What Every Entrepreneur Needs to Know About Alimony
Entrepreneurship is difficult; the entrepreneurial life is a mixture of long hours, high risk and financial uncertainty. Often entrepreneurs end up being the worst spouses, even if they don’t mean to be. In order to make a business venture succeed the entrepreneur has to work long hours, spend a lot of time away from home, and may also deplete financial resources in the process.
Obviously this lifestyle can be the recipe for a marriage disaster. Any number of things related to your entrepreneurship can contribute to the dissolution of your marriage. While you are working hard to get the business up and running, your spouse may look elsewhere for companionship. You may begin fighting about money. Your spouse may not want to take on the risk of starting a business and be resentful that you went for it anyway. The possibilities are endless.
Not only is divorce common amongst entrepreneurs, there are unique considerations that entrepreneurs must face that other divorcing couples do not have to contemplate. Custody issues are complex because many entrepreneurs don’t have a significant amount of time to spend with their children. Property division is complicated because it is difficult to place a value on the business. True to form, support issues are also difficult to settle because it is hard to verify an entrepreneur’s income.
Calculating spousal support, or alimony can create quite a headache when a spouse is an entrepreneur. What exactly is any entrepreneur’s income? Some entrepreneurs never actually take a paycheck from the business. In fact, entrepreneurs are often advised to pay themselves just enough to get by, at least until the business begins to turn a profit. Some take a set amount each month, while others take variable amounts depending on how the business is doing. Even some of the most famous entrepreneurs actually have little cash on hand; the wealth is tied up in the company.
Basic Requirements of Alimony
Alimony, or spousal support is money that one spouse pays another spouse after the parties separate. In order for a spouse to be entitled to alimony, he or she must prove that they are the dependent spouse, that the other spouse is the supporting spouse, and that an award of alimony would be equitable considering all relevant factors.
Alimony is very discretionary and varies widely from case to case. Unlike child support, there are no clear guidelines or worksheets to use. The duration of the marriage, the parties’ standard of living, the relative earnings and earning capacities of the spouses and the contribution of one spouse as a homemaker are just a few of the factors outlined in the North Carolina alimony statute. The statute goes on to explain that additionally, “any other factor relating to the economic circumstances of the parties that the court finds to be just and proper” may also be considered.
How to Calculate an Entrepreneur’s Income
It can be quite a challenge to determine an entrepreneur’s income. Some entrepreneurs never actually take a paycheck from the business. In fact, entrepreneurs are often advised to pay themselves just enough to get by, at least until the business begins to turn a profit. Some take a set amount each month, while others take variable amounts depending on how the business is doing. Even some of the most famous entrepreneurs actually have little cash on hand; the wealth is tied up in the company.
Each type of business is different, and brings with it it’s own unique complexities to consider. Calculating income for a local coffee shop owner who has started generating a profit is clearly much different than calculating income for an entrepreneur working on a technology startup that won’t be profitable for years. Consider another type of entrepreneur; one who owns an import/export business whose cash flow varies dramatically based on fluctuations in inventory. As we discuss the various ways to calculate income, keep in mind the nature of the business venture will be a major factor in how income is calculated.
Attorneys will pour through relevant tax forms and financial statements including the balance sheet, income statement, statement of cash flows, and the statement of equity. Each of these documents has financial data that is helpful in untangling an entrepreneur’s true income.
In calculating your income you need to be sure to exclude phantom income, which occurs when income from the business flows to a personal tax return. When this happens, the tax return will reflect a much higher income than the business owner truly pocketed. This exact situation happened to a North Carolina business owner not very long ago. Because of the phantom income, it appeared as though he made a million dollars during the previous year. Based on this income, the court awarded his former spouse $25,000 per month in alimony. The truth is, much of that million dollars was phantom income and it was nearly impossible for him to meet his alimony obligation.
The bottom line is that it is essential to prepare the most detailed cash flow statement possible and also predict what your future cash flow may be. Only then can you have an idea of how much you can afford to pay in spousal support. If you don’t heed this advice, and your alimony payments are more than the amount the free cash flow allows, you may jeopardize the company’s future.
Hire an Expert
Couple the fact that it is difficult to calculate income for an entrepreneur with the gravity of making a mistake in calculating income and you will see why it is a good idea to involve an expert. Your attorney should hire a forensic accountant with experience in both calculating net cash flow and predicting cash flow. This expert should be good at explaining his methods and findings as he will need to not only be able to explain his calculations to you and your attorney, but also potentially the judge.
Your spouse may hire an expert as well, and you may end up with a “battle of the experts” situation. Spouses tend to disagree with each other when it comes to how much money the entrepreneur spouse actually makes. The entrepreneur typically claims he earns less income than the non-entrepreneur spouse will claim he makes.
Avoid Hiding Income
It is easy to hide income and assets when you are a business owner, and many business owners are particularly tempted to do this once divorce proceedings have begun. The less the business is worth, the less the entrepreneur will have to pay his spouse in property division. The less income the entrepreneur makes, the less he will owe in child support and spousal support. It is obvious why an entrepreneur may intentionally hide business related assets and earnings.
In addition to actively hiding income, entrepreneurs also may have unreported income. Cash intensive businesses can generate a significant amount of cash that isn’t reported. Earnings from offshore accounts can also generate unreported income. An entrepreneur might even be tempted to overstate expenses to make it look as though his earnings are less than they actually are.
While you may think this is a great idea, think again. It’s easy to get caught, and the consequences can be severe. If you have attorneys and experts pouring through your financials, chances are some of this hidden income will be found. Sometimes even a simple lifestyle analysis can raise red flags and cause someone to take a second look at your finances.
The consequences of hiding income to lower a support obligation can be more than just a slap on the wrist. Tax fraud is a federal crime with serious consequences. Anyone can report potential fraud to the IRS simply by filling out IRS form 3949-A. If the IRS investigates and discovers fraud you could face massive fines or even jail time. So, while it may seem smart to under-report your income to avoid paying alimony, it most likely is not worth the penalties you would incur should you be reported to the IRS and found guilty of tax fraud.
One of the most important things for an entrepreneur to keep in mind, is that under certain circumstances, alimony can be modified. So, if something happens and your business venture is suddenly not as profitable as it was previously, there is a chance that your alimony obligation could be lessened. There are some requirements that must be met to have the ability to modify the alimony award.
First, alimony must be set forth in a court order in order to be modified. If you agreed to a spousal support amount in a separation agreement, it may not later be altered. As an entrepreneur, you may want to consider obtaining an order on alimony rather than including in a separation agreement so that in the event that the business becomes less profitable, you still have the option to modify it.
Next, a substantial change in circumstances must have occurred since the original order was entered. So you must provide evidence that proves the facts have changed since the original order enough to warrant a substantial change in circumstances. You’ll need to be sure there is a record of the circumstances that existed at the time of the original order, including findings of fact as to the parties’ financial condition and the like so you can show that things have changed.
Alimony payments are taxable to the receiving spouse as any other income or wages would be taxed. On the flip side, alimony payments are deductible for the paying spouse. However, there is a way in which the parties can avoid said tax implications.
If the legal instrument (court order or separation agreement) expressly states that the payments are not taxable/deductible then the payments are in fact neither taxable nor deductible. This exception allows for spouses to opt out of the ordinary tax considerations that attach to alimony payments.
By clearly stating that the payments are not to be included in gross income for tax purposes, and not to be deducted, the payments will not be considered alimony and the tax implications that would otherwise exist no longer apply.
Another important tax implication that can arise in alimony cases is the alimony recapture rule. This rule applies when the alimony payments decrease substantially or end during the first three calendar years.
A substantial decrease is defined in the rule as one of two situations: when the amount paid in the third year plus $15,000 is less than the amount paid in the second year, or when the payments in the second and third years are averaged and this average plus $15,000 is less than the payments in the first year.
If the above defined substantial decrease occurs, the paying spouse must “recapture” any excess alimony over the first and second years. Those payments that were previously deducted will have to be reported and recaptured in the third year post-separation.
On the other hand, the receiving spouse may deduct that portion of the alimony payments previously included and taxed as income. Recapture can be tricky, but if you think it is an issue in your case, feel free to use our recapture calculator.
In sum, be very cautious when it comes to discussing alimony with your former spouse. It is always best to involve an expert who can dig into your company’s finances to see what your true after-tax cash flow is, excluding any phantom income. If you don’t take this seriously, you could end up paying more alimony than you can afford. The silver lining here is that so long as the alimony award is included in a court order, it can be modified if you can show a substantial change in circumstances.