Calculating net income of small business owners
In the November issue we discussed the Child Support Statute, specifically the formula for determining how to calculate from gross income to net income. The column really focused on W-2 employees. In this month's column we will review some guidelines for calculating the net income of small business owners, sole proprietors and shareholders in closely held businesses.
The first part of the column is the nuts and bolts of calculating net income of a small business owner, a sole proprietor or a shareholder in a closely held business. It is necessary in these type of situations to examine the tax returns of the particular individual and, if that person is a sole proprietor play particular attention to the expenses claimed on Schedule C.
Small business owners in a partnership will always have a partnership return with a K-1 distribution at the end of the year. Shareholders in closely held businesses will usually make the election for Subchapter S status. You should pay very careful attention to the corporate income tax return. A number of small business owners use a corporate tax return to allocate the expenses of the business which may or may not be applicable under the Child Support Statute in going from gross income to net income. It is very important to obtain the corporate tax returns in a small closely held business prior to finalizing any child support.
Members of Limited Liability Corporations are treated as partners. They receive a K-1 distribution at the end of the year. However, your analysis cannot stop with just a partnership return. There is usually a corporate tax return that is also generated and must be perused for the type of expenses that are generally allowed favorable income tax treatment but are not necessarily deductions in going from gross to net income under Section 505 of the Illinois Marriage and Dissolution of Marriage Act.
A good example is that a small business owner or a sole proprietor will always take, as a deduction on his Federal income tax, expenses for a motor vehicle. Sometimes all the motor vehicle is used for is transporting the taxpayer from his home to his work. It is my belief that this is not a proper deduction in computing net income from gross income. All of the motor vehicle expenses, including gasoline, tolls, repairs and maintenance of the vehicle including payments of the vehicle and depreciation of the same should be added back into the net income shown on a sole proprietor's Schedule C or a small business owner's corporate return. As a rule, always peruse for motor vehicle deductions and entertainment on the partnership returns and the corporate business returns.
A relevant question is to ask yourself why should the children of the non-custodial parent pay for the non-custodial parent to operate and own (or lease) a motor vehicle.
Another area to look at is the entertainment expense that is utilized on the tax return. Certainly, client entertainment in certain respects is a legitimate business expense and is used to generate income. However, meeting your colleagues at lunch to discuss an upcoming case or a physician's meeting at a restaurant to discuss a patient does not qualify under the Child Support Statute.
Please recall that the only place where these type of deductions would ever be allowed under the Child Support Statute would be under 750 ILCS 5/505(a)(3)(h) which states in relevant part the following:
"(h) Expenditures for repayment of debts that represent reasonable and necessary expenses for the production of income, medical expenditures necessary to preserve life or health, reasonable expenditures for the benefit of the child and the other parent, exclusive of gifts. The court shall reduce net income in determining the minimum amount of support to be ordered only for the period that such payments are due and shall enter an order containing provisions for its self-executing modification upon termination of such payment period."
In the case of IRMO Carpel, 232 Ill. App. 3d 806, 597 N.E. 2d 847 (1991), the Court was dealing with a situation where the non-custodial parent was arguing that if certain expenses are allowable as deductions under the Internal Revenue Code then they should be allowable as the proper determination of how to get from gross income to net income for purposes of child support. The Appellate Court in Carpel disagreed and reasoned that it is well settled that tax reported income does not provide conclusive evidence of either the supporting parent's gross or net income under the Illinois Marriage and Dissolution of Marriage Act which, pursuant to subsection (a) of Section 505 provides its own guidelines on deductions on how to calculate net income. The deductions in the Illinois Marriage and Dissolution of Marriage Act under Section 505(a), reflect different policies and purposes than the Federal Tax Code.
This is significant and it means that you do not blindly accept those expenses that are contained on the tax returns submitted to you by the non-custodial parent in determining how to get from gross to net income for purposes of computing child support in a situation where you are dealing with a small business owner, a sole proprietor or a shareholder in a closely held business.
Another area that exhibits some concern among practitioners and the courts is whether to deduct or to allow a deduction for depreciation expense of capital assets in determining net income. On this issue, the 1st District Appellate Court in the case of Posey v. Tate, 275 Ill. App. 3d 822, 656 N.E. 2d 222 (1995) allow the deduction of straight line depreciation from net income from the operation of four rental properties by the non-custodial parent in determining that non-custodial parent's net income for purposes of calculating the child support obligation.
In my opinion, the Posey courts rationale is faulty. The court stated the following in its determination of whether or not depreciation is an expenditure for repayment of debts that represent reasonable and necessary expenses for the production of income:
"Black's Law Dictionary defines 'depreciation' as the 'spreading out (of)' the cost of a capital assets over its estimated useful life... a decline in value of property caused by wear or obsolescence and... usually measured by a set formula which reflects these elements over a given period of useful life of property (citation) (the consistent, gradual process of estimating and allocating cost of capital investments over estimated useful life of assets in order to match cost against earnings) Black's Law Dictionary 441 (6th ed. 1990).
Thus depreciation is not income, but a return of capital. The subject's depreciation expense, which has been allowed as a deduction on a supporting parent's tax return, to child support would be to assess such support against capital instead of income. At the end of a capital asset's useful life, its productive capacity is exhausted. The useful tables mandated by the Internal Revenue Service, which in this instance establishes that the useful life of the rental properties is 27½ years, provide uniformity. This is particularly so with a straightline method of depreciation is used, as opposed to an accelerated from which would distort net income, denying a child proper support. We therefore find that the deduction of straightline depreciation from net income by defendant, a taxpayer who is obligated to pay child support, is fair and proper for he has shown that such a deduction to be 'reasonable and necessary expense for the production of income' and that it is subject to a specified repayment schedule, as contemplated by Section 505(a)(3)(h)." 275 Ill. App. 3d at 8-26 827.
That the court's rationale that the productive capacity of the rental properties would be exhausted after 27½ years is not in keeping with any measure of recent real estate values for rental properties in northeastern Illinois. If anything, the value of this type of capital actually increased over the course of time. Therefore, it appears that depreciation is just a way for the government to allow a reasonable allowance for the exhaustion, and wear and tear of property used in trade or business, but it is not actually a reasonable and necessary expense for the production of income. The better rationale would be if an apartment building owner was forced to repair the building by way of tuckpointing or replacing the roof. That would be a necessary expense for the production of income as if you allow your building to leak when it rains you will not retain tenants. Whether or not you can deduct depreciation on a building usually does not represent reasonable and necessary expenses for the production of income. Depreciation is a tax incentive to a business owner to invest in new properties and equipment.
A better analysis of depreciation and its relation to the Child Support Statute is by the Illinois Supreme Court in the case of IRMO Minear, 181 Ill. 2d 552, 693 N.E. 2d 379, (1998). At the trial court level the depreciation expense was never explained as to why it was an expenditure for repayment of debts. The Appellate Court then held that the deduction for depreciation in determining net income as defined under the Child Support Statute was improper. The Illinois Supreme Court did not go that far and stated in its opinion the following:
"Without deciding whether a depreciation expense may in all cases be excluded from consideration in determining an individual's available income, we find that Robert has failed to present evidence that would, under the Rule he proposes, warrant exclusion of that expense. Because no evidence was offered to explain the basis for the $10,874.00 depreciation expense noted on the balance sheet and income statement, we cannot say that the judge in any event abused his discretion in refusing to deduct this expense in determining Robert's available income." 181 Ill. 2d at 560.
CONCLUSION
In trying to analyze your particular situation, it is always necessary to look at the exact verbage in the Statute and follow the dictates of the Illinois courts with relation to determining whether or not certain expenses claimed are permissible under the Child Support Statute irrespective of whether they are proper deductions under the Internal Revenue Code.
