S corporations and child support

Are retained earnings really earned income or not?

All in the Family

Dan Stefani

Dan Stefani is a principal at Katz & Stefani and primarily handles family law matters that require detailed analyses of complex transactions and business valuations. His work on behalf of mainly high net worth clients, as well as spouses of high net worth individuals, involves valuations of closely held corporations, partnerships and other entities, child custody and support issues as well as paternity and domestic violence.

The Illinois Appellate Court, 1st District, on March 13 issued the opinion of In re Marriage of Moorthy, 2015 IL App (1st) 132077. The case involved a post-decree modification of child support requested by the payee ex-spouse.

Well after the parties’ divorce, the payor ex-spouse acquired a 91 percent ownership interest in an S corporation which paid him wages. The entity also reported K-1 income to the payor ex-spouse as his share of the entity’s net income.

The issue was whether, in addition to his W-2 wages, any K-1 income reported as a result of his ownership in the S corporation (but not actually received by him) could be considered as imputed income to him for purposes of recalculating his child-support obligation.

The trial court held that the payor ex-spouse’s share of the retained earnings from his majority owned subchapter S corporation which were not distributed to him should not be imputed to him for purposes of calculating his child-support obligation. The appellate court affirmed.

In a case of first impression, the appellate court looked to Illinois case law regarding the classification of retained earnings in pre-decree cases as marital or nonmarital property where one spouse owns a portion and/or all of a closely held corporation that pays that owner money for his or her work efforts but any additional retained earnings are not distributed.

The appellate court also looked at cases from other jurisdictions that have adjudicated the issue as it relates to payment of child support.

The trial court determined that the following factors were relevant in deciding whether the retained earnings of a closely held corporation constitute income for purposes of calculating a parent’s child-support obligation: Whether the party was the sole shareholder; whether the party was manipulating his or her income and therefore underpaying him or herself; whether the retained earnings were excessive; and whether there was a legitimate business purpose for not distributing the retained earnings.

The trial court found that the retained earnings were necessary to meet the company’s payroll, overhead and other expenses that were required and necessary for the company’s stability and that the payor spouse owed a fiduciary obligation to the 9 percent minority shareholder to act in the best interest of the corporation.

The court further found that the payor spouse had articulated a legitimate business purpose for not distributing the earnings historically and found no evidence that he manipulated his income in order to reduce his child-support obligation based in part on the fact that his W-2 wages were at a consistent level of $50,000 per year in 2007 through 2014.

The payee spouse asserted, in part, that under Section 505 of the Illinois Marriage and Dissolution of Marriage Act (IMDMA), the term “net income” should include the payor’s proportional share of his company’s retained earnings because he had control over whether the earnings were distributed and he identified no business purpose for not distributing the earnings.

The appellate court noted that “net income” may include a value of payments that are taxable under the Internal Revenue Code but that do not qualify as “income” for child-support purposes under IMDMA.

The appellate court’s analysis began with a review of Illinois case law regarding retained earnings and whether they are marital or nonmarital property. The court noted that these cases analyzed whether retained earnings constituted marital property, not whether they are to be considered imputed income for child-support purposes.

The court focused primarily on In re Marriage of Joynt, 375 Ill.App.3d 20, in which the appellate court held that retained earnings of a nonmarital closely held S corporation — in which the husband owned 33 percent of the stock — constituted nonmarital property. The main reason was that the husband held a minority percentage of the shares, and as such, he could not have unilaterally declared a dividend.

The Joynt court also found that the testimony indicated that the retained earnings were used for corporate expenses and that the husband’s compensation was reasonable and fair and that there was no evidence to support that he used the retained earnings to shelter what would otherwise be marital property.

The court then analyzed decisions from foreign jurisdictions regarding the issue of retained earnings and child support. The court here further noted that heightened scrutiny would be appropriate when the obligor has the power to control distributions but that control is not dispositive of whether an S corporation’s retained earnings must be included in an obligor’s income when calculating child support.

The holding of this case leaves questions as to the analysis if the case was pre-decree, because there would be not only the issue of whether the undistributed retained earnings were marital and/or nonmarital property but whether the undistributed retained earnings would also be used to impute income to the payor for child-support purposes.

Courts should be careful to avoid this potential detrimental “double-dip” against the payor spouse if certain retained earnings were found to be not only marital property but also imputed as income to the payor spouse for child-support purposes.