Are Retained Earnings of Sub-S Corps Fair Game for Child Support?

The issue of whether a certain type of business profit should be considered personal income for support purposes has always been a difficult one. A recent Illinois Appellate Court decision may have clarified the issue.

Since a sub-S corporation is a pass-through entity, this corporate structure is often utilized in small businesses for federal tax purposes. The business does not pay income taxes at the corporate level. Instead, the income is directly passed through to its shareholders based on their ownership interest and the shareholders pay taxes on their allocated portion of the earnings. The shareholders, in turn, pay taxes irrespective of whether the income is actually distributed to them personally. Making things more complicated, it is not uncommon for sub-S corporations to make distributions in an amount necessary only to cover the tax liability since taxes are owed irrespective of whether a distribution is made.

The inherent challenge with such closely-held companies, especially where one of the litigants is a majority owner, is that there is arguably an ability of the owner to manipulate income and hold back earnings in the business in an effort to reduce his or her support obligation. This exact issue went up on appeal in Illinois in the case of In re Marriage of Moorthy and Arjuna, 2015 IL App (1st) 132077. A mother filed for an increase in child support eight (8) years after the original divorce. The mother took the position that the business profit the father kept in the business year after year (retained earnings) should be imputed to him as income for the purpose of calculating child support. In contrast, the father argued that historically he never made any distributions except to pay taxes and that he needed the funds as working capital to keep the business afloat.

In a case of first impression in Illinois, the Moorthy Court held that a fact-specific analysis should be done in each case in order to determine whether retained earnings should be imputed to the sole or majority shareholder for purposes of calculating child support. Id. at 14, ¶ 64. Accordingly, when doing this analysis, the court should evaluate the following factors:

  1. The extent of the obligor’s ownership share in the corporation.
  2. The obligor’s ability to decide whether corporate earnings should be retained or distributed.
  3. The corporation’s history of retained earnings and distributions, in comparison to post-divorce corporation activities.
  4. Whether the retained earnings are excessive.
  5. Where there is evidence that income is actually being manipulated.

Applying these factors in Moorthy, the Court declined to impute the company’s retained earnings as personal income to the father – and thus, he was not required to pay child support on those earnings. However, it can be asserted that presumably, if a shareholder is in a position to unilaterally determine whether earnings should be retained or distributed, a closer analysis of the last three factors will need to occur.

Therefore, in making the argument that earnings should be imputed as personal income to the payor, a support recipient will need to seek discovery in order to be able to show the court the history of the company’s retained earnings and analyze whether those earnings are “excessive” based on the business’ current operations. Moreover, the support recipient may also be able to make the argument that if some shareholders are receiving distributions and the support payor is not, income is being manipulated. This is significant because in Moorthy, the Court noted that the mother did not present any evidence to contradict the father’s lengthy testimony that he needed to maintain the earnings as working capital for expenses throughout the year which included the following:

  • Contracts he was obligated to pay even if there were no projects available to be billed out;
  • Business expenses that the company had with respect to some of the contract employees;
  • Payroll, wages, taxes, insurance and other obligations of the company.

Going forward post Moorthy, when a closely held company is involved, in order to successfully assert the position that the retained earnings should be imputed as income, the support recipient may need to hire an expert to opine on whether the earnings are in line with what the business’ needs are and to give an opinion on whether there is any evidence that income is being manipulated. A business owner, on the other hand, will need to be prepared to support his or her arguments as to why the company must retain the earnings as working capital.

The amount of money that a closely held business generates post-divorce has often been a complicated issue. With the Moorthy case, however, both the parties and their attorneys now have some concrete guidance on what a court must evaluate when considering whether money held back in a business should be imputed for calculating support. Although Moorthy dealt solely with the issue of child support, the holding would presumably be extended to maintenance/ spousal support as well.