Personal tax returns contain a wealth of information that family lawyers can use to identify assets and income, which can help drive the discovery/information gathering process. Here are the key areas of the personal tax return that family lawyers should be most concerned with.
By Jason H. Soman, Forensic Accountant and Business Valuator
For a family lawyer, the ability to quickly identify key financial issues early on in a divorce matter can make or break a case. For high net worth couples, these issues can be complex, especially if either of the parties engage in “divorce planning.” As a forensic accountant that specializes in divorce matters, the personal tax returns are one of the first documents I review at the onset of a case.
Reviewing Personal Tax Returns: Areas of Interest for Family Lawyers
Income: W-2s, Deferred Compensation, Business Income
Determining the parties’ income is usually one of the most important financial issues in a divorce matter. If the parties are salaried employees there is typically a schedule that shows their incomes reported on their W-2s. W-2 wages are often understated due to 401k contributions, health insurance premiums, etc. and thus, requests for actual W-2s and pay-stubs are imperative to understand actual compensation.
For individuals that receive deferred compensation, such as stock grants, stock options, performance units, phantom stock, restricted stock, etc., income may be reported when funds are received rather than when the compensation is earned. Therefore, a review of compensation plan documents, award agreements and other supporting documentation will be required to determine what, if any, deferred compensation could be considered i) a marital asset to be divided, or ii) income for support purposes.
For business owners that report business income on Schedules C and E, a detailed review of additional financial information will be required to determine the parties’ true income and available cash flow, as well as the value of any underlying business assets. Income reported on the tax return may not reflect cash received by a spouse and conversely, cash received by a spouse may also not be considered income for tax purposes.
Schedule A – Itemized Deductions
Itemized deductions reduce taxable income. Married taxpayers will choose to itemize if their deductions exceed the standard deduction ($24,400 in 2019). If the parties own their residence, real estate taxes and mortgage interest are typically reported as an itemized deduction. Due to limitations on the amount that can be deducted, mortgage interest and property taxes may not reflect the full cost to the parties due to a $10,000 combined cap on state and local income, sales, and property taxes, and a limitation to deductible mortgage interest which is currently limited to a $750,000 mortgage. Schedule A may also include information on medical expenses, unreimbursed job expenses, and charitable contributions.
In my role as a forensic accountant, if I become aware of any loans reported in Schedule A, I make requests for loan documents, including any appraisals, the initial application and any documents that were used to justify the financial status of the parties at the time of loan issuance. This is requested to provide an alternate picture of the parties’ finances when they were likely motivated to paint an optimistic picture for a prospective lender. Unsurprisingly, a titled spouse will often reverse course on the strength of their financial situation during a divorce action and representations previously made on a credit application can provide evidence to the contrary.
Schedule B – Interest and Dividend Income
Schedule B reports interest and dividends. Oftentimes, personal tax returns will provide specific account numbers that can be used to identify assets owned by the parties. In determining the parties’ incomes, it is important to note that interest and dividends received from pass-through entities (S-corporations, LLCs, and partnerships) do not reflect cash received; rather, it reflects interest income received by those entities, whose income is in turn “passed through” to the partners/shareholders of that entity.
Schedule C – Profit & Loss from Business
Schedule C will report profit and loss from a sole proprietorship or a single-member LLC. However, Schedule C will not give all the information required to assess the financial position of these companies since this schedule does not include a balance sheet that shows an entity’s assets and liabilities. In most instances, it will be necessary to request balance sheets of the sole proprietorship or single member LLC that correspond to Schedule C businesses reported in the personal tax returns.
Schedule D – Capital Gains/Losses
Schedule D reports gains on the sales of investments including real estate, stocks, bonds, artwork, or other property considered to be capital assets. Assets held for more than a year are taxed at more favorable rates. The tax is typically applied to the selling price less the cost of the investment (known as “tax basis”).
When I see larger than usual capital gains reported on a tax return, I want to understand what happened to the proceeds (e.g., were the proceeds reinvested or distributed?). This is especially important during the pendency of a divorce action where assets that existed at the commencement of an action may have realized gains/losses to the parties and/or could have been transmuted into the form of other assets. It is also important to consider any automatic orders in place at the time of the transaction.
Capital losses are limited to $3,000 in any given year and it is common to see this dollar amount reported on a tax return. Losses that exceed $3,000 can be carried forward to be applied in later years. This is important because a capital loss carryforward can have value to the parties in the form of future tax savings.
Schedule E – Supplemental Income and Loss
Schedule E is an important schedule as it relates to couples that own rental real estate, royalties, or interests in closely held or pass-through businesses. While Schedule E is divided into five parts, Parts I and II report the most common sources of income seen in divorce matters.
Schedule E – Part I:
This section relates to rental real estate and royalties which are reported in a similar manner as Schedule C, discussed above. Like with businesses reported in Schedule C, I will typically request a balance sheets or other supporting documents for any properties contained in Part I of Schedule E since assets and liabilities are not reported here. In addition, it is important to ensure that appraisals are done for all real properties as well as any other income producing property. Furthermore, if there are any royalties, additional requests to understand the amount and duration of such royalty payments will likely be needed.
Schedule E – Part II:
Part II relates to income from pass-through entities. It is important to ensure that all pass-through entities are disclosed during the action. Reviewing Part II of Schedule E can enable the family law attorney to identify closely held business interests owned by the parties.
The tax preparer prepares this section of the return using Schedule K-1, which is a report of a partner’s/shareholder’s proportionate share of the pass-through entities’ income, which is reported on the partner/shareholder’s tax return. The K-1 also reports the amount of distributions received by a partner/shareholder from each entity on an annual basis.
Similar to pass-through interest and dividends reported on Schedule B, it is important to note that the amounts reported as pass-through income in Part II of Schedule E will not necessarily reflect cash received from investments in pass-through businesses, and rather reflects profits and losses allocated to them individually for tax purposes.
Therefore, in almost all instances, I will request the K-1s used to prepare the tax returns as these are not typically attached here and contain relevant information not provided in Schedule E. The actual K-1s will provide information such as the value of the partner’s/shareholder’s capital/equity, distributions received, and other pertinent information. For each pass-through interest contained in this section, I will also request additional information including business tax returns, financial statements, agreements, as well as other relevant documentation.
Page 2 – Refund Section
Each tax year, taxpayers can defer receiving a tax refund and elect to apply these overpayments to future taxes. Oftentimes, a titled spouse may elect to overpay his/her tax estimates and apply it to future taxes, with the hope that once the divorce is over, they can elect to have this “tax asset” refunded to them or applied to post-marital earnings. On the Federal form 1040, you can see this on Lines 20 and 21 for tax year 2019. There is a similar breakdown on state and local tax returns.
Reviewing Personal Tax Returns: Summary
While personal tax returns report a myriad of detailed information, a family law attorney can focus on certain key sections of a return to assist their clients. Each case is unique, and there is no “one size fits all” approach to reviewing this information. However, understanding the potential scope of financial issues early on can provide an advantage as it relates to discovery and information gathering and may uncover concealed assets and income.
While the personal tax returns can provide a preliminary view into the parties’ income, assets, and liabilities, family law attorneys must be cognizant of the fact that additional supporting information will be required to determine the value of the parties’ assets and liabilities and available cash flow for purposes of determining spousal support.
 This amount is $1 million for mortgages borrowed between October 13, 1987-December 16, 2017 and unlimited for mortgages taken out before October 13, 1987.
Jason H. Soman, CPA/ABV, ASA, CFE is a forensic accountant and business valuator with MPI Business Valuation & Advisory, headquartered in Lawrenceville, New Jersey. Mr. Soman specializes in advising legal counsel and clients on issues relating to business valuation, spousal support, and other financial forensic issues in divorce matters.
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