The guest author of this article is Erica D. Price, CPA, CVA, CFE, Manager at Paradigm Forensics, LLC. Erica is a Collaborative Financial with Mayland Collaborative Divorce.
Determining an accurate estimate of actual ongoing income is an essential part of any divorce process. Whether the divorce is being handled in the courts through litigation, mediation, or going through the Collaborative Divorce Process, determining each partner’s actual ongoing income should be an expected step in the divorce journey. Actual income is significant because it is used to determine alimony and child support.
In a traditional litigation setting in Maryland, alimony and child support are decided by the Court. The Maryland Code identifies several factors that should be considered when determining an award of alimony, and child support is generally calculated using the formula in Maryland’s Child Support Guidelines. In both instances, the Court has the power to modify the applicable standard in extraordinary circumstances. Alternatively, individuals pursuing separation through the Collaborative Divorce Process are not beholden to standard practice and instead are able to negotiate, with help from their team of professionals, to arrive at a proposal that works for their unique situation.
Here are some items that are typically counted as “income” for the purposes of divorce:
- Wages and Salaries: This includes all wages received, including W-2 wages, tips, bonuses, and commissions. Even though bonuses or commissions may not be guaranteed, if they are consistently paid out in prior years, they should be considered when estimating actual ongoing income.
- 1099 and Self-Employment Income: Any income received in capacity as a 1099 independent contractor (reported on Form 1099-NEC) and any self-employment income earned as sole proprietor of a business. This includes freelance work. It is important to note that this income may be offset by expenses incurred to generate said income. The net amount is typically reported on Schedule C of an individual’s tax return.
- Dividends and Interest Income: Any income, earned from dividends or interest, regardless of whether or not it is taxable, is considered as income for divorce purposes. However, this should be analyzed closely, as this income should be reported by the party who is expected to retain the related asset after separation, even if the asset is in the other party’s name.
- Business Ownership Income: Ownership interests in businesses, whether they are 100% or a minority interest, require special consideration for income determination in divorce. There are generally two ways to assess income from business ownership: net income and distributions. When considering net income as the metric, an expert would be following the precedent set by Lane v. Lane, which is typically appropriate for 100% or majority ownership interests. This method assumes that the owner has control over company operations, including compensation structure and distributions. As a result, the net income plus any personal expenses paid by the business (that were not recorded as distributions) are considered to determine actual income, and distributions from the business are excluded. The other relevant case law is Walker v. Grow. In this case, an expert would start with the distributions received by the party and then any personal expenses paid by the business that were not allocated as distributions would be added back to arrive at actual income. Both methods take into account expenses paid by the Company on behalf of the owner, and both methods require the expert to make sure any such personal expenses are not double counted based on the approach used and how they are recorded in the company’s books. Finally, both methods may also consider an addback (increase in income) for non-cash expenses, typically depreciation and amortization expense.
What about some items that are typically adjusted out of, or are excluded from, the calculation of actual income? Capital gains and losses (which are earned as a result of selling assets) are frequently included in the initial calculation of income, but are then removed as an adjusting item. This is because, often, this income stems from events that are non-recurring. There are of course exceptions. For example, for a day trader who has significant capital gain/loss activity year after year, such activity would be expected to continue into the future. In such an example, the related gain/loss would typically not be adjusted out of actual income. Additionally, capital gains/losses earned from restricted stocks and stock options require special consideration from the financial expert to ensure that their value is not double counted (between the gain or loss realized and the value of the assets themselves).
Regardless of the avenue used to pursue divorce, the determination of income is an important step. This calculation becomes even more significant when there is disparity in income earned by the parties, or if the financial situation of either party is complex (such as owning multiple businesses). Gathering a qualified team, including a knowledgeable attorney and a skilled forensic accountant, will help ensure your case is handled appropriately.
