Dividing S-Corp Retained Earnings

by Wes Cowell; updated 2 October 2015 -- suggest a corretion

 

Where one spouse holds shares in an S-Corp., the corporations retained earnings may be characterized as marital or non-marital — it depends on several factors.  Need advice?  Call, leave your info, or schedulescheduleschedule a consult.

 

Profits of an S corp. may be passed on to the shareholders, or may be retained by the business as an asset, called “retained earnings.”  Each shareholder has an interest in any retained earnings.   For shares characterized as “marital,” the treatment of retained earnings is easy:  the shareholding spouse must compensate the non-shareholding spouse for his or her portion as allocated by the court or settlement agreement.  In a case where marital property is divided 50/50, for example, the shareholding spouse must compensate the non-shareholding spouse for 50% of the shareholder’s interest in the retained earnings.

 

Things get complicated, however, for shares characterized as “non-marital” property.  The problems arises from the Illinois divorce law that says that when a spouse contributes personal effort to non-marital property, the marriage has a right to be reimbursed for the spouse’s effort.  For example, consider a marriage where one spouse owns non-marital shares in a closely-held business.  During the marriage, the spouse is compensated for the work performed at the business.  The effort expended is a kind of marital asset.  The compensation for the effort is, likewise, a marital asset.  Another product resulting from the effort, however, may be an increase in the business’s retained earnings.  Those retained earnings can increase the value of the spouse’s shares, they may be held by the business, or may be passed on directly to the spouse as a distribution.

 

Does the marriage have a claim to a portion (or all) of the increase in value of the non-marital shares?   Does the marriage have a claim to a portion (or all) of the retained earnings – even though the marriage owns no shares in the company and the only connection is through the spouse’s non-marital shares?

 

The retained earnings themselves may not be divided between the spouses.  They are non-marital property and belong solely to the shareholding spouse.  The effort that went in to producing those retained earnings, however, may trigger the kind of analysis above, and may require the shareholding spouse to reimburse the marriage for the effort that resulted in the retained earnings.  Illinois law provides:

 

When a spouse contributes personal effort to non-marital property, it shall be deemed a contribution from the marital estate, which shall receive reimbursement for the efforts if the efforts are significant and result in substantial appreciation to the non-marital property, except that if the marital estate reasonably has been compensated for his or her efforts, it shall not be deemed a contribution to the non-marital estate and there shall be no reimbursement to the marital estate.  The court may provide for reimbursement out of the marital property to be divided or by imposing a lien against the non-marital property which received the contribution.

750 ILCS 5/503(c)(2)(B)

 

 

 

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