The sad truth is that entrepreneurs are more likely to end up going through a divorce than those who work traditional jobs. Entrepreneurship is risky, requires working long hours, and can plummet a couple into serious debt. Many aspects of being an entrepreneur can lead to the breakdown of a marriage. While the payoff may be huge if your business venture is a success, your marriage may be a casualty lost along the way.
Divorce for entrepreneurs creates considerations that are unique from most other divorces. Custody issues are complex because of the time entrepreneurs spend on the business. 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. Even child support, which is typically easy to determine, is more complicated for entrepreneurs.
Generally, when it comes to family law matters, child support is the easiest issue to settle. There are Child Support Guidelines in North Carolina that mandate how much a person’s child support obligation is based on a standard formula. You enter each parent’s income, child care expenses, health insurance expenses for the child, and extraordinary expenses related to the child into a worksheet and get a number that represents the child support obligation owed. It’s pretty black and white, unless of course it is hard to calculate your income.
Therein lies the problem of calculating child support for 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.
Because entrepreneurs are not your typical w-2 employees with salaries that reflect their true earnings, it can be hard to agree on an income to incorporate into the child support worksheet. Reconciling the guidelines for those with non-verifiable income can create quite a headache. The non-entrepreneur spouse will advocate that the entrepreneur makes more than the entrepreneur will claim he makes so that the amount of child support owed will be higher. This article will discuss various ways to address the complexities related to determining an appropriate child support amount.
Impact of Divorce on the Business
Before we get into how to calculate income and other child support related concerns, it is worth noting that most businesses are not thriving in the year leading up to divorce. Many entrepreneurs will see a significant dip in revenue as they deal with the breakdown of their marriage. This is especially true for business owners with children. The emotional strain of divorce combined with the time spent dealing with attorneys typically does not create the most ideal situation for the entrepreneur. The business can take yet another hit if the entrepreneur has a new love interest, as this just diverts a business owner’s time and energy even more.
As you consider how you plan to calculate your income for child support purposes keep in mind the notion that your business may not have been thriving in the year leading up to your divorce. You may be thinking this is actually a good thing, the lower the income, the lower the child support obligation, right? Don’t be so hasty to take this position, we will discuss why it might not be in your best interest to lowball your income later in this article.
How To Calculate Income
Income is more than a salary; income includes commissions, bonuses, tips, rental income, royalties, interest, in-kind and fringe benefits, lottery winnings and even stock options. So, it is important to think beyond simply the salary that you take from your business venture when it comes to determining income.
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.
The way the business is organized and the accounting method used will also be factors to consider when trying determining income. This matters because tax forms are generally the first place to look when it comes to ascertaining a business owner’s income. A sole proprietorship, corporation, partnership, and LLC each have certain tax forms that will report earnings in different ways. Additionally, whether you have chosen the cash method, the accrual method, or a hybrid method of accounting will also be important to consider while pouring through tax records.
In addition to the relevant tax forms, be prepared to consider the following four financial statements: the balance sheet, income statement, statement of cash flows, and the statement of equity. Each of these also has financial data that is helpful in deciphering an entrepreneur’s true income. Specifically for business owners, the income used to calculate child support should be calculated on actual cash flow rather than income reported on a tax return.
There are several models used to try and come up with a figure to use on the child support worksheet. First, there is the “Average Historic Income” theory. This method would take a look back at the previous year, and see how much the entrepreneur paid himself over the course of the year to find the average monthly amount taken as income. That income would then be the amount used on the child support worksheet. There are pros and cons to this method, the most notable problem with it being that the profitability of any given business could drastically change from one year to the next. Not to mention, as we discussed earlier, most entrepreneurs experience a decline in revenue in the year leading up to divorce.
Another more complex method used to calculate an entrepreneur’s income is to predict future business income. This might require the use of an expert who can dig into the finances of your business venture. Past performance, as well as market trends and your business plan will all be considered in predicting future earnings. Whether angel investors back your startup or if it is funded by the help of venture capitalists will also be something to consider. Even if you get an expert to predict future income, it is clearly speculative and many unforeseen circumstances can lead to the predicted figure to stray far from what the entrepreneur actually earned.
Prepare for Conflict
Be aware that the time and effort you spend trying to pinpoint a figure that reflects your income may be all for naught if your former spouse disagrees with the figure you have come up with. 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.
The grey area associated with an entrepreneur’s income combined with the contentious nature of divorce is the recipe for a fight. No matter how long either party pours over the financial documents it may be necessary to hire a forensic expert to come up with a figure. It is not uncommon in these situations for both parties to hire experts, essentially creating a “battle of the experts.” This sort of contentiousness is usually more prevalent when it comes to valuing the business from a property division standpoint, but it can still happen when there is a dispute over the child support obligation.
Tricks to Lower 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.
Income can ben hidden in the following ways:
- Depreciation and expensing for tax purposes.
- Pass through entity distributions.
- False lease of office space/rental of equipment.
- Loans between owners or close friends and family members
In addition to actively hiding income, entrepreneurs also frequently have unreported income. Cash intensive businesses can generate a significant of cash that isn’t reported. Earnings from offshore accounts can also generate unreported income. Overstating expenses is yet another trick to make it look as though an entrepreneur’s earnings are less than they actually are.
Clearly there are plenty of tricks to make your income appear less than it is. Why not protect yourself by using these tricks so that your child support obligation is less?
First, it’s easy to get caught. Family law attorneys have plenty of experience pouring through documents obtained through discovery and know to look for certain inconsistencies.
Even a simple lifestyle analysis can lead to deeper investigation into your financial paperwork. If you claim you generate a modest income from the business but your mortgage or rent payment is $3,000 a month, that’s an obvious red flag. Or, if your bank statements reflect that you are spending an unreasonable amount of money on dining or leisure, it will cause an attorney to take a deeper look. Outside of a lifestyle analysis, there are many other ways that an attorney can unearth inconsistencies. If the attorney fails to pick up on these discrepancies, a forensic accountant can most certainly find hidden income.
The consequences of hiding income to lower a child 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 lower your child support obligation, 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 final note that an entrepreneur should consider regarding child support is that the amount of time that the child spends with each parent factors into the child support calculation. If your child is primarily in the custody of your former spouse, your child support obligation will be higher than if you are sharing custody equally.