Forensic Accounting Perspectives : New York Business Valuation, Divorce, Business Disputes, Shareholder Disputes, Litigation Support & Accounting Forensics in Connecticut, New York & New Jersey

December is an exciting month for sports fans, particularly New York sports fans. The area’s football teams are both bidding for playoff berths; basketball and hockey fans are settling in with mixed feelings about their team’s early performance; and major league baseball’s “hot stove” league is a buzz with the potential of free agent signings.

This year’s biggest baseball free agent star is pitcher Cliff Lee. And to no surprise the New York Yankees are among the few teams bidding for his affection. The Angels, Rangers, and Yankees have all reportedly “pitched” Cliff Lee and have offered him a king’s ransom to play for their team. 

Each of the three teams courting Mr. Lee has something different to offer. California has beautiful weather; Texas has no state income tax; and New York has an opportunity to earn millions of dollars above a baseball contract in endorsements and sponsorships. There is little doubt that in addition to his agent, family, and friends Mr. Lee is getting plenty of advice from a variety of marketing, legal, and tax professionals.

Even though I have not been asked, I thought I would give my two cents to Mr. Lee’s quandary. Cliff, stay away from New York. It could be your financial ruin.

Assume Cliff Lee signs with the Yankees for seven years at $25 million per year and contracts for an additional $5 million per year for marketing. It doesn’t take a forensic accountant to compute that during the next seven years he will earn $210 million.   But suppose Lee, A-Rod, and Jeter go out one night to celebrate a big win over their arch rivals, the Boston Red Sox. We all know that Alex Rodriguez and Derek Jeter are magnets for beautiful women. And just suppose Cliff Lee decides shortly thereafter that he would be happier living as a bachelor in New York City. Unlike any other state in the union, New York State provides equitable distribution for the enhanced earnings capacity acquired during marriage; a concept that the future ex-Mrs. Lee will shortly learn.

The enhanced earnings capacity (commonly referred to as EEC) is computed as the present value of the enhancement in earnings over an expected work life. In Lee’s case, this expectancy would extend over the next seven years of his new contract and may proceed for many years thereafter, if he should be fortunate enough to become a coach, commentator, or television analyst after his playing days are over.

The approach to calculating the enhanced earnings capacity in New York State was established in 1985 as a result of a New York Appellate Court’s decision in O’Brien v. O’Brien. This concept was later reaffirmed in 1995 in the New York Court’s decision in McSparron v. McSparron; as well as many other cases that followed. The methodology employed to this calculationspecific to Cliff Lee can be broken down into five steps:

1. Determine Cliff Lee’s earnings capacity at the commencement of the hypothetical divorce action, resulting from signing with the NY Yankees. This is referred to as Top-Line Earnings.
2. Determine Cliff Lee’s earnings capacity if he had not become a baseball phenom and continued the career path chosen at the time of marriage. This is referred to as Base-Line Earnings.
3. Compute the after-tax earnings of the Top-Line and Base-Line amounts by applying federal, state and local income tax rates, as well as the social security and medicare tax.
4. The difference between the net after-tax earnings of each earnings base is the net enhanced earnings capacity attributable to his record setting contract.
5. Compute the present value of the net enhanced earnings capacity over his NY Yankee contract.

For illustrative purposes, let’s assume that Cliff Lee had a bachelor’s degree at the time of marriage. Let’s further assume that a white male with a bachelor’s degree, living in New York City at Mr. Lee’s current age would earn $125,000 per year. This is the amount considered as a proxy for Base-Line earnings.

The following table illustrates the after-tax earnings of both the Top-line and Base-Line amounts; as well as the annual net enhanced earnings capacity.

A present value discount rate is designed to reflect the value of money in a relatively risk free investment. Economists, financial analysts and accountants generally agree that the real rate of interest is between 2% and 4%. The courts have historically accepted 3% as the present value factor applied in this computation; but in recent cases have considered rates between 5% and 10%. The present value discount rate is very important. As the present value discount factor increases, the total enhanced earnings computation decreases.

Based upon these computations, the enhanced earnings capacity attributed to Cliff Lee’s potential seven year contract with the NY Yankees is $102 Million (Rounded). The following table illustrates this computation.

Since New York is an equitable distribution State, a portion of this amount would belong to his soon to be ex-wife. In some instances the courts have awarded as much as a 50% share and in others as little as 10%.

As you can imagine, there are a variety of things Cliff Lee has to consider when deciding which mound to call home next year. Will he flourish in the California sun; the familiarity of Texas home cooking; or the cement jungle of New York City. Only time will tell. But what we do know is this – getting divorced in New York State after signing a record setting free agent contract could be more painful than losing in the World Series to the San Francisco Giants.

For more information about the computation and application of the enhanced earnings capacity calculation, including our Enhanced Earnings Capacity Questionnaire, please visit our website.

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There may be no glory in being a family law attorney these days, especially when it comes to dealing with the often challenging economic consequences in a divorce action.

Clients may initially contact you with one issue related to their potential divorce, but often these concerns can quickly manifest as emotions and pressures begin to develop.

Perhaps the questions attorneys resist the most or feel least comfortable in answering pertain to divorce-related tax matters. Many individuals, including those contemplating divorce, will be reaching out to you for answers to a variety of tax-related divorce questions. So, this may be the best time to revisit some of the questions you may be faced with.

Here are ten divorce-related tax issues that all matrimonial and family law attorneys should know.

1.       Taxability of Assets Distributed Incident to Divorce

In many instances one of the most disputed issues in a divorce is the distribution of the marital assets. This is commonly referred to as “equitable distribution” or “ED”. Under the Internal Revenue Code (IRC) Section 1041 (a), no gain or loss is recognized on the transfer (acquisition or distribution) incident to divorce provided such transfer occurs within one year after the divorce or related to the ending of the marriage. 

The ending of the marriage is defined pursuant to a divorce or separation agreement and occurs within six years after the date on which the marriage ended. 

Practice Tip: Often, one of the most significant marital assets is the marital residence and/or a business. The values of these assets should be appraised by an independent credentialed valuation expert in the early stages of the divorce proceeding.

2.       Tax Deductibility of Professional Fees

Legal and other professional fees related to getting a divorce are generally not tax deductible. These non-deductible costs include expenses related in arriving at financial settlements and retaining income-producing property. However, some legal and accounting expenses can be deducted as a miscellaneous itemized deduction, subject to the 2% limitation (and also as a preference for alternative minimum tax purposes). Here is a short list of some of these exceptions:

• Fees related to tax advice related to a divorce,
• Fees to determine or collect alimony,
• Fees to determine estate tax consequences of property settlements, and
•  Appraisal and actuary fees to determine tax liabilities or to assist in obtaining alimony

Practice Tip: When your client retains an accounting/tax professional ask them to prepare their invoices with specific descriptions so that the tax deductible portion of their charges can be easily determined.

3.       Alimony v. Child Support

In simple terms, alimony is taxable to the recipient and deductible by the payer. To qualify as alimony under IRC Section 71(b) the payments must meet the following requirements:

• Payments are required under a written divorce or separation agreement,
• The payment cannot be designated as “not alimony”,
• Spouses may not be members of the same household,
•  Payments may not be treated as child support,
•  Payments must cease upon death of recipient, and
•  The parties cannot file a joint tax return

Child Support is never taxable, and there are a few other common payments that do not qualify as alimony, such as:

• Non-cash transfers,
• Payments for use of property, and
• Payments to keep up the payer’s property

In addition, an often neglected issue pertains to the short-fall of child support obligations. When an individual is obligated to pay (both) alimony and child support, payments are first applied to satisfy child support obligations and then to alimony. In other words, child support obligations must be fully satisfied before any amount of alimony is considered deductible.

Practice Tip: When structuring alimony agreements one should be conscious of the possible applicable alimony recapture rules. If there is a decrease or termination of alimony during the first three calendar years, recapture rules apply if the alimony in the second or third calendar year is $15,000 less than in the prior year. The recapture provision may be initiated by one or more of the following:

• Failure to make timely payments,
• Change in divorce or separation agreement,
• Reduction in spouse support needs, and
• Reduction in payers ability to provide support

4.       Sale of Personal Residence

If you live in your “Principal Residence” for any two of the last five years you are eligible for a capital gain exclusion upon the sale of the home. This exclusion is $250,000 for a single taxpayer and $500,000 for a married couple. Because of the significant difference in tax treatment, the tax consequences related to the sale of the marital home should be considered early on in the divorce settlement negotiations.

Practice Tip: If the sale of the marital residence is contemplated, consider the transaction prior to the termination of the marriage in order to take advantage the higher exclusion amount in order to secure more proceeds from the sale.

5.       Filing Status

An individual’s marital status is determined as of the last day of the calendar year – December 31^st. Married individuals can file jointly or married filing separate. When the parties file jointly each is jointly liable for the tax obligation, regardless of what a divorce instrument may say. 

The married filing separate status is the highest tax rate. When spouses file separate returns they both must utilize the standard or itemized deductions. The first one to file establishes the requirements for the other to follow. When married individuals file their tax returns separately we often find other critical issues being considered. 

If an individual is divorced as of December 31^st, even if married and living together with their ex-spouse sometime during the year, they must file as a single taxpayer or head of household for that year.

For those that are still married at the end of the year but were legally separated on December 31^st or have not lived with their spouse for the last six months of the year – they may be able to file as head of household. This filing status is attractive because the tax rates are significantly less than for those filing as married filing separate. 

To file head of household a number of requirements must be met:

• The individual must have paid more than half of the cost of keeping a home for a child or other qualifying person,
•  This individual is entitled to claim the qualifying person as a tax exemption, and
•   The qualifying person must have lived in the individual’s home for more than half the year

Practice Tip: Income Tax projections utilizing different scenarios are an often neglected but valuable planning tool. This exercise should be performed for years before and after the termination of the marriage.

6.       Children/Dependents Personal Exemptions

Generally, the custodial parent is entitled to the dependency exemption as long as the parents (individually or together) provide at least one-half of the dependents support. However, there are two exceptions to this general rule:

•  When the custodial parent relinquishes the rights to the exemption, or
•   When a multiple support agreement is established

Practice Tip: Dependent exemptions often vary by agreement. When preparing these arrangements make sure you consider the age of the child/dependent and the taxable income of each parent.

7.       Deductibility of Mortgage Interest & Real Estate Taxes

When a couples’ principal residence is jointly owned and the mortgage interest and real estate taxes are paid from a joint account there is a presumption that these payments are attributed to each party on a 50/50 basis. 

However, when a home is jointly owned and these payments are paid directly by the non-occupant spouse, half of the mortgage interest and real estate taxes is deductible to the paying spouse as an itemized deduction and the remainder qualifies as alimony. The occupying spouse must report these amounts as income (alimony) but is able to deduct the interest and taxes as an itemized deduction.

If the home is owned only by the occupying spouse but the non-occupying spouse is still obligated on the mortgage, the non-occupying spouse can only deduct the mortgage interest if a minor child of the marriage resides in the home. The non-occupying spouse cannot deduct any of the real estate taxes, since he or she has no ownership in the property.

Alternatively, if the non-occupying spouse solely owns the house and pays the mortgage interest and real estate taxes then those amounts can be deducted in their entirety as an itemized deduction. The occupying spouse would not have to report these amounts as alimony.

Practice Tip: Don’t assume that the marital residence is jointly owned by each the husband and wife. Inquire as to who owns the property and who is obligated on the primary and secondary mortgages.

8.       IRA’s and Retirement Plans

A Qualified Domestic Relations Order (QDRO) is a useful tool to designate a portion of a qualified retirement plan to the other spouse. This vehicle allows the distribution of the marital asset without damaging the integrity of the plan or the creation of a taxable event. Benefits are taxed when distributions are made, not when the QDRO is established. QDRO’s do not apply to Individual Retirement Accounts (IRA’s); however, IRA’s transferred pursuant to a divorce or separation agreement is not a taxable event.

Practice Tip: The use of a QDRO is an accessible tool to facilitate the equitable distribution of assets when there are limited liquid assets.

9.       Stock Option & Deferred Compensation Plans

The transfer of an interest in a non-statutory stock option or a non-qualified deferred compensation plan incident to a divorce is not a taxable event. However, income is reported when the former spouse exercises the stock options or when the deferred compensation is paid (or made available).

Practice Tip: Stock option & deferred compensation plans can be identified within employment contracts and/or annual wage reporting statements. Obtain the periodic statements (monthly, quarterly, annual, etc.) for your file.

10.   Innocent Spouse Relief

There are currently three sections of Internal Revenue Code that provide relief from tax liability to spouses:

• Innocent Spouse (IRC Section 6015 (b)),
• Separation of Liability (IRC Section 6015 (c)), and
• Equitable Relief (IRC Section 6015 (f))
• When applicable, the courts have considered the following factors to determine their applicability:
• Knowledge,
• Economic hardship,
• Benefit,
• Compliance with tax laws,
• Tax liability attributed to non-requesting spouse,
• Marital status, and
• Spousal abuse

Practice Tip: If you plan to invoke the innocent spouse rule prepare your argument by addressing as many of the above factors discussed above. IRS Form 8857, Request for Innocent Spouse Relief, is filed separately, not with the couples’ individual income tax returns.

We hope this brief summary is of value to you and your practice. Your questions or comments regarding this information are always welcome.  

For additional timely information to assist your family law and matrimonial law practice please feel free to visit our website www.msgcpa@msgcpa.com, or call our offices.

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I often tell of my first experience as an expert witness in a matrimonial matter. At that time there was not a plethora of literature that addressed the search for omitted income or hidden assets. Much of what we now call forensic accounting was performed intuitively by those of us with strong auditing backgrounds.

The “money spouse” was in a family business. Income, sales, and payroll tax returns were all filed on time and appeared to be complete and accurate. The problem appeared when the reported income (net of income taxes) was compared to the ordinary living expenses on the “non-money spouse’s” Certified Net Worth Statement.

As you probably guessed, the expenses greatly exceeded the funds earned and available to pay these expenses. Now that the red flag has been raised, two obvious questions emerged; (1) Were the expenses listed on the net worth statement actually paid or merely the non-money spouse’s wish list?; and (2) Were there other sources of funds such as increase in loans and/or credit card debt, distributions from other entities, receipt of gifts, etc. to account for this difference.

Truth be told, you don’t necessarily need to be an auditor or forensic accountant to smell a thief. However, to catch the culprit red handed you need the skills of a gumshoe. This article is designed to provide attorneys with a road map to identify those possible treasures found within tax returns.

Business tax returns report the assets, liabilities, equity, revenues, and expenses of an entity. The balance sheet primarily lists the historical cost of what the entity owns (assets) and its obligations (liabilities). Assets are those items that have economic value or which are used in the ordinary course of business. These are also commonly referred to as the business’s resources. Examples of assets are cash, inventory, fixed assets, and real estate. Liabilities represent amounts owed. Examples of liabilities are amounts due to vendors and suppliers, mortgage/loan obligations and other debts.

When analyzing the balance sheet of a business one should verify that these assets and liabilities are truly business related and not personal. Examples of personal assets hidden within the confines of a business commonly include automobiles, real estate, investments and other tangible assets. A good start in this analysis is to request a detailed fixed asset schedule and then identify what assets are actually being used in the normal course of business. Don’t forget to look for other assets identified within the balance sheet. Potentially, any excess assets identified may be personal.

Liabilities should also be considered. Recorded and paid debts should be verified to insure that they relate to the business. The payment of obligations can be easily traced to its source. If payments are being made, then an asset or benefit should exist. You may even identify debt payments where an asset is not apparent or recorded.

The income and expense sections of tax returns are also rich sources of information. However, the devil is in the detail. There are two common ways to identify personal expenses. First, compare expense categories year by year. Spikes and valleys within the same category commonly detect personal spending. Second, obtain grouping schedules and transaction listings for deductions taken. Identifying vendors, suppliers, and other payees often highlights those that may not be business related. The Treasury calls these non-deductible expenses, the forensic accounting community frequently refers to them as discretionary items. Expense categories that commonly contain such items are travel, meals, entertainment, automobile, and miscellaneous.

Further analysis can also identify hidden assets, such as real property. A review of the utility and real estate tax payments may uncover property not otherwise known. But these items may not necessarily be found only within the expense detail of tax returns. Amounts paid on behalf of the business owner may be recorded as a dividend distribution, loan payment or even salary. In these instances, the true nature of the disbursement can be easily disguised.

Personal income tax returns can also serve as an investigative tool. A review of itemized deductions can be very informative. For instance, a deduction for investment management fees can lead to the discovery of an undisclosed investment portfolio. Since such fees are commonly based upon the principal value of the portfolio, this amount may be reasonably estimated. And don’t forget about the miscellaneous deduction for the safe deposit box rental. Unfortunately, you won’t know what assets are kept there until you open the box.

A review of the pass-through entities on Schedule E, Supplemental Income and Loss, can also be informative. Schedule E lists the income and losses attributed to ownership interests from business entities. Bank and brokerage accounts appear on Schedule B, Interest and Dividend Income. What may be the most important observation in analyzing Schedules E and B are the change in their components from year to year. The change in bank, brokerage, and investment accounts may be an indication of money being moved.

Another item to note is the change in interest and dividend income. This may reflect a change in returns on investment or the alteration of principal investment. You may also want to trace the proceeds for the sale of stocks and investments. These transactions are itemized on Schedule D, Capital Gains and Losses on Form 1040.

The paths on which business and individual income tax returns take you may be limitless. Although this process may be an expensive task, more times than not it provides an insight to a couple’s finances that may otherwise go undetected. Hopefully, this blog will make you aware of the potential issues you may encounter and how you may want to address these matters with your client.

I will be lecturing on this topic, “Finding Hidden Treasures In Tax Returns” at the upcoming annual conference sponsored by the Association of Divorce Financial Planners (CDFA) this fall.  Please visit their website for registration information.

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Since our last blog was published, the New York State Assembly gave final passage on July 1st to no-fault divorce, clearing the way for New York State to allowing couples to end their marriages quickly when one spouse believes the union is over. The new measure, which requires one spouse to swear under oath that the relationship has broken down irretrievably for at least six months, is the final piece of a legislative package enacting the most sweeping changes to the state’s divorce laws in 40 years. This final legislative approval comes after what one member of the Assembly called “an awfully long and hard battle.” The bills now await Governor Paterson’s signature.

No-fault divorce has long been opposed by the Catholic Church, with the view that the legislation would make divorce easier; feminists argued that no-fault did not address the concerns of poorer women. The National Organization for Women of New York State has found itself on the same side of the issue as the Church, although the New York City chapter of NOW supports the legislation.

Marcia Pappas, president of the New York State chapter of NOW, has written recently, “No-fault can take away the bargaining leverage of the non-moneyed spouse—and that is usually the woman….In fairness, any partner to a marriage should be provided with notice that the other partner wants a divorce and given an opportunity to negotiate the terms for the divorce. Often, there is fault with ‘divorce on demand,’ not only can the more moneyed spouse begin hiding assets (which happens even under our current laws), but this spouse can proceed quickly with legal actions before the other spouse, with limited means, even has the time to find and hire an attorney.”

Until 2004, the Women’s Bar Association has also objected to no-fault divorce. But as Annette G. Hasapidis, co-chairwoman of the association’s legislation committee has said, “We came to the realization that forcing one party to either admit or be found at fault in the deterioration of a marriage provides no economic or other advantage to either party. And more importantly, it harms the children of the marriage.” The concern of advocates for women that there would be difficulty receiving appropriate alimony or child support was considered unsupportable by the Women’s Bar Association.

Both supporters and opponents have concerns regarding the creation of a formula that computes alimony. This mechanism, however, is intended to alleviate the conflict and legal jockeying commonly associated with the determination of spousal maintenance.

The Honorable Sondra Miller, currently Chief Counsel of the White Plains law firm McCarthy Fingar, has been advocating for an amendment to allow no-fault divorce for many years. Recently, we had the opportunity to interview Judge Miller for our podcast on this historic legislation. Some of the key questions she thoughtfully addresses include: Why is no-fault divorce still a hot-button issue for politically liberal groups, religious groups and even among certain members of the legal community? Why has it been such an uphill battle for New York legislators to simplify New York State's divorce laws? Is it possible to measure the impact on children without no-fault divorce?

Please visit our Web site www.msgcpa.com to hear our edifying podcast interview with the Honorable Sondra Miller.

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Forty years ago, no-fault divorce was a controversial topic. Among the arguments made against it was that the full-time homemaker would lose leverage if unilateral divorce became a reality. But the American household has changed considerably over the years: more and more, two-parent earner households are the norm, and the working mom/stay-at-home dad model has become commonplace. Since 1969, when Gov. Reagan signed the nation’s first no-fault divorce law, the country has gradually fallen into place with no-fault divorce legislation—except for New York State.

But that seems about to change. On Tuesday, June 15, the State Senate’s Democratic Majority passed a legislative package that seeks to finally end New York’s status as the remaining state without no-fault divorce. The No-Fault Divorce bill restructures New York State’s matrimonial law to streamline the process and improve the outcome of divorce for New Yorkers. The bill, approved 32-29, would allow no-fault divorce after a marriage has “irretrievably” broken down for six months or more and after all financial and custody issues are resolved. The legislative package must still pass the State Assembly, which is considering two bills that would adopt some version of no-fault divorce.

Senator Ruth Hassell-Thompson, a Democrat from Westchester and the Bronx who was chief Senate sponsor of the bill, said after the vote, “What I’m hoping is that because the Assembly now has a partner in the Senate, that will give impetus to help the Assembly move along.”

Under current law, New York couples who want to divorce must fault their spouse on specific grounds, such as adultery or cruel and inhuman treatment. Otherwise, couples must legally separate for a year before being allowed to file for divorce. Proponents of no-fault divorce say a great deal of time and expense—often beyond the means of a spouse—is wasted on legal fees, making a difficult situation considerably worse. The New York Senate legislation—S3890—would permit spouses unilaterally to initiate divorce proceedings in which the court rather than the parties will resolve issues such as property division, alimony, child support and custody.

There have been many concerted efforts over the years to change New York State’s divorce laws, but to no avail. In 2006, for example, a panel appointed by Judith S. Kaye, then New York State’s chief judge, urged a major overhaul of New York’s divorce and child custody rules—including allowing, at long last, no-fault divorce. But opponents, including the National Organization of Women, the Catholic Church and, until 2004, the Women’s Bar Association of the State of New York, objected to change in the law because, among other reasons, it would raise New York State’s divorce rate and hurt women financially.

Perhaps now, after decades of opposition, and the passage of the legislative package by a slim margin, divorcing spouses in New York State will finally be able to avoid the costly litigation and seemingly endless custody battles that have become all so common when a marriage irrevocably ends.

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