages. Shareholder distributions represent the total cash benefit an individual receives from the business. They can comprise personal expenses run through the business, cash withdrawals, or taxes remitted to the taxing bodies on the shareholder’s behalf. While further investigation may be required to confirm that personal expenses are properly reported, the distribution figure seen in box D offers a holistic and accurate approach to income determination as this amount is not included in the taxable income figure shown on the personal tax return.

It is important to note that while a personal tax return separates interest, dividends, and Schedule E-business income for tax purposes, the distribution total reflected on a Schedule K-1’s box D should be comprehensive. Forensic analysis is required to confirm that distributions are properly reported, and sometimes adjustments to distributions are needed to arrive at an accurate cash flow figure. This often includes any personal expenses reported as business expenses, ranging from personal car payments to family vacations. Financial experts must be diligent to ensure that their cash flow conclusion does not misrepresent the cash flow benefit from the business to the individual. Because box 16D’s total can include interest income or dividends, it is easy to overestimate the individual’s cash flow benefit by double counting and adding these totals again.

Attorneys rely on cash flow over tax basis numbers because they better reflect the money that is actually available to an individual. The tax basis on a personal tax return seldom reflects the cash that a party can spend, and shareholder distributions are a pivotal element of the cash flow calculation. While conducting proper forensic analysis to verify the authenticity of a business owner’s reported distributions can be time-consuming, ensuring an accurate cash flow conclusion is vital, a necessity in matrimonial litigation.