Small Business Income and
Subchapter S-Corps

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

 

When a small business owner leaves profits parked in the business, it's a case-by-case fight whether those "retained earnings" count for child support. The court applies heightened scrutiny in caes where the obligor controls distributions.  Need advice? Callleave your info., or schedulescheduleschedule a consult.

 

Nearly all small businesses are "subchapter S-Corporations," or "S-Corps."  Big businesses must pay tax on their profits; S-corps do not -- profits in an S-Corp simply pass on to the owner and are counted in the owner's income when calculating income taxes.  The payment of profit to the owner is called a "distribution" and it is reported to the I.R.S. on a K-1 form just like payroll income is reported on a W-2 form.  Profits may be distributed to an owner throughout the year -- if there's enough profit in the business and the owner wants some, he can just grab some and it will be reported to the I.R.S., later.  A small business owner may receive a salary of, say, $100,000.  Throughout the year the owner may take, say, an additional $75,000 in little dribs and drabs every few days.  At the end of the year the business may have a profit of, say, $225,000, which the owner then takes at the end of the year.  The owner would receive a W-2 reporting $100,000 in income and a K-1 reporting the $300,000 distribution, for a total income of $400,000.

 

Sometimes, however, instead of taking all of the profits each year small business owner's leave some of the profit sitting in the business (called "retained earnings") to ensure its continued growth and to cover overhead expenses in the event of a downturn.  That money left in the business -- the retained earnings -- is still reported to the I.R.S. as the owner's income just as if it were a distribution that went in the owner's pocket.  To anyone looking at the tax forms, it looks like the owner had a lot of profit going into his pocket.  The owner, however, receives only some in his pocket . . . and the rest stays with the business to cover possible, future expenses.  So, if a small business owner is supposed to pay child support, we know that the salary is "income;" and we know that the money received as distributions is "income;" but what about the retained earnings the owner VOLUNTARILY leaves parked in the business?

 

Moorthy v. Arjuna:  That was the problem in Moorthy v. Arjuna, 2015 IL App (1st) 132077 (Ill. App., 2015).  Moorthy and Arjuna married in December, 2000; had a daughter in March, 2002, and divorced in June, 2003.  Moorthy was awarded sole custody of the child and Arjuna was to pay 20% of his net income from the salary he received from a family-owned, IT consulting business called Mahantech Corp.  In 2006, Arjuna received about a third of the business as the stock was then worthless.  In 2007 the company nearly went broke and Arjuna paid $500 to buy 91% of Mahantech from a relative.  In May, 2011, Moorthy went back to court to seek an increase in child support and the issue finally made it to a hearing a year later in May, 2012. 

 

The evidence showed that over the years since the divorce, his salary remained at $50,000.  His annual K-1 distributions, however, were 2008: $91,071, 2009: $117,967,  2010: 117,281, 2011:  $25,429.  All divorce lawyers will share my assessment that "I'm shocked, shocked to find" Arjuna's income plummeted just at the time Moorthy filed her petition to increase support.  Moorthy pointed to the K-1s and argued that Arjuna received more than $100,000 in income each year that hadn't been included in the support calculation.  It seemed like her request to increase support was a slam-dunk.

 

Arjuna explained that he didn't pocket all that money.   Although he had to pay taxes on it (actually his business paid the tax on the retained earnings), it stayed parked in the business.  The only money he took home was his $50,000 salary.  Arjuna said he needed to leave the retained earnings parked in the business and it should not be counted as part of his "net income."  He needed the money to cover expenses for his employees; expenses that were unpredictable and could be huge.  He explained that his business wrote computer code for information networks and he needed to bring in employees, and their families, from India on visas.  To do that, he had to follow all kinds of immigration rules and that meant paying all kinds of filling fees and attorney fees.  He had to pay the employees whether the work contract continued or was cancelled.  If the customer cancelled the contract or stopped paying invoices, immigration rules said that Arjuna could not lay off his employees; he had to keep paying them.  Worse, the only way he could terminate an employee before the end of their commitment, was to pay to fly the employee and family (and all their possessions) back to India.  Arjuna said he needed to keep the extra money in the business to cover these expenses when they popped up from time to time.

 

The trial court agreed with Arjuna.  Moorthy appealed.

 

The appellate court analyzed more than a dozen cases from Illinois and other jurisdictions and affirmed the trial court's ruling.  The Appellate court said:

 

"courts should engage in a case-by-case, fact-specific analysis to determine whether retained earnings of a corporation should be imputed to the sole or majority shareholder for purposes of calculating child support.  Relevant factors in this analysis include: (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 corporations' history of retained earnings and distributions, in comparison to post-divorce corporation activity, (4) whether the retained earnings are excessive, and (5) whether there is evidence that income is actually being manipulated."

Moorthy v. Arjuna, 2015 IL App (1st) 132077 (Ill. App., 2015).

 

The other Illinois cases analyzed in Moorthy are:

 

In re:  Marriage of Joynt, 375 Ill.App.3d 817, 847 N.E.2d 916 (3d Dist., 2007):  This is a property division case, not a child support case.  Michael Joynt held a 33% interest in an S-Corp.  He didn't have control over the distribution of retained earnings.  THe retianed earnings were mostly used for legitimate corporate expenses.  His compensation was fair and there wasn't any indication he was using the S-corp to hide income in the form of the retained earnings.  The retained earnings held to be Michael's non-marital property for purposes of property division.  By extension, retained 

 

In re:  Marriage of Lundahl, 396 Ill.App.3d 495, 919 N.E.2d 480 (1st. Dist., 2009):  This case is the opposite of Joynt.  Here, Daniel Lundahl 

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