Family Practice
March 2001 Newsletter for the TBA Family Law Section
In this issue
From the Chair
Make Life Easier for Yourself by Dealing with Client Expectations Up Front
Appreciation of Separate Assets: What is Marital, What is Not?
From the Chair
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Welcome to 2001! It’s difficult for me to accept that two months of this year have come and gone as this is written. As I write, an on-line CLE course on the Parenting Plan legislation is being created and preliminary planning is underway for the Family Law Section-sponsored CLE programs for Fall 2001 and Spring 2002.
The Section is also planning a general meeting to be held in conjunction with the TBA Annual Convention in Nashville in June. Please plan to attend and get involved with your Section. According to the TBA staff, there are more than 200 members in the Family Law Section. The Section does not just benefit its members, however. Each year attorneys who are not Section members benefit from CLE programs and activities of the Section.
At the Section’s January meeting held in connection with the TBA Mid-Winter meeting in Nashville, much of the discussion centered on how the Section can best serve its members and the bar in general. I have in my past columns solicited input from members as to programming and services that the Section could provide. While it’s tempting to take the lack of response as an indicator that the Section is successfully meeting its members’ needs, that conclusion does not necessarily follow. The Section’s membership is quite diverse.
Consequently, its members have diverse needs that the Section is well placed to meet. However, without input, the Section leadership, acting as a “Benevolent Dictator,” will continue to sponsor CLE programs and services that appear to us to be timely and useful. Put us to work, or even better, get involved yourself. I, along with the other officers and the representatives from each grand division, are waiting to hear from you. v
Greg McMillan, Chair, Knoxville, Sheppeard & Swanson PLC; graduated from the University of Tennessee College of Law in 1992; member of the Knoxville, Tennessee, and American Bar Associations Family Law Sections.
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Make Life Easier for Yourself by Dealing with Client Expectations Up Front
by Shelbourne Ferguson Jr., Attorney, Kingsport
hat we all want to ultimately achieve is CUSTOMER SATISFACTION. I know that is a marketing word. Some of you may think that marketing is at worst, unethical, and at best, a foreign language. Whatever we call it, we know that it is better that a client walk out of our office satisfied than unsatisfied. The referrals of satisfied clients are the major source of our future business. Unsatisfied clients tend to end up with the disciplinary counsel or complaining to all their friends and family in our community. Several years ago I discovered a formula for determining client satisfaction. This formula demonstrates just how the factors that affect client satisfaction interrelate. The formula goes like this: CLIENT SATISFACTION = LEVEL OF SERVICE - THE CLIENT’S EXPECTATIONS.
Let me give you an example of how the formula works away from the law office. I was looking for a new car a few years back. My brother-in-law owned a Lexus: “The greatest car I ever owned,” he said. I had checked all the consumer ratings and had confirmed in my mind that, for the money, there was no better car on the road. I went to the local dealer for a test drive. My expectations matched my excitement of buying a new car. I turned the key and … I could hear the engine. The salesman and I pulled onto the road and I turned on the air conditioner which blew a steady stream into my face drying out my contacts. I got up to speed and was passed by an 18-wheeler. The wind of the truck caused a slight sway in the Lexus. I could hear the truck driver shifting into top gear. The radio worked fine, but it wasn’t quite concert-hall-quality.
I was disappointed. My expectations had been so high that the Lexus couldn’t live up to what I had in my mind should be the best car in the world for the money. Attorneys can affect client satisfaction in three ways. First, we can provide a superior level of service or an ordinary one. Second, we can “promise” an unrealistic outcome or a sound one. Third, we can simply not even try to find out what the client’s expectations are or we can deal with their expectations.
I am not going to discuss the first issue. I assume that all of you provide a superior level of service. The second issue is a “no-brainer.” If you haven’t learned not to make wild promises about outcomes, you will eventually find out the consequences in a very painful way — either before the Bar or in a malpractice action. I want to suggest that you spend more time in your initial conference with clients dealing with the expectations they have carried in with them when they come to see you. While the following discussion areas are not exhaustive, you should at least cover these four topics in your first client conference: the legal process; the time line; the possible outcomes; and the costs involved.
My initial conference with a potential client takes between an hour and ninety minutes. I know that’s a long time, but it is ultimately worth it. I explain how one gets a divorce in Tennessee. Whether this is the first or fourth divorce, I’ve found that even “experienced” clients don’t understand the legal process. For one thing, a divorce is not an experience they try to remember. In addition, as you know, this business changes frequently.
I pay particular attention to explain how long the legal process takes. So often, the uninitiated thinks that “I file today, I’m divorced next week.” I explain the possibility of several hearings, mediation, discovery and conferences and months to wait for the final hearing. As you know, most clients want to know whether there will be spousal support; how much child support will be paid; who will be the primary parent; what kind of visitation will be established; how the property will be divided; and who will pay the debts. Generally, we all know that we can’t be very specific until we have the benefit of discovery and financial affidavits. Don’t take the chance of predicting outcomes for them. You are better off explaining how thorough you’ll be before you can advise them.
Lastly, I cover the anticipated costs. We discuss retainer. I explain the billing process and my expectations of payment. At the end of the conference I give every potential client a booklet I have written titled What You Need to Know About Divorce. It serves several purposes. It spells out in greater detail what I have covered in the initial client conference. I encourage the client to read it later that day and “anytime you have a question.” Another purpose for the booklet is to protect me from malpractice if a client claims I told them something wrong. The booklet confirms what I tell them. Lastly, it becomes a marketing piece. Clients will often give the booklet to friends who are contemplating divorce. I suddenly become “the expert” because I’ve written a booklet on the subject.
Let me tell you one way I have personally benefited from this approach by specifically dealing with the client’s expectations in advance. I get virtually no calls at home or on my cell phone! No, I don’t have an unlisted number. In fact, at the close of the initial conference, I take my business card, turn it over, and write my home phone number down for them. I then hand the card to them and say, “If you have an emergency, don’t hesitate to call me at home.” The message is clear — don’t call unless there is an emergency. Because I have dealt with their expectations up front, they tend to not call. Because I have emphasized “the emergency” aspect of calling me at home, they tend to not call. Because they have the booklet they can review, they tend to not call me at home to answer some questions their third cousin by marriage has brought up to them. They can find the answers for themselves. Because my hourly rate is sufficiently high and they have been told it applies to phone calls, they tend to not call to chat.
We all want satisfied clients. Life is so much sweeter with satisfied clients. One simple but effective way to assure satisfaction in most cases is to follow the formula: Client Satisfaction = The Level of Service - The Client’s Expectations. Deal with their expectations up front.
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Appreciation of Separate Assets: What is Marital, What is Not?
by J. Steven Anderson, Attorney at Law, Memphis
Any attorneys and judges seem to feel that if anything of value accrues during a marriage it is marital property and should be divided at the time of divorce in an equitable (often equal) manner. Issues with regard to division of property are not always so black and white. Gray areas creep into our case load on a regular basis. Classification and distribution of the increase in value of Separate Property can be particularly gray. As family law attorneys we must look very closely at the statutes and case law in order to find “toe holds” that give us an opportunity to present the facts of a case in a manner most beneficial to our clients.
The first and most obvious place to look is to the statute itself. Tenn. Code Ann. Section 36-4-121(b)(1)(A)(1999) states:
(1)(A) “Marital property” means all real and personal property, both tangible and intangible, acquired by either or both spouses during the course of the marriage up to the date of the final divorce hearing and owned by either or both spouses as of the date of filing of a complaint for divorce, except in the case of fraudulent conveyance in anticipation of filing, and including any property to which a right was acquired up to the date of the final divorce hearing, and valued as of a date as near as reasonably possible to the final divorce hearing date.
(B) “Marital property” includes income from, and any increase in value during the marriage of, property determined to be separate property in accordance with subdivision (b)(2) if each party substantially contributed to its preservation and appreciation and the value of vested pension, retirement or other fringe benefit rights accrued during the period of the marriage.
Some lawyers and judges seem to mentally edit the definition so that it reads “all property acquired during the course of the marriage will be deemed marital property, including any income from, and any increase in value during the marriage of separate property, if each party substantially contributed to its preservation and appreciation.” Because the definition of substantial contribution is so broad, it seems that many lawyers and some judges presume its existence.
Contrast the definition of Separate Property1 with that of Marital Property. Whereas the language used to define marital property is inclusive and expansive, the definition of separate property is short and limited.
After a determination that grounds exist, and perhaps a determination of children issues, the courts must determine which of the identified assets of the marriage are separate and which are marital. There is a presumption that marital assets are owned equally.2 The court will divide them in an equitable (not necessarily equal) manner. The court must next look to Separate Property in order to determine whether any part of it should be deemed marital. In order to make a claim of marital interest against your client’s separate property your adversary must: (1) have asked that Marital Property be divided; (2) prove substantial contribution to the preservation of the asset; (3) prove substantial contribution to the appreciation of the separate asset; (4) prove the value of the separate asset at the time of the marriage, gift or inheritance; and (5) prove an increase in the value of the separate asset during the marriage. It is imperative that you have looked closely at these factors in order to determine whether or not the property can defend against a claim of marital interest or, at the very least, if the division of a marital interest can be weighted in favor of your client.
Unless a division of marital property is specifically prayed for, the court has no jurisdiction to make such a division.3 Most lawyers won’t miss such a basic prayer for relief, but we should all be aware that the request should be specifically made.
Substantial contribution to the preservation and appreciation of the property by the non-owner spouse is required. Note the “and”; both the factors are required.4 Such contribution can be indirect, allowing the homemaker, etc., an interest in business or other property in which they have no direct involvement.5 However, you should remember that a party relying upon this form of indirect contribution must have fulfilled their role if they are to take equal shares. Failure to fulfill the role completely may be a basis for overcoming the presumption of equality of interest in the marital portion of a Separate Asset. Periods of separation during the marriage have been cited as a basis to decrease the interest of the non-owner spouse.6 Laziness or distraction by non-family interests (e.g. volunteer work, self-improvement) may also be elements showing that division of the marital portion of Separate Property should be weighted in favor of the owner spouse.
Increase in the value of Separate Property resulting from outside market forces, development of adjacent real estate, construction of highways, etc., which have nothing to do with contribution of either party has been held not to be a basis for establishing a marital portion of separate property.7 On the other hand, if contribution by the non-owner spouse assisted in the appreciation of the property, the court may choose to simply divide the increase equally, even if the contribution was not responsible for the increase in value.8
A non-owner spouse must show an increase in the value of the separate asset in order to claim that a marital portion exists. In order to do this it is necessary to show the value of the asset at the time of the marriage or, if Separate Property is acquired after the marriage, the value at the time of acquisition. It is not enough simply to show the value at the time of the divorce. There is no presumption that the value of property increases over time. In order to provide sufficient proof for the trial court to ascertain the amount of the increase, credible testimony must be offered to show the value of the property in question at both times.9
Take care to remember the last few words of subsection (b)(1)(C) regarding “other factors” the court may consider and which have set out in subsection (c). Most importantly for the limited scope of this article, are the “duration of marriage” a factor10 and the requirement that homemaker and wage earner be given the same weight “if each party has fulfilled its role.”11 If a marriage is of short duration the “significance in value of a spouse’s non-monetary contribution is diminished and claims by one spouse to another spouse’s Separate Property are minimal at best.”12 The Batson court goes on to say that the property should be divided in such a manner as to place the couple “in the same position they would have been in had the marriage never taken place.”13 These sections may be a basis for overcoming the presumption of the accrual of marital interest or, at least, for rebuttal of the presumption of equality.
Pay careful attention to the category of Separate Property created by gifts to the owner spouse. Even if the gift was between the parties, the increase in value may be marital property subject to division. In the Denton14 case, when a husband transferred all of his interest in jointly owned real estate to his wife, the court found donative intent and therefore deemed the property to be Separate Property of wife.15 Even so, the increase in value of that Separate Property after the gift was delivered was Marital Property in which husband was given an interest.
This brief treatise is intended to be more of a warning than an exhaustive instruction on presenting and defending against claims of marital interest in separate assets. Protect your client, and yourself, by carefully going over the history of each valuable asset. Don’t let the term such as “gift” and “inheritance” hinder you from a careful analysis in order to determine whether your client may have an interest in it or a defense to the future ex-spouse’s claim. Remember, the presumption of equality of marital property can be rebutted. Also, just because there has been an appreciation in value of Separate Property during the term of a marriage does not mean such increase should be deemed a marital asset. Make certain that you prove all of the necessary elements if you are the proponent of a marital property theory and be on the lookout for any missed or assumed elements if you are attacking the theory. Your client, and your malpractice carrier, will appreciate your efforts. v
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1. Tenn. Code Ann. 36-4-121(b)(2).
2. See Salisbury v. Salisbury, 657 S.W.2d 761 (Tenn. Ct. App. 1983).
3. See Spence v. Allstate Insurance Company, 833 S.W.2d 586 (Tenn. 1994) at 593.
4. Tenn. Code Ann. 36-4-121(b)(1)(B).
5. Id. at (c)(5).
6. See Koch v. Koch, 874 S.W.2d 571 (Tenn. Ct. App. 1993) at 578.
7. See Harrison v. Harrison, 912 S.W.2d 124 (Tenn. 1995) at 127.
8. See Denton v. Denton, 33 S.W.3rd 229.
9. See Garfinkle v. Garfinkle, 945 S.W.2d 744 (Tenn. Ct. App. 1996) at 747.
10. Tenn. Code Ann. 36-4-121(c)(1).
11. Id. at (5).
12. See Batson v. Batson, 769 S.W.2d 849 (Tenn. App. 1988) at 859.
13. Id. at 859.
14. Denton, Id. at 229.
15. Id. at 229.
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Client’s Introduction to Tennessee’s New Parenting Plan Law
by R. Miles Mason Sr., Attorney, Memphis
As of Jan. 1 the concept of “custody” disappeared from most of Tennessee’s law books. This was a direct result of our new “parenting plan” legislation. As understanding of this law evolves, every judge and family law attorney across the state will, for years to come, struggle with its interpretation. To many clients’ dissatisfaction, the exact answer to a particular question may not exist until a judge rules on the issue. Even then, the judge’s decision has no precedential effect unless the Court of Appeals affirms it. This article is designed to provide a basic introduction to the new law and, thus, will not address everything you need to know. Your lawyer will need to answer your remaining questions, at least as far as they can be answered at this point.
Generally, the new law requires, in order for the parties to receive a divorce, court approval of a permanent parenting plan that complies with certain strict statutory requirements. For those divorces that have become final prior to the enactment of the parenting plan law, any change with respect to the children must comply with the new law. Statutory requirements for the permanent parenting plan include listing out in detail the responsibilities of each parent with respect to decision-making; to where the children will sleep during weekdays, weekends, and holidays; to educational decisions; to financial support; to the procedure by which the parents will handle disagreements (most parties will choose mandatory mediation); and to any other important child development issues. Also, the law requires that the plan list all rights possessed by the parents as enacted by the Legislature, which include the right to telephone access with the children and unfettered rights to medical and school records. The parenting plan form is very detailed and will require a sincere effort by both parents for the agreement to be reached. This law, in effect, will require parents to act like adults. Few exceptions exist, but important exceptions apply in those situations involving domestic violence.
Creating this permanent parenting plan can be procedurally challenging. If there is not immediate agreement between the parties, mandatory mediation is an extra step that a party can request or a court can impose. For those parents seeking divorce who can get along, this should not pose a serious problem, only a few extra headaches. For those parents who cannot agree and do not get along, a serious investment of time and resources will be needed. In theory, this investment should pay dividends in the long run, reducing the need and expense of returning to the court system when conflicts arise.
As a beginning point, there are new terms to learn. “Primary residential parent” takes the place of “sole custodian.” “Residential time” replaces “visitation.” Taking the old words out of our vocabulary will be challenging, especially since the new terms do not mean exactly the same as the old. Final decision-making authority, a.k.a. control, as a concept still exists. Final decision-making authority will most likely be possessed by the “primary residential parent.” For day-to-day decision-making, the parent with whom the children are residing at that time will have the say-so. For major decisions, however, there will be an opportunity to divide important parental responsibility between the parents. The new law created a parenting plan form which, by design, can allow for the splitting of decision-making authority by subject matter between the parents on such important issues as education, health care, extra-curricular activities, and religious training. Depending upon the particular parent’s perspective, the permanent parenting plan will either help the parties avoid conflict or create conflict where it did not exist before.
According to the new law, shortly after filing for divorce, both parents must attend a parenting education seminar lasting at least four (4) hours. The only exception to this requirement may be those cases in which a parenting plan has already been agreed upon. Even in cases of complete agreement, some judges might require everyone to attend the classes, regardless of individual situations. In some cases where sincere disagreement appears inevitable, the parties may first be required to seek court approval of a temporary parenting plan. Temporary parenting plans require almost the same amount of detail as permanent parenting plans but are not designed to last forever.
In the event no permanent parenting plan is agreed upon, the first stop will most likely be mandatory mediation. Although there are other forms of alternative dispute resolution allowed, mediation will be the most common form. If the alternative dispute resolution process fails, the parents will head towards trial. Proposed permanent parenting plans must be filed and served no less than forty-five (45) days prior to the trial date. In the event one parent fails to file a proposed parenting plan, that parent runs the risk of having the filing parent’s plan approved by default. Each proposed parenting plan must include an attached statement of income and expenses and be signed under oath that the plan was proposed in good faith and in the best interest of the child.
One bit of good news is that this new law has been tested in some parts of the state. The report from those courts is that a vast majority of the resulting parenting plans have looked very similar to those Marital Dissolution Agreements we have seen in the past. Other than the imposed mandatory alternative dispute resolution requirement, the only major trend has been an increase in co-parenting arrangements that provide for almost equal residential time with the children.
The new parenting plan law has not changed child support. Prior to the new law, the parent with whom children resided more often received support according to the Guidelines, unless the other parent had more than “standard visitation.” On average, if a child resided with a parent more than three (3) nights out of every fourteen (14), that parent could argue in favor of a reduction from the Child Support guidelines. The parenting plan law, so far, has not changed this situation.
Strategically, those parties who are not represented by an attorney can be at a serious disadvantage. Relying upon the statements of an opposing spouse who is represented can be damaging, especially if the statements are not completely candid. As before the new law, the first few decisions following separation or filing the divorce are very, very important. Under the new parenting plan law, waiting to take action or seek advice can be a very bad thing.
Without a doubt, the new parenting law can create opportunities for parents to put aside differences and address the actual best interests of the children. While the new law does create an additional fat layer of bureaucracy for every divorcing parent, serious detriment resulting from this change in the law will come only to the uninformed parent or those parents who would have cooperated anyway. The public demanded a new law be created to revolutionize the litigation nightmare that custody fights created. Right or wrong, the new parenting plan law is here.
Client’s Introduction to Tennessee’s New Parenting Plan Law is copyrighted by Miles Mason Sr., and Crone & Mason, PLC. E-mail Miles Mason Sr. at mmason@cronemason.com for more information if you would like to reprint this article for your clients with permission and attribution.
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Forensic Accounting: Performing Autopsies on Paper
by Robert Vance, CPA, CVA, CFP
erforming an autopsy on paper may not seem as exciting as watching Quincy, M.D. reconstruct a crime on television, but forensic accountants can sometimes work magic on figures in a divorce or other lawsuit. The CPA can verify the existence of hidden, deferred or transferred income, validate claims of separate property, determine disposal income and the standard of living and identify transmuted property. He or she can also identify personal assets acquired by a small business and ascertain its unreported income. This article will focus on discovering hidden income using the form 1040, U.S. Individual Income Tax Return as the starting point. The 1040, however, is not always a completely accurate reflection of a target’s true income. The individual may own tax-free investments, underreport income and exploit fringe benefits, report losses or low income (legitimately) and still draw considerable cash from that business and he may sell-off assets owned by a small business.
After reading the preceding paragraph, you probably concluded that the individuals with the most flexibility in tax return manipulation are the small business owners — sole proprietors, general partners, LLC members, and regular and S corporation owners. In preparation for litigation where income is in question, always obtain several years of forms 1040 and W-2, state returns and any related small business returns such as form 1065 and K-1, 1120S and K-1 and 1120. If you suspect these returns to be forgeries or you cannot obtain them, have your client file IRS form 4506 for a form 1040 with W-2s, and, if the client is a company officer, he can also obtain the business returns.
Start with the basics on the form 1040
Start with the 1040, but do not hesitate to perform an autopsy if the patient appears dead. Review several years of returns to gauge the level of income and deductions. Income tends to fall and expenses rise in anticipation of a divorce or lawsuit.
Schedule A (Itemized Deductions). Prepayments for future benefit may be detected on Schedule A. Analyze the property taxes that should be due annually to see if substantially more is deducted. Prepayment of a year or two of taxes can add up. Perform the same check on mortgage interest. An increase in interest deduction from one year to the next could indicate prepayment of a few mortgage payments, and, conversely, a large decrease in deduction could indicate a refinancing or large principal pay-down.
Form W-2. Inspect the line 1 Wages and line 5 Medicare Wages boxes. Are these amounts different? Observe the line 15 check boxes; is Pension or Deferred Compensation checked? If yes to either question, this employee has a retirement or 401(k) plan or other salary reduction benefit. If state income tax is withheld in excess of 6-8%, or by a person who does not live or work in the withholding state, or federal tax withholding is a larger percentage than the tax bracket the person would likely fall within, then this person may plan to file for a large refund after the suit. In addition, do not assume that the W-2 is necessarily prepared correctly since many errors or omissions occur on them.
Schedule B (Interest and Dividends). If interest and dividends are reported, then some asset is obviously generating the income. If the person owns growth stocks or other non-dividend producing assets, then little or no income will be reported. Although nontaxable municipal interest is supposed to be reported on line 8b of form 1040, many filers omit this since tax-exempt income is not reported to the IRS. Be aware that assets may be transferred to a child through an UGMA, to another person by gift, to a trust or a corporation, and the IRS reporting is on that other entity’s SSN or EIN.
Schedule C (Sole Proprietorship). A sole proprietor does not have to keep a balanced, double-entry accounting system, i.e., many owners keep their records in a coffee-stained spiral notebook. Since the income statement and balance sheet are not required to be reported and reconciled together on the return, as is the case with a corporation, partnership or LLC, manipulation can occur. Consider whether or not the company is the type that would sell inventory and/or carry receivables on account. Most Schedules C are reported on the cash basis, thus receivables and inventory may exist but are not recorded anywhere. If possible, inspect sales tax returns, customer invoices or cash register tapes to ensure that all income is reported and not pocketed. Watch for excessive vehicle, travel, meals and miscellaneous expenses. Depreciation can be manipulated legitimately for tax reporting by writing off the full value of assets under IRC Sec. 179. Also note that assets that might appear to be leased may in fact be a disguised purchase.
Schedule E, (Rental, Partnership/LLC and S Corporation). A common legitimate tax dodge allows individuals to pay rent to themselves for buildings they own and their small business uses, in place of a larger salary or draw. The rent expense is deducted on the business return, but the reportable income is sometimes mysteriously absent on the individual’s 1040 rental income Schedule E.
Profit or loss from a small business, after all expenses, for a partner, LLC member or S corporation owner is reported to them in the form of a Schedule K-1, which is an attachment to a business tax return. A partner or LLC member should not receive a W-2 to report his income since he is not a legal employee, and an S corporation owner should receive a W-2. When inspecting the partnership/LLC and S corporation income section on page 2 of Schedule E of the 1040, scrutinize the income/loss and IRC Sec. 179 expense taken. This does not necessarily reflect the actual income received by this owner. An S corporation owner will commonly take compensation in the form of “S corporation draws”, which is essentially a non-reported return of capital likened to a dividend, in place of or in addition to his W-2. If the K-1 is correct, the draw figure will appear on the second page. If not reported there, check the corporate tax return balance sheet on page 4 for the distributions. In a recent divorce case, I observed an owner’s S corporation K-1 that reported income of $49,250. The owner took no W-2, but rather took all of his compensation, $78,500, as an S corporation draw (which is against IRS rulings because it avoids payroll taxes). The K-1 was in error and did not report this draw, but I did discover it in on the corporate tax return. The payroll tax avoidance issue was backup ammunition for my client for another day.
The partner/LLC member receives most of his compensation by taking return of capital draws. The draws should be reported on the K-1 and on the form 1065, page 4. Be aware that both LLCs and partnerships file on form 1065, the partnership tax return. Another form of compensation, likened to a salary, is called a “guaranteed payment” and should be reported on that partner’s/member’s K-1. A common error, or deception, is to not report the guaranteed payment (salary) on the K-1 and bypass paying tax on it. Once again, income reported on the K-1 does not necessarily reflect the owner’s actual income received.
Another aspect to consider is the amount of capital or loans a small business owner may invest in or loan to his company. Owners can easily bury capital on a tax return. Track the retained earnings or partners equity from year to year. The basic formula is beginning (prior year) balance plus net income earned less draws equals ending balance. Analyze the total capital and owner-related loans. If these balances seem high for the type of business, ask yourself if this business needs a large amount of accumulated capital to operate.
Forensic techniques after the tax returns are dead
Dead men don’t talk, and sometimes tax returns don’t either. CPAs will often be called upon to conduct an autopsy on the paper to determine the cause of discrepancy in income claimed versus reality. The exercise of finding unreported income is very useful for alimony and child support issues, but also allows for some good negotiating room. Assuming no personal or business financial statements are available and the tax returns are silent, then where do you look? Five basic methods are available to prove unreported income: the Transaction Method, Net Worth Method, Expenditures Method, Bank Deposit Method and Percentage Method.
Transaction Method. This is the easiest method to employ since it involves identifying a specific item or transaction that was not reported on a tax return such as a real estate sale or securities sale. Most financial transactions and earnings are reported to the IRS on some type of form, like a 1099. An individual may fail to identify to the court or report on the tax return items that are recorded on a 1099-S, from a real estate sale, or 1099-B, from a broker sale of securities. This is discussed as a general concept above in relation to erroneous K-1 reporting. A business might also inflate inventory values or create fictitious payables in order to depress reportable income. In this case, a thorough fraud audit may need to be conducted on the business’ books.
Net Worth Method. Many civil and criminal tax cases use this method to determine unreported income and to support findings from other methods employed. The concept is simple — if a individual’s net worth from one year to the next increases beyond the reported income, then unreported income probably exists. Outside of a 1040, records of assets can be obtained from county assessors, bank and brokerage accounts, federal estate and gift tax returns and loan/credit card applications. After an unsubstantiated increase in net worth is established, a likely source for this income must be determined other than from accumulated cash, loans, inheritances, gifts, insurance proceeds, etc. If the individual claims the likely source was from accumulated cash, you need to establish the unreasonableness of this by searching for checks returned for insufficient funds, bankrupt filings, offers in compromise or installment agreements with the IRS, Social Security and employer records showing low income, deposition answers about cash on hand, etc.
Expenditures Method. This method is very simple to understand and apply and is useful when the individual spends most of his income and does not save much. Establish annual expenses through affidavits, checkbooks, bank statements, canceled checks. If the expenses exceed the reported income and it can be established that the gap was not bridged with accumulated cash, loans, inheritances, gifts or insurance proceeds, you probably have found unreported income.
Bank Deposits Method. The IRS commonly uses this method to catch tax cheats. All deposits recorded in all banks and other institutions are totaled, cash received by the individual that was not deposited and used to pay expenses is added, deposits that do not represent already reported and known taxable income are subtracted and business expenses paid by check or cash are subtracted. Finally, the standard or itemized deductions and exemptions, as reported in the 1040, are deducted to arrive at taxable income. If more taxable income is found with this formula than was reported on the 1040, the individual probably has unreported income.
Percentage Method. Not used as often, but this is a good method for supporting findings from other methods when investigating a business. An established and reliable profit percentage, typical of that business, is multiplied by a reported income base, such as sales or gross profit, to determine net income. The formula net income is compared to that reported on tax returns or financial statements to establish an underreporting of income.
I used a variation of this method combined with the business valuation method of capitalized returns a few years ago in a divorce. The case involved a small town family that owned the local cable company and several other businesses in town. The husband owned a separate property minority share of the businesses and had successfully stalled producing financial statements and tax returns, but we did have all of the 1040s for this five-year duration marriage. The attorney that employed me had been assigned this case a few days before trial and needed me to very quickly establish an increase in value of the separate property since an antinuptial agreement was signed. I established a value of the businesses in each year of the marriage by taking his minority reported income on the 1040s and “grossing it up” to a full value using his ownership percentage and a reasonable rate of return. This gross up provided me with a figure for goodwill, which I added to the “hard assets” he had reported on an affidavit. Together, the goodwill and hard assets established a value that the wife was able to show had increased substantially during the marriage. The judge approved of the easy-to-understand methodology and awarded a decent property settlement, despite the antinuptial agreement.
Conclusion. The transfer of income between an individual’s 1040 and his business return, and visa versa, can be easily manipulated and go undetected, but is not necessarily illegal. Tax returns are often the first, best shot at establishing income and discovering assets. Read between the lines and keep your eye on the cash flow. If that still is not finding the income and assets that seems to exist, employ a forensic accountant to perform an autopsy on the paper.
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Client’s Introduction to Tennessee’s New Parenting Plan Law
Forensic Accounting: Performing Autopsies on Paper
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