Calculating Business Income for Child and Spousal Support
Entrepreneurship in the United States is booming. According to the U.S. Chamber of Commerce, there are over 33 million small businesses in America. In 2023 a record breaking 5.5 million new business applications were filed.
What does this mean for divorce professionals? Closely held and small businesses can create unique challenges in family law cases, particularly in determining true available income for child and spousal support. In this article we will explore common issues related to business income and expenses all divorce professionals must know.
What is Business Income?
The IRS requires businesses to report all income sources. Business income may include gross revenue from the sale of goods and services, or payments received in real estate rentals or transactions. Services include professional services and consulting. A business must include income payment exchanges in the form of property or services at the fair market value of that property or services.
Calculating Business Income
Most closely held businesses keep records of their income and business expenses. For many businesses, the final profit or loss flows through to the personal taxes of the owners. Unfortunately, there are a number of ways closely held businesses can minimize income and maximize expenses in a divorce support case.
Many of these are valid business practices, while others are a little shadier. It would be a mistake for divorce practitioners to accept tax records or Profit and Loss statement numbers as the full story. It is vital to look closely at a business’s records and examine all income and expenses. Next, let’s examine common business expenses that could impact the available income in a support case.
Business Expenses
Business expenses, write-offs, or deductions that are both ordinary and necessary can be deducted from business income and reduce the owner’s final tax liability. Business expenses generally fall into common categories such as advertising, travel, payroll, rent, and many others.
It is common for some business owners to pay personal expenses with company funds. This could innocently be a cell phone or car used for mixed business and personal purposes. Rather than classifying the transaction as a payment or distribution to the owner, they instead classify the event as a business expense. By classifying the transaction as an expense rather than an owner’s draw or income, the business owner avoids personal taxes on the funds and reduces the business’s overall tax liability.
Personal expenses generally are not valid tax write offs against business income. Paying personal expenses from a business account is a questionable business practice that often comes to light in divorce proceedings.
Taxes and Overpayments
Small businesses and self-employed individuals are generally required to file an annual tax return and pay estimated taxes quarterly. While most taxpayers calculate their tax liability carefully, those facing divorce may have an incentive to overpay their taxes.
By overpaying taxes, the business documents will show regular tax payments but will not show that a refund will conveniently be issued after the case is resolved. Professionals should carefully examine income and taxes paid over the last business year and check the personal returns for refunds for excessive overpayments, as that income should be added back to the owner for support purposes.
Maximizing Retirement Contributions
Financial experts often advise workers to save up to 15% of their pre-tax income solely for retirement. Employers set up retirement plans for their employees and will often match retirement contributions as a perk to attract and retain employees. Small and individually owned businesses are also able to take advantage of retirement planning, which also happens to be a tax savings strategy.
Business owners are in a unique position when it comes to retirement savings. For instance, a true solo business owner wears two hats—as employer and sole employee. In that case, the solo business owner as an “employee” can contribute up to $23,000 of their income into a Solo 401k in 2024 plus an additional $7,500 for those 50 and older.
Additionally, the business owner as “employer” may also contribute up to 25% of net earnings from self-employment for total contributions of $69,000 for 2024, including the above salary deferrals. Matching retirement contributions for employees is a legitimate business expense that lowers business profits and ultimately the owner’s final personal tax liability. While this is perfectly acceptable practice for federal income and taxation, that income deferral into retirement savings may be considered available income for child and spousal support calculations.
Most states recognize that parents and newly separated couples must save for retirement, but each state handles this “income deferral” differently for child and spousal support calculations. It is important for divorce practitioners to be familiar with the different types of retirement accounts available to business owners, the maximum allowable contributions, and how their local state statute treats those funds for child and spousal support purposes.
Qualifying Business Income Deductions
One of the changes under the Tax Cuts and Jobs Act (TCJA) of 2017 was the addition of a deduction on business pass-through income. Under Internal Revenue Code, Section 199A, individuals and businesses may obtain a deduction of up to 20% on “qualified business income” from their pass-through entities but subject to certain limitations (QBID).
The pass-through deduction may apply to many businesses including S corporations, LLCs taxed as partnerships, partnerships, and sole proprietorships. Before the TCJA, there was no provision allowing taxpayers to deduct a portion of their pass-through business income. This is a valuable tax savings that puts money back into the business owners’ hands. Family Law Software will calculate QBID for qualifying individuals and entities.
Spouse and Children as Employees
Did you know business owners can hire their spouse or minor children to “work” for the business? Savvy business owners often hire their children for simple clerical work, as models for blog posts, or as an on-site greeter. This can create a large deductible business expense for the owner, reducing the owner’s tax liability, all while keeping the money in the family.
This is all legal, and the IRS allows business owners to hire spouses and children while maintaining their tax status and other small business benefits intact for tax purposes. The question post-divorce is whether the children or spouse will remain on the payroll or if those funds should be added back and reflected in the business owner’s income for support purposes.
Family Law Software Solutions
Family Law Software is your solution to accurately calculate business income and tax liabilities faced by business owners. We also offer ways to put “expensed” money back into child or spousal support calculations for fair and accurate results.
Each divorce case raises unique issues. The above are just a few ways businesses owners can take advantage of tax savings and seemingly reduce income. Learn more about these and other important issues in our business income webinar.
Helpful Resources
IRS Retirement Plans for Self-Employed People: https://www.irs.gov/retirement-plans/retirement-plans-for-self-employed-people
New business applications are booming. Track them by state: U.S. Chamber of Commerce: https://www.uschamber.com/small-business/new-business-applications-a-state-by-state-view