Retained Earnings and Divorce

Retained earnings, from an accounting standpoint, refer to the portion of a business’s net income which is retained by the business, rather than being paid out in dividends to shareholders. The reason retained earnings are relevant to family law is that for purposes of child support or spousal support, each spouse’s income is carefully calculated.  The Florida child support statute has a section that defines income. It reads: “Business income from sources such as self-employment, partnership, close corporations, and independent contracts. “Business income” means gross receipts minus ordinary and necessary expenses required to produce income.”  This definition is subject to argument and opens the door for retained earnings to affect the final determination of many issues found in a divorce.

If that sentence left you confused, don’t feel alone. In simpler terms, retained earnings are profits made by a business that is held in reserve and used for specific goals. These goals could include paying off business debts or reinvesting into the business. As an example, if one spouse had a backhoe business, and had been putting a portion of the business income back each month in order to replace an old, worn-out backhoe, then that spouse would not want that money (retained earnings) to be calculated as part of his or her income during a divorce in order to determine spousal support, child support, or distribution of assets.

Retained Earnings Contribute to the Overall Value of the Spouse’s Business

On the flip side, retained earnings contribute to the overall value of the business; shareholders have an interest in the retained earnings as well as a say in how those retained earnings are used. If, during the divorce, the court determines a spouse’s shares in the business are marital property, their value should be divided fairly with the other spouse. But should those retained earnings also be divvied up?

Earnings Do Not Always Equal Income

An important distinction to make during your divorce negotiations is that earnings are not always synonymous for income. The definition of marital property should only include income received by each spouse, yet retained earnings, while clearly income received by the business or corporation, may not, in fact, be income received by the divorcing shareholder.

The issue becomes even fuzzier when federal tax laws are brought into the mix; The retained earnings of certain types of corporations are taxed to the shareholders individually, even if those earnings are never actually received by the shareholder. What if marital funds were used to pay the taxes on those retained earnings? Does that mean the retained earnings are marital property, to be divided, even at the expense of the business?

When Retained Earnings May Be Deemed a Marital Asset

As a general rule, the court will order retained earnings to be split like any marital asset when:

• The business spouse has failed to show that the retained earnings are necessary to replenish or replace business assets;
• The degree of control exercised by the business spouse over the business is significant;
• The historical practices of the business for dealing with retained earnings don’t support keeping them out of the spouse’s income, or
• The court determines the “corporate veil” must be lifted in order to ensure that all money available for child support or spousal support is fully reflected. In the case of sole shareholders who control the income of their business, this is particularly important.

Often the court will, depending on the circumstances of the case and the facts of the business, agree that some pre-tax corporate income should be attributed back to the business spouse, usually from 25-100 percent.

Determining Divorce Income in Florida is More Complex for a Business Owner

Perhaps you are a sub-chapter “S” business owner who needs to determine an issue pertaining to additional income in order to prevent drawn-out litigation. In a sub-chapter “S” business, the income from the business passes through to the owners, even if the corporation retains the income. The spouse seeking spousal support or child support is likely to want that pass-through income to be included in the total amount of the other’s spouse’s income. For the business owner who never actually has access to that money, this can be a bitter realization.

Defining Income in Florida

If you believe this could be your situation, there are important facts to know about how the state of Florida defines income. First of all, Florida has a much more encompassing definition of each spouse’s income than the IRS. As an example, while you don’t have to pay federal taxes on disability benefits or military housing allowances, Florida does consider that income during divorce determination. Pass-through retained earnings, however, are taxed by the IRS, even though you may not actually have that money at your disposal. For this reason, and because those retained earnings may be crucial to your paying business debts as they come in, the court should not include that income in your total income.

Reasons Retained Earnings Should Not Be Considered Income

The Florida Subchapter S Revision Act forbids taking distributions from a business if the bills of the business are not getting paid. Many businesses try to keep a minimum of three to six months of operating expenses in the form of retained earnings. This is considered both reasonable and legitimate. Since Florida Statutes on income determination define income as a payment to the individual, then it hardly seems reasonable that retained earnings would be defined as income. Even more important, if your child support and/or spousal support payments are based on your ability to make money in your business, then it is important you be allowed to keep your retained earnings in order to do just that. If those retained earnings are considered income, and divided up, you, the business owner, might not be able to pay your bills or expand your business.

Retained Earnings Used to Shield Income

Unfortunately, while this is all very reasonable, some business owners have abused the entire process by retaining income only to shield it from his or her spouse during the divorce. Therefore, you should be allowed to keep retained earnings, only when you are actually retaining those earnings to pay expenses for your business or in anticipation of expanding your business—retained earnings may not be used as a method to avoid paying your fair share.

Further, if your spouse or his or her attorney feel you are using the retained earnings category to shield or conceal income, you may be unpleasantly surprised to find people you do business with receiving subpoenas. Obviously, this would never be a good thing for your business. If you are the spouse with the business, it is important that you only use retained earnings in the manner they were meant to be used, rather than to shield money from your spouse.

Misunderstandings Surround Retained Earnings

One of the primary reasons cases go unresolved during mediation is due to a misunderstanding of the law and the facts surrounding the case. If you are the business owner, it will likely be up to you and your attorney to educate the other side regarding the retained earnings of your business. If you have bylaws and articles for your business, then these documents may clearly show you are a minority shareholder with no control over retained earnings. If this is the case, then the issue should be resolved.

If other shareholders are leaving in the same amount of their retained earnings as you are proposing to leave, then you would want to show that. A business budget, which shows what six months of operating capital looks like could also be one way to show you need to keep your retained earnings and not declare it as income. If none of these tactics are successful in convincing your spouse and/or his or her attorney that your retained earnings should not be deemed income, it may be necessary to hire an expert accountant who can perform an income analysis on both you and your spouse.

Retained Earnings Not Considered Income More Often

By and large, retained earnings of a business or corporation are not considered marital property, rather are considered corporate assets; as a corporate asset, the shareholder does not actually have legal access to these assets. More than one court has found that this does not change even when the business is organized as an S Corporation, the shareholders are individually taxed on the retained earnings, and marital funds were used to pay those taxes. Even so, there are certain exceptions as determined by the courts.

As an example, a Minnesota decision in Nardini v. Nardini held that a small business held by the husband which sold and serviced firefighting equipment, was primarily developed during the marriage, therefore the retained earnings should be considered marital property, and split. In two Minnesota Court of Appeals cases, retained earnings were held as separate property, because the business in question was operated by independent third parties with sole management control. In these particular cases, the determining factor appeared to be the degree of control the business spouse exercised over the business, therefore that degree of control might be the issue.

Is Control of the Business the Only Issue?

It can, however, be too simplistic to assume control will be either totally present or totally absent. A spouse may have a certain degree of influence over the decision to hold back earnings, but may not unilaterally control that decision. A partner in a small business, with, say, four or five shareholders, does not have total control over how retained earnings will be used, but does have at least significant influence in that decision.

Assuming there is significant discretion on the part of the business spouse in how the retained earnings will be used, there must still exist a valid reason for why the earnings were retained. In other words, even if the business spouse has control, but there are no valid reasons for retaining income, that income may be deemed marital property.

Does a Prenuptial Agreement Shield You?

If you and your spouse had a prenuptial agreement that provides any increase in the value of the separate property will remain separate, you may think retained earnings of your business will not be an issue. This may or may not be true. Even when a pre or post-nuptial agreement clearly states that increases in the value of a business a spouse brought into the marriage are to be considered separate property, the income generated from that separate property may still be considered marital.

In Heineman v. Heineman, such an agreement initially resulted in the trial court determining a wife’s retained earnings from her studio were an increase in value, therefore separate property under the agreement. An appellate court, however, reversed that decision, determining the retained earnings were to be considered income from the separate property—the retained earnings accumulated from money that would have otherwise been paid to the wife as a salary and therefore were deemed marital property.

If you are thinking about a divorce, or you are in the midst of a divorce, and you believe retained earnings in your business or the business of your spouse will be an issue, now is a good time to discuss this with your Ayo and Iken attorney in order to develop a workable strategy. Your attorney can determine whether the facts are on your side, then present it to your spouse and his or her attorney in a way it will make sense and avoid a long, drawn-out battle.

Author’s note from Attorney Howard Iken: Retained earnings are profits kept by a business for specific goals such as paying off debts or reinvesting. During a divorce, retained earnings can affect the determination of spousal support, child support, or asset distribution. Retained earnings can be seen as income or not depending on certain factors. The court may order retained earnings to be split like any marital asset when certain conditions are met. Defining income in Florida is more complex for business owners, particularly for sub-chapter S businesses, where income from the business passes through to the owners even if the corporation retains the income. The court should not include retained earnings in total income as they may be crucial to paying business debts.