Understated Business Income

It is not unusual to see business income significantly decrease during the course of a divorce. This can happen for numerous reasons. The owner is understandably distracted by the divorce itself. Divorce is threatening. Dealing with attorneys and the court system is distracting and threatening. The entire process takes the owner’s mind off his business, and the result can be lost sales or other business inefficiencies.

Owners can be distracted by new relationships. The relationship that caused the divorce or a relationship started after the separation can distract an owner. The result is that the business operation can suffer because of the physical or mental absence of the owner.

The owner may be afraid of losing contact with his children and become super mom or dad, seeing the children much more than he or she did during the course of the marriage. This means time away from the business usually with a resulting drop in income.

The parents can also intentionally reduce the income of their businesses. Parents refusing to accept contracts or delaying the acceptance of contracts (sandbagging) are not unheard of. Loading up on supplies, prepaying expenses or misstating inventories can also be used to understate income. Parents can also charge personal expenses to the business or fail to report income earned. All of these situations can understate business income during a divorce.

BUSINESS TAX RETURNS VERSUS THE IRS

The tax returns filed by the business owner may have to be investigated and consequently adjusted to include unreported income or to exclude expenses unrelated to the business. The adjustments made are in response to local child support enforcement rules or simply to reflect the true economic income of the business. The adjustments made may or may not reflect compliance with IRS (Internal Revenue Service) regulations. However, the perceived risk is that any investigation will reveal items that are not in compliance with IRS regulations.

HEADS UP: On no less than three occasions, I have had ex-wives who were angry at their ex-spouses, the system, and the universe in general, turn their offending exes over to the IRS. The result was uniform. The IRS did nothing. Even when the IRS was handed the package in evidentiary form and all they basically had to do was make the adjustment, they declined any type of action. It could be that during that time the IRS was taking a lot of heat from the public because they had abused some of their power and they didn’t feel like taking on another problem. Or it could be that the IRS gets slurries of ex-spouses turning each other in and have found that such actions are usually based on revenge and not actual tax reporting fraud. But for whatever reason, I have found the IRS reluctant to get involved in these types of situations.

In addition, I have reviewed the audits of IRS agents on several occasions. Since my reviews of the businesses in question were very similar to that performed by the IRS, I was able to compare the adjustments I had made to theirs. I found adjustments that I did make for child support determination purposes and would have made based upon my knowledge of IRS regulations if I had been an IRS agent. I considered that either I did not understand the regulations, did not understand the audit procedures performed by the IRS, or had missed the point completely. In any case, when someone now asks me how the IRS would handle a particular issue, I can respond with a clear conscience, “I don’t know.”

The business owners who are investigated and their spouses have one thing in common; they are reluctant to disclose questionable business practices for fear those practices will become known to the IRS. This situation is both a lever and a lock. It can force a business owner into major concessions concerning his or her income. It can also keep the investigator from the information needed to determine a fair income for child support.

Consequently, this is a type of risk assessment and the first step in the process is to recognize how the information concerning the business operations could get to the IRS. If the matter does not proceed to court, information could only get to the IRS through the parties involved in the divorce or child support modification process. These normally include the parties, attorneys, CPA, mediator, and financial investigator.

The parties usually have no desire to involve the IRS in their situation. Or if they do, they are normally informed by their advisors that starting another war in the midst of a divorce is an incredibly bad idea. This leaves the attorneys, any CPA involved, mediators and the financial investigator. Except in rare circumstances, all are bound by strict rules of confidentiality. Attorneys have attorney-client privilege and cannot reveal client confidences. The CPA for the business and mediators have strict rules of confidentiality and can only be made to reveal confidential information if ordered to do so by a court. Financial investigators such as independent CPAs, Certified Fraud Examiners, or investigators within child support enforcement agencies also have rules of confidentiality, and those rules can only be overridden by court order.

Therefore, the parties do not have an incentive to reveal the operations of the business to the IRS and all other parties normally involved are bound by various rules of confidentiality. The risk of disclosure in this regard is therefore very low.

The situation changes if the matter proceeds to court. In that case everything becomes a matter of public record. Unless sealed by the court (a rare action), all testimony, schedules, and documentation become available to the public. This means that, conceivably, the IRS could go to public records of this nature to obtain information to adjust tax returns.

Judges also become a variable in the risk assessment. Judges are not bound by rules of confidentiality. Therefore, they could refer the parties to the IRS or require them to file amended tax returns. There may be laws, policies or individual quirks that govern whether or not a judge will interact with the IRS. Investigators should be aware of these factors. However, in reality, most judges are so overburdened that they do not consider becoming voluntarily involved with the IRS an effective use of resources.

The best way to avoid having any possible problems being made public is to make the adjustments to the income and then have the parties stipulate to the adjustments. This means that an investigator can have a one line adjustment on his or her income summary that says something as simple as, “Income Adjustment.” By agreement, neither attorney asks about the adjustment during trial, and the problem is not made public.

HEADS UP: In a situation similar to that outlined above, I did have one judge ask me about the adjustment. I simply told him that the adjustment represented items that the parent had claimed on their tax return that were not allowed in computing child support. If he had asked me what the IRS would think about the items that had been claimed, I would have told him the truth: “I don’t know.”

HEADS UP: The IRS makes provisions for spouses of taxpayers who misstate their tax returns. Depending upon the circumstances, the IRS may determine the spouse is innocent of any liability for the misstated return. They may also separate the liability between the couple or may make a decision based on equity (what is fair in the circumstances). These categories are called respectively, Innocent Spouse, Separation of Liability, and Equitable Relief. The provision can be used to elicit cooperation from an otherwise reluctant spouse of the business owner. For further information, refer to IRS Publication 971).

INTERVIEWING

The key to interviewing is to establish a rapport with the party being interviewed. This is most easily accomplished by being friendly, straightforward, and respectful. Most parents are not criminals and do not deserve to be treated as such. It also helps to quell the fears of the parent being interviewed. A father who owns a business, for example, fears that the investigator will make ridiculous adjustments to his income that will result in child support payments that he cannot make. An investigator can relieve such fear by saying, “I’m basically here to establish a fair amount of child support. I don’t want you in the situation where you have to pay too much, and I certainly don’t want your children hurt by not having enough money to live on.”

The other fear the parent may well have is that, as indicated above, the parent’s tax return may not be in compliance with IRS regulations. The parent fears that he or she will have to deal with the IRS, or explain the tax return to the court, or both. The investigator can assure the parent, “I don’t care how the tax return was filed. I don’t know how the IRS would treat any given item in your tax returns. My job is to determine income for child support. I have to insure that all of the income is reported and all of the business expenses are really business expenses.” That’s it. My investigation is confidential. I can’t share the information with anyone but the parties involved.

Interviewing is about asking questions to ascertain certain information, but it is also about listening. Asking open ended questions or general questions gives the person being interviewed a chance to talk about other things that they may consider important.

Battle Lines

What Rentals?

I was meeting with the bookkeeper for a realtor. We had finished going through the income of the business and I was gathering up my stuff intending to address the expenses the next day. Keeping the conversation going with the bookkeeper I said, “Well, that wasn’t too bad was it? We got all of the revenue done in a couple of hours. It’s nice when it’s all on computers isn’t it?

She agreed and added, “It’d be nice if it was all on the computer.”

I stopped loading my stuff and asked, “It’s not all on the computer?”

She responded, “Isn’t rental income, income for child support?”

I responded that it was and simply asked, “Is there something you want to tell me?”

She said, “The checks from the rentals are being taken by the owner and cashed, but you can’t tell him I told you.”

“What rentals?” I asked.

The conversation went on for a bit, and I got enough information to know what to look for. The next day armed with the knowledge that there were rentals, I searched the expenses for items that were related to the property. Then, with that evidence in hand, I asked the business owner, “I seem to have expenses related to rental property that you own. However, I can’t see where the revenue is recorded. Can you help me?”

I had to hand it to the owner, he didn’t flinch. He took about ten seconds to assess the situation and looked straight at me,”You won’t find the revenue on the books.”

“OK,” I said, “How much do you collect from the rentals?”

He told me and I made the adjustment. He assumed that I had received my knowledge of the rentals from the expense review.

In conclusion, interviewing is an art that is developed through practice. Simply put, the more you do of it, the better you get. However, friendliness and curiosity will often take experienced and inexperienced investigators where they need to be.

GETTING INFORMATION FROM OTHER SOURCES

The discussions to this point have addressed getting information through the usual channels. That is, mainly through the discovery process and interviewing those individuals with relevant knowledge such as parents and bookkeepers. However, there are numerous other means of getting information that investigators can use in their pursuit of facts and information. For example, many times investigators run into problems interpreting parents’ pay stubs. This is because space is limited on the documents, and they are usually designed by computer programmers. Therefore, abbreviations and acronyms are common. This means that the investigator may not understand what line each line item represents and therefore will not know whether or not it is relevant to his or her investigation. The investigator can most certainly go through the discovery process and wait weeks or months for a response. Or the investigator can simply call the employer. The telephone conversation may sound like the following:

Investigator: Hi, I’m Nick Bourdeau. I’m working on a child support calculation for one of your employees, and I don’t understand some of the line items on his pay stub. I was hoping you could help me. He wants the calculations done right away, so he can get divorced.

[NOTE: I did not say I was working for an attorney. I did not say I was working for the mother, and the father was the employee. I did not say the employee’s name. Nothing I said was untrue. I am friendly, and I am slightly urgent in my request.]

Bookkeeper: I’m sorry. All of the information concerning our employees is confidential. Unless you have written permission, I can’t give out any information.

Investigator: I understand completely. I don’t have permission to talk to you either, so we’re in the same boat. We can’t talk about a specific employee, but we can talk about things that are common to all the employees. All I need is to understand some of the abbreviations on the pay stub. You probably know what they are because they are on your pay stub. Can you please help me? I need to get this done so they won’t yell at me.

[NOTE: I put myself on the same level as the bookkeeper as far as confidentiality was concerned, eliminating her fears about getting in trouble. I didn’t have permission to talk to her because I hadn’t asked for it. I again plead for help expressing some urgency.]

Bookkeeper: Like what?

Investigator: Well, I think I know what FICA, and Medicare, but what about WWPL?

Bookkeeper: Pension Plan. All employees are required to participate.

Investigator: Ok, great. What about GGPA?

Bookkeeper: What did you say, “GGPA?”

Investigator: That’s right. Strange, huh?

Bookkeeper: That is strange. What’s the employee number?

[Right there the bookkeeper crossed the line. We went from talking about general entries on pay stubs to specific entries on one pay stub. However, I do not pause.]

Investigator: 97-2536

Bookkeeper: One second. Oh, that’s a bonus incentive for productivity. It’s associated with a large contract we got this year. If the employees beat certain completion guidelines, they receive bonuses.

Investigator: Will the employees on the contract continue to receive bonuses?

Bookkeeper: Probably. The managers are getting bonuses too. Word has it they will make sure that they get their share of the bonuses.

[NOTE: I obtained income information about a specific employee by starting to ask questions in general. I learned that the employee was involved in a specific contract and would be receiving additional revenue from it in the future.]

Investigators can commonly get more information that they are strictly entitled to by being friendly, respectful, and expressing a small amount of urgency. In addition, human nature being what it is, simply asking for help triggers a sympathetic response in most people.

However, investigators should be very cautious about obtaining information through deceit. For example, investigators may find themselves in court explaining how they lied to get information. This will immediately throw their credibility into question: “You lied to get this information. How do we know you are not lying now?” In addition, there may be state or federal laws protecting individuals in some circumstances. If an investigator lies, he or she may end up the target of an investigation instead of conducting one. When in doubt concerning the consequences of a particular line of inquiry, investigators should consult with the attorney on the case or their own attorney.

VARIANCE ANALYSIS

When analyzing a number of years of tax returns, investigators often perform a formal or informal variance analysis. This means that they compare line items from year to year noting significant changes. In the formal approach, the investigator mathematically compares individual line items. For example, in the last year of operation the business recorded supplies expense of $8,124. In the previous year it had recorded expenses of only $5,369. The mathematical comparison would be:

(8,124 – 5,369) ÷ 5369 = .51 or 51%

This mathematical comparison is done for each line on the tax return. The investigator then sets a percentage amount that will be reviewed. If that percentage amount is 20%, for example, the contents of the supplies expense would be reviewed. An informal review means that the investigator simply scans the tax return analysis and reviews those items that stand out.

Variance analyses will sometimes reveal items that create adjustments that are valuable in determining income for child support. More often than not, they reveal changes in, or misclassifications of, items within the line item. For example, in the example above, the difference could be caused by computer supplies, which were previously in miscellaneous expense, being moved to the supplies line item. Changes in classification or even errors in classification do not affect the allowability of a cost. That is, if the cost was necessary for the generation of the income of the business, it is allowed. If it was not, then it is added back to income.

Battle Lines

Very Taxing

I was reviewing the records of a small machine shop. I scanned the analysis I had prepared and noted that taxes expense increased from around $5,000 to about $14,000. Taxes incurred by a sole proprietorship (entered on Schedule C) are not income taxes. They may be the taxes on the real estate on which the business operates or on the vehicles that the business runs. Therefore, these taxes shouldn’t vary significantly from year to year. Review indicated that the owner had recorded his quarterly estimated tax payments, (1040-ES remittances), for his personal income taxes within the tax expense of the business. These expenses, under no circumstances, are expenses of the business

At this point, I could have regrouped and performed a formal variance analysis of all of the expenses and then analyzed all accounts over a certain percentage change. However, I considered that if the owner had made this type of entry, then all expense items had the potential for erroneous entries. Instead, I chose to perform a detailed review of the check register, questioning everything over a year’s period that looked like it didn’t belong. I was correct: the owner had buried personal expenses throughout the expenses of the business.

INTERNAL CONTROL

Businesses have systems that are designed to protect the integrity (accuracy) of the records of the business and its assets. These are essentially systems of checks and balances. For example, at the end of the day, the total cash in a check-out clerk’s till is added up and compared to the total rung up on the till. If they do not balance, then the business owner knows something is wrong. Either the clerk has taken cash from the register, or the clerk has made a mistake. In either case, the difference prompts an inquiry that serves to protect an asset of the business (cash) and the records of the business (total sales). The systems of internal control in a business can be very simple, as in the example, or very complex. In general, smaller businesses have simpler systems of internal control that get more sophisticated as the business gets larger.

The child support investigator is seeking those systems which are in place that assure that the revenue of a business is all reported and that the expenses claimed are associated with the operation of the business.

For example, assume that a business that deals with a lot of cash is being investigated. Assume also that the bookkeeper of the business records as income the sales that are generated by the business each day. Any differences between cash that should be in the till and sales is charged to the owner’s draw account. This means that even if the owner is taking cash from the business, the total sales of the business are not being understated. If however, this system was not in place, there could be a significant risk of income being understated.

Some businesses do not deal in cash. All of the payments received are in the form of checks. In those cases the investigator’s review of unreported income might be limited. If the business is dealing with regular customers, pulling a check out and trying to cash it without reporting it creates significant bookkeeping problems. That is, the accounts receivable for the customer will not be properly credited, and the business could run into trouble with the customer. Even if the business does not deal with regular customers, cashing checks is a problem. This is because banks generally refuse to cash business checks.

The presence or absence of internal control from the perspective of the investigator can also be assessed from the form of the business and its owners. For example, if there are two or more partners in a partnership, an investigator might consider that internal control will be adequate. This is because generally partners watch each other. For example, a partner might be expected to protest if another partner paid for his babysitter with a company check. This isn’t always true. Sometimes partners will agree to pay personal expenses out of the business. In those cases where the partners are related, for example two brothers, the investigator should assume that no internal control is being provided by the form of the business or its owners.

Larger businesses with many owners usually provide the investigator with the most assurance that the internal control is adequate and the revenue and expenses are being handled correctly. In a small business, an owner has no one to answer to. If he directs that an income item not be reported or personal expenses charged to the business, he has no one to tell him that he can’t do it. In a large business, there are many owners and employees who will challenge inappropriate accounting activities.

In some cases the investigator will find that even in small businesses one or two employees will not tolerate improper accounting in spite of the wishes of the owner. Unfortunately, the only way to determine the existence of these individuals is to get into the business, interview them, and test their work. See Bookkeepers in Chapter 18, The Players and the Stages.

CREDIT CARDS

Many businesses use credit cards as an integral part of their operation. The most common use of credit cards is for employees or owners when they are traveling. However, the cards are handy sources of immediate purchasing power or even cash. Therefore, prudent or not, the cards may be an integral part of the actual financing of the operation.

The expenditures made by the cards are subject to the same scrutiny as purchases paid for by check. However, credit card use in a business may add an additional layer to the investigation. For example, a questionable checking expenditure starts with its identification in the check register and then the pursuit of supporting documentation which supports or denies its claim as a business expense. The credit card expenditure starts with its identification in the check register. Then credit card statements have to be obtained because the detail in the check register is insufficient. From the statements the investigator selects questionable items. Then supporting documentation is obtained on the questionable items. The additional steps take time and cost money. However, due to the universal versatility of the cards, material expenditures should be examined.

MATERIALITY

For as long as there have been accountants, they have struggled with the concept of materiality. In essence, materiality means whether or not a particular item makes a difference or not. For example, a mistake of $1,000 in sales on financial statements will not make a difference (be material) to a banker making a loan if total sales of the business are $9,888,943. The error is called immaterial, and it will have no effect on whether the business gets the loan or not. However, issues of materiality are not always as obvious as in the example.

Not only is the concept uncertain, it is also relative. For example, a drop in income of $150 per month is probably not material to someone who has income of $4,500 per month. It is definitely material to someone who only has $790 of income per month.

Investigators are always faced with the economic trade offs that are inherent to child support income investigations. That is, they have limited time and resources to make the adjustments necessary to compute a fair amount of child support. However, making the adjustments to perfect income would probably require recreating the books and records of the business. This is not practical, nor is it possible. Therefore, experienced investigators will recognize the reality of the situation and pursue those adjustments that will give them the highest increases to income with the least effort. They also recognize that they will never find all of the adjustments.

In conducting child support determinations, investigators should also be aware of the materiality perceptions of the parents. What may seem insignificant to an investigator may be perceived as monumental to a parent and derail the lines of communication between the parent and the investigator. The best way for an investigator to handle the situation is to recognize the feelings of the parent, but also educate the parent as to the realities of the situation. See Battle Lines for an example.

HEADS UP: There are some individuals (most probably attorneys) that will protest that I am only looking for adjustments that will increase income. Well, let’s think about it. How many business owners seek to overpay their taxes? At a minimum, owners religiously take every exemption they are entitled to. Not to do so may jeopardize the existence of the business and is frankly, just stupid. So consequently, I rarely see deductions that owners have failed to claim. If I do find them, I allow them. The goal does not change based on perspective; I am still trying to determine a fair amount of child support.

Nicholas L. Bourdeau has been practicing in the area of forensic accounting since 1986. He has appeared in court over a 150 times on issues associated with the valuation of marital estates, businesses, child support, maintenance, pensions, fraud, and damages. He has been a contract instructor for the State of Montana Child Support Enforcement Division and consulted with the Division’s Guideline Revision Oversight Committee. In addition to being a CPA, Bourdeau is accredited in Business Valuations by the AICPA and is a Certified Fraud Examiner under the Association of Certified Fraud Examiners. He is the author of The Determination of Income for Child Support, from which this article is excerpted.