Properly Determining Income for Successful Divorce Financial Settlements

As Certified Divorce Financial Analyst (CDFA®), one of the most critical aspects I support in divorce cases is understanding and calculating the various types of income that play a pivotal role in financial settlements. This post aims to shed light on the different types of income considered in divorce financial settlements and how these differ from the income definitions used by the IRS.

Types of Income in Divorce Financial Settlements

When determining financial settlements in a divorce, courts aim to ensure a fair distribution of assets and income between the parties. To achieve this, a comprehensive understanding of all income sources is essential. Here are the primary types of income considered:

Earned Income

Salaries and Wages: This is the most straightforward type of income, including regular salaries, hourly wages, bonuses, and commissions.

Self-Employment Income: For those who run their businesses or work as contractors, self-employment income comes into play. This includes net profits from business operations, consulting fees, and freelance work.

Unearned Income

Investment Income: This category includes dividends, interest from savings accounts, and income from other investments like stocks and bonds.

Rental Income: Income generated from rental properties is a significant consideration. This includes rent received minus allowable expenses.

Passive Income

Royalties: Royalties from intellectual property such as books, music, patents, and trademarks are included.

Capital Gains: Profits from the sale of assets such as real estate, stocks, or other investments fall under this category.

Other Income Sources

Retirement Benefits: Pensions, 401(k) disbursements, and other retirement benefits are considered in the settlement.

Social Security Benefits: In some cases, social security benefits may also be included, especially if one party is already receiving them.

Alimony and Child Support: Any alimony or child support received from a previous marriage is also factored in.

Differences Between Divorce and IRS Income

While the types of income considered in divorce settlements may seem similar to those recognized by the IRS, there are noteworthy differences in definitions and inclusions.

Gross vs. Net Income

For IRS purposes, the portion of ‘total income’ included in Line 1a of Form 1040 excludes pre-tax deductions such as health, dental, and vision insurance, retirement contributions, and flexible spending accounts. The IRS only includes taxable wages, tips, and other compensation for federal income tax purposes.  However, some aspects of divorce settlements (such as child support) include pre-tax deductions.  In many cases, this means that the IRS uses Box 1 of an employer’s W2 form and divorce settlements use Box 5.

Business, Rental, and Farm Income

The IRS considers profits to define taxable income from business ownership, rental properties and farming activities.  Divorce settlements consider cash flow.  A major difference involves capital equipment annual depreciation (profit) versus capital equipment expenditures for a given year (cash flow).   Also, the IRS may tax aspects of retained earnings in different years than they are distributed to a recipient as cash flow.  Family law frequently allows only ‘reasonable business expenses’ to be deducted from revenues, so Baron Analytics frequently performs financial forensics and works with law firms that are skilled with arguing the ‘reasonableness’ of business expenses… and the courts may rule differently than the values of expenses filed in tax returns.

Non-Taxable Income

Certain types of income that might not be taxed by the IRS are still considered in divorce settlements. For example:

Municipal Bond Interest: While interest from municipal bonds is typically tax-exempt, it is still considered income in divorce settlements.

Life Insurance Proceeds: The IRS often excludes life insurance proceeds from taxable income, but courts may include these in the financial assessments for divorces.

Gift and estate Income: The IRS includes various exclusions for which gifts, inheritances, and estate transfers need not be declared nor taxed.  However, all wealth gained from these sources are considered as income for divorces in most states.

Spousal and Child Support: The IRS disregards spousal and child support payments.  However, support payments from prior relationships are considered as income for divorces in most states.

Imputed Income

In divorce proceedings, courts may impute income to a party who is unemployed or underemployed, based on their potential earning capacity. The IRS does not impute income; it only considers actual income received.  Imputed income can derive from underemployment, from incorrectly represented income, or from inequitably deferred income.

Underemployment: While vocational experts commonly are used when assessing underemployment, analytics can show statistical variations in income correlated with events such as date of separation.  This can be valuable for spouses that are paid hourly.

Incorrectly Represented Income: Clients sometimes claim that a spouse has throttled business performance to reduced income and marital equity in the business supposedly to advantage a divorce settlement. Similar to ‘Underemployment’, analytics can show business performance trends and compare changes in trends to business or personal events or situations.

Inequitably Deferred Income: Executives have more influence with how they structure and time their compensation.  They have more opportunity to change terms of bonuses and vesting schedules to defer compensation until after a divorce. Analysts can perform forensic reviews of compensation agreements to value, timing and present value of these deferred compensation.

Fringe and Other Benefits

Certain non-monetary benefits, such as company cars, health insurance, and stock options, may be considered part of income in a divorce settlement, even though the IRS may not tax these benefits.  Likewise, loyalty points may be disregarded by the IRS but considered as income for divorces.

The Role of Forensic Accountants

In complex divorce cases, forensic accountants play a crucial role to estimate and understand each spouse’s income. As an experienced and certified divorce financial analyst (CDFA®), Baron Analytics helps uncover income sources, evaluate the income gained from business ownership, quantify imputed income, and provide expert testimony on income and asset valuations. Our income intake template includes over 50 different types of income to better capture all different sources of income. Our business valuation model includes a detailed forensic to recognize and challenge profit versus cash flow through a ‘reasonableness’ lens. Our expertise ensures that all income sources are accurately identified, defensibly quantified, and fairly included in the financial settlement.

Conclusion

The calculation of income for divorce financial settlements is a multifaceted process that requires a thorough understanding of various income sources and their implications. While there are overlaps with IRS definitions, key differences must be recognized to ensure a fair and equitable distribution of assets. As accountants, our role is to navigate these complexities, provide accurate assessments, and contribute to a just resolution for both parties involved in the divorce.

Understanding the types of income used in divorce financial settlements and how they differ from the IRS’s definition of income is crucial. By recognizing these distinctions, Baron Analytics can better assist in achieving fair outcomes that support the financial well-being of our clients post-divorce.