In March 2010, Howard’s Article “Use of Forensic Accountants in Family Law Cases” was published in the Family Law Forum, an electronic publication of the Family Law Section of the North Carolina Bar.
Howard’s article is educational for lawyers and discusses how and when Forensic Accounting is beneficial in equitable distribution cases.
Use of Forensic Accountants in Family Law Cases
A typical family law case involves issues of custody, child support, spousal support (PSS and alimony), and equitable distribution. No matter how large or small the incomes and estates all of these cases involve the same issues and require the same legal and factual analysis.
When speaking with perspective clients I often describe the purpose of North Carolina’s laws relating to the dissolution of a marriage as the system by which a family’s financial affairs are restructured as a result of the end of a marriage.
With the possible exception of child custody all of the legal issues cited above have as their primary focus the financial structure of the family. The family’s income streams, debts, and assets must be understood and gaining this understanding requires a careful analysis of the financial aspects of each family experiencing divorce.
With rare exception I insist that my clients retain a forensic accountant to assist both them and me as we pursue the clear understanding of these matters necessary to effectively negotiate a settlement or present the issues for trial. I want this forensic accountant retained as soon as possible after I am retained so that he or she can become an integral member of the team that will be representing and advising my client. In my practice the team consists of me, my paralegals, the forensic accountant, and my client.
To be sure, in some cases other experts are necessary to appraise real estate interests, art work, jewelry, etc. but these experts seldom become a central member of the team. Forensic accounting is sometimes described simply as accounting that is used in a legal setting. This self evident observation however does not describe a critical aspect of forensic accounting that you must consider when assisting your client in the selection of an appropriate forensic accountant. A forensic accountant used in a litigation setting must be a willing and effective witness in depositions or trials. Another critical attribute of an effective forensic accountant in the divorce setting is that the accountant be willing to work closely with the lawyer and client throughout the handling of the case.
I have limited use for a forensic accountant that is satisfied to define an assignment, produce a report and then simply wait to be called as a witness. I want the forensic account to attend depositions of other witnesses that may be testifying about the financial aspects of the marriage, attend the mediation, and attend settlement conferences where any of the financial aspects of a potential settlement will be seriously considered.
What skills does a forensic accountant bring to the table? In my experience the forensic accountants (that I use and that have been used by opposing counsel in my cases) are certified public accountants (CPA’s) that have as a significant part as their practice working with attorneys in litigation support roles. In essence, forensic accountants analyze money. By shifting through sometimes complex financial documents, forensic accountants help develop an accurate assessment of the relevant financial situation. The forensic accounts with which I work also maintain a tax practice and are invaluable resources for analyzing the often complex tax issues that arise in handling divorce cases. Moreover, the forensic accountants with whom I am familiar with are also experienced and certified in business valuations.
I have also been privileged to work with a number of forensic accountants that have a great deal of real world experience in helping their clients with various transactions unrelated to litigation. These accountants have often assisted clients with business acquisitions, business mergers, business sales, partnership dissolutions, financing arrangements with both public and private lenders, and a myriad of other commercial transactions that are not driven by pending or threatened litigation. Since I want the accountant to be a part of the team this real world experience in structuring different types of commercial transactions can provide a number of tools, options, ideas, and insights into various approaches to the settlement or trial of cases.
In some cases, particularly those that may involve complex business valuations, you may want more than one accounting expert. For example, you may want a business valuation expert that has particular expertise in the valuation of the business or other commercial enterprise at issue in the case but perhaps does not possess the other skills or training necessary to provide the forensic accounting, tax advice, and settlement and litigation strategy assistance. Nevertheless, I maintain that in most cases if you carefully select the proper accountant you can find all of these skill sets in one package.
Particular Applications of Forensic Accounting
The North Carolina Child Support Guidelines were designed to accomplish several public policy goals; included among them was to bring some uniformity to the establishment of child support as well as simplicity in the calculation of child support. To a large extent these guidelines have accomplished these goals. Nevertheless, many cases present us with child support questions, the answers to which are not readily apparent.
The child support guidelines provide a rebuttable presumption but the Court on its on Motion or either party may move for a deviation from the guidelines. The party seeking the deviation must generally establish that an application of the guidelines would not meet, or would exceed, the reasonable needs of the child considering the relative ability of each parent to provide support. Whether proposing the deviation or defending against a proposed deviation the most critical evidence for most Judges is going to be “the reasonable needs of the child for support”.
This requires a careful analysis and presentation of evidence relative to the financial needs of the child or children. The most customary evidence upon which these findings are based is the actual past expenditures made by the family in supporting the child or children. In turn, this generally requires a lifestyle analysis. A forensic accountant can be called upon to create a detailed picture of a family’s financial lifestyle by investigating and accounting for the flow of cash through the marriage. This analysis can account for how and at what rate funds were spent during the marriage and identify with particularity those expenses allocable to the support of the child.
The child support guidelines also make clear that in cases in which the parents combined adjusted gross income is more than $25,000 per month ($300,000 per year) the supporting parent’s basic child support obligation can not be determined by using the child support schedule. In such cases, the child support guidelines mandate that the Court determine child support on a case by case basis considering the reasonable needs of the children and the relative ability of each parent to provide support. Again, a lifestyle analysis is required in order to determine the financial needs of the children.
Here, as is also the case when a deviation is sought, the court must also consider the relative ability of each parent to provide support determining the ability of a parent to provide support necessarily requires a determination of each parent’s income and, in some cases, each parent’s assets. The analysis of each parents assets and liabilities can be best performed the forensic accountant.
The guidelines provide: “The schedule of Basic Child Support Obligations is based upon net income converted to gross annual income by incorporating the federal tax rates, North Carolina tax rates, and FICA. Gross income is income before deductions for federal or state income taxes, social security or Medicare taxes, health insurance premiums, retirement contributions, or other amounts withheld from income.” A not uncommon situation involves a parent’s receipt of tax free income–from municipal bonds for example. How is that income handled for the purposes of determining child support? It must be converted to gross income in accordance with the definition of income cited above. Who is best able to make this calculation and then persuasively present that evidence to the Court? A forensic accountant.
More commonly child support cases present challenges in determining a party’s income and the child support guidelines contain a rather lengthy and detailed definition of income. Case law has developed that expands and explains other aspects of income but in the final analysis for a proper determination of child support either pursuant to the guidelines or otherwise each parent’s income must be determined. Remember, forensic accountants analyze money. In particular they are adept at analyzing cash flows. With some exceptions cash flows more accurately reflect income than a tax return or wage statement. This is particularly true with self employed individuals, independent contractors, outside sales persons and those who generate income from passive sources such royalties, rental income from real estate, etc.
The forensic accountant’s abilities and skills in discovering and quantifying each party’s incomes and cash flows is often in an essential part of the proper analysis and presentation of the child support case.
The child support guidelines also assume that the parent who receives child support claims the tax exemptions for the children. In other words the amount of support contained in the child support schedule has been adjusted for federal and North Carolina State income taxes making the assumption that the party receiving child support is paying less tax by virtue of claiming the children as exemptions. The guidelines provide that if the parent who receives child support has minimal or no income tax liability the Court may require the custodial parent to assign the exemption to the supporting parent and deviate from the guidelines. Even without a minimal or no income situation, I’ve seen requests for deviation based on a reallocation of the dependency exemptions. How do you calculate the benefit to the obligor spouse of receiving the child support exemptions and the cost, if any, to the obligee spouse of losing the right to claim the children as exemptions? Your friendly forensic accountant of course!
Many cases involve issues of post-separation support and alimony. The statutes and case law developed therefrom delineate the rights of a dependent spouse to receive and the obligations of the supporting spouse to pay alimony or post-separation support. In either instance (PSS or alimony) there are number of factors for the Court to consider in determining the issues of entitlement, amount and duration of spousal support. Not all of these factors are purely of a financial nature but a central focus of all spousal support cases involves a detailed analysis of the relative financial positions of the parties.
Unlike our child support laws, there are no guidelines to determine the amount and duration of alimony or, indeed, even the entitlement to alimony.
A partial list of the economic factors present in spousal support cases is a follows:
- The relative earnings and earning capacities of the spouses; and
- The amount and sources of earned and unearned income of both spouses, including, but not limited to, earnings, dividends, and benefits such as medical, retirement, insurance, social security, or others;
- The standard of living of the spouses established during the marriage;
- The relative assets and liabilities of the spouses and the relative debt service requirements of the spouses, including legal obligations of support;
- The relative needs of the spouses;
- The federal, state, and local tax ramifications of the alimony reward;
- Any other factor relating to the economic circumstances of the parties that the Court finds to be just and proper;
- The fact that income received by either party was previously considered by the Court in determining the value of a marital or divisible asset in an equitable distribution of the parties’ marital or divisible property.
In my experiences any spousal support case requires a lifestyle analysis. As discussed in the child support section above this is clearly the province of a forensic accountant. An analysis of the parties’ expenditures for lifestyle expenses is indispensable in determining whether or not a purported dependent spouse is in fact, a dependent spouse and entitled to receive support.
Evidence with respect to all of the financial aspects of a spousal support case is best developed and presented with the use of a forensic accountant. Certainly, your client can testify with respect to many of these matters. I submit that this type of testimony is much less reliable and much less persuasive than the same information being developed and analyzed by a forensic accountant. Even in those rare circumstances where our client has the skills and analytical abilities necessary to perform the analysis their creditability will always be more suspect in the eyes of the Court or opposing counsel than that of independently trained and qualified forensic accountant.
In many cases the last factor mentioned above (commonly called the “double dipping” factor) presents unique opportunities for advocacy utilizing the knowledge and skills of a forensic accountant. For example, if in the underlying equitable distribution case the supporting spouses’ medical practice was valued and distributed as part of the marital estate it is highly likely that the valuation methodology used to value the medical practice involved an analysis based upon the projected future earnings of the supporting spouse from the continued operation of the medical practice. If the primary source of income for the supporting spouse is the post separation earnings from the ongoing practice of medicine should the Court exclude some or all of that income as being available to pay future alimony? Whether representing the dependent spouse or the supporting spouse explaining and quantifying this factor is exclusively the province of a forensic accountant.
As we all know there are tax ramifications to the payment and receipt of alimony. The Internal Revenue Code will often treat alimony as deductible to the payor and includable as taxable income to the payee. The Internal Revenue Code contains specific conditions which must be met in order to receive this tax treatment. I rely heavily on the forensic accountant for advice with respect to whether a particular settlement structure that involves the payment of “alimony” will or will not be treated as alimony for tax purposes under the internal revenue code. Your client needs to know without question whether or not the payments denominated as alimony will be treated as such by the IRS.
When evaluating a settlement that involves the payment of alimony that will be both deductible and includable or when presenting evidence to a Court as to the appropriate amount of alimony it is imperative that you be able to present evidence as to the taxes that will be due from the dependent spouse and the taxes that will be paid by the supporting spouse. For illustrative purposes consider a supporting spouse paying the maximum federal and state taxes and a dependent spouse with three (3) dependent children living with her and little or no other taxable income. A $5,000 alimony payment by the supporting spouse may result in an after tax “cost” of only $3,000. The same amount received by the dependent spouse may result in an after tax benefit (i.e. disposable income) of nearly $4,000 or more.
This information is critical for your client, the Court, and the parties. The only reliable way to perform these calculations and present this evidence to a Court or during mediation is with your forensic accountant.
We are seeing many cases involving either the establishment of spousal support or an alimony modification involving parties who are retired or very near retirement at the time of the determination. There have been some recent cases dealing with the difficulties presented in these circumstances. Generally, the problems I have seen involve the extent to which a supporting spouse might be required to deplete their assets in order to pay support. The converse is also becoming more frequently an issue. To what extent should we expect a dependent spouse to deplete their estate to provide for their own support if they are otherwise entitled to receive alimony? These cases uncertainly involve an analysis of incomes, expenses, etc. that are common to all spousal support cases, however, these cases also focus on the unique circumstance of parties who are retired and as part of their retirement planning in fact expected to begin to deplete their estates to provide for their retirement. The recent economic crisis has caused many of the estates to be depleted by 50% or more.
An analysis of the estates and the rate by which either the dependent spouse or supporting spouse estates would be depleted in order to continue to pay an existing or increased amount of alimony or receive an existing or reduced sum of alimony are critical inquires. A forensic accountant is invaluable in analyzing and quantifying these issues.
Dealing with motions to modify alimony also requires the analysis of incomes, expenses, and lifestyles with the added element of being required to determine whether or not there has been a substantial change in condition since the entry of the last support order. This requires that you determine the party’s incomes and expenses at the time the last support order was established. Sometimes this information is thoroughly outlined in the pre-existing support order but in my experience these orders are often entered by consent without extensive findings or the orders drafted were woefully inadequate in detailing the expenses and incomes upon which the prior support order was based. Here again the financial inquires we have outlined above must be developed and the evidence presented not only with respect to the parties current circumstances, but also with respect to their financial circumstances at the time of the entry of the prior order.
The issues presented in an equitable distribution case are perhaps the most fertile vineyard in which the forensic accountant labors. An analysis of any equitable distribution case requires four steps.
Identification: What do the parties own? You need a laundry list of everything owned by the Husband, the Wife, the two of them jointly, anything held in trust for their benefit, etc.
Classification: With respect to each asset you must determine whether it is marital property, separate property, or can be characterized as having both marital and separate components.
Evaluation: You must determine the net value (generally net fair market value) as of the date of separation. The better practice is to value all assets including purely separate property. In the event that there may have been any appreciation in the value of any separate property during the marriage you must then establish to what extent that appreciation is passive and to what extent it is active.
Distribution: How you divide the value of the marital estate between the parties not only involves the mechanics of the actual division of the assets but a determination as to whether or not there should be an equal or unequal division of the assets.
In addition to the assets discussed above you must determine the marital debts. Marital debts are those debts incurred during marriage that existed on date of separation that were incurred for a marital purpose. The qualifying language “incurred for a marital purpose” presents challenges in many cases. How do you trace the charges that have resulted in the several outstanding balances that existed on credit cards at the time separation in order to make this determination? The team member best suited for this task is the forensic accountant.
Dealing with issues involving divisible assets and divisible debt continues to baffle and confound. However, it is essential that we do an appropriate “accounting” with respect to economic activity and transactions that relate to marital property which occur after the date of separation and prior to the date of division.
A forensic accountant, especially one that has had experience with our equitable distribution process, can provide great value in each and every one of the issues identified above.
Often we represent the spouse that has not been involved in the financial management of the family’s affairs nor have they been involved in any family owned or operated business or professional enterprise. Finding assets, and, indeed, locating hidden assets and hidden income is an essential part of the analysis of many equitable distribution cases. This requires an extensive review of all types of financial information and documentation. Done properly, this requires the skills possessed by the forensic accountant.
The accountant can also perform many of the valuation tasks that are presented when one or both parties have an ownership interest in any business or professional enterprise. As mentioned previously in some cases it might be preferable to have a business valuation expert that has as their sole assignment the valuation of a business enterprise but in most cases I’ve have found that to be unnecessary.
Separate property issues also present complex financial problems. Because of the presumption that any assets acquired during marriage are presumed to be marital if you represent the party claiming that an asset is separate you have the burden of proof. This requires “tracing” the source of funds or the source of acquisition of the asset or assets in question. The forensic accountant is ideally suited to tell you what information is necessary to perform this tracing and thereafter to actually conduct a forensic analysis necessary to develop and present the evidence to support your contentions or refute those of your adversary.
If there are issues involving the appreciation (or depreciation) of a separate property interest what information is required to perform the analysis and who is best suited to perform it? With respect to such appreciation or depreciation to what extent has it been active or passive? All of these questions are within the expertise of the forensic accountant.
A recurring issue in equitable distribution cases involves separating the marital and separate components of defined contribution plans such as profit sharing plans, IRA’s, and 401(k) plans. Once again, identifying the documents and other information necessary to analyze this problem and the performance of the actual calculations necessary to do so are within the providence of the forensic accountant.
A myriad of tax issues arise in equitable distribution cases. One of the most common and unfortunately one of the most frequently ignored of these issues are taxes that are “embedded” – taxes that will not be payable as a result of the settlement or any transactions relating to the settlement but taxes which will almost certainly be incurred at sometime in the future when the asset is actually sold to a third party. To illustrate this issue I give the following example to most of my clients:
“As part of the division of marital assets there are two pieces of unimproved real estate – White Acre and Black Acre. Each tract is worth $100,000 and there are no liens or encumbrances on either. You are going to receive one of these tracks and your spouse the other track. Which do you choose?”
They typically respond that either tract will acceptable. I then have to explain.
You can not make an intelligent choice without a vital piece of missing information – White Acre has a tax basis of $20,000 and Black Acre has a tax basis of $80,000. Now which do you pick?”
Some of my clients still don’t know the impact of that additional information about the tax basis because they really don’t have an appreciation for the impact of capital gains taxes. When you sell White Acre for $100,000 you will pay capital gains taxes on $80,000. When you sell Black Acre for $100,000 you will pay capital gains taxes on only $20,000. The tax due on White acre assuming a 15% capital gains tax rate is $12,000. Using the same capital gains tax rate the tax due on the sale of Black Acre is only $3,000.
Without this information neither you nor your client can make well informed choices on the division of assets. In fact, in my practice, I usually have the value of assets “tax impacted” so that when we determine the value of the marital estate we are discounting the value of any appreciated capital assets to reflect the reality that at some point in the future those taxes are going to actually be realized.
These embedded taxes are important in many other aspects of the equitable distribution case. For example, $100,000 in an IRA is not equal in value to $100,000 in a certificate of deposit. The money contained in the IRA represents pre-tax dollars and the money contained in the certificate of deposit represents after-tax dollars.
You need to be able to identify the documents and other information necessary to determine the tax basis of any assets that comprise of part of the marital estate and quantify in a rational way the financial impact of those taxes. “Who ya’ gonna call?” The team member best suited to do so: the forensic accountant.
I have covered only some of the many ways in which forensic accountants can bring real value to you and your client in handling the financial aspects of marriage dissolution in North Carolina.
In summary a forensic accountant can assist in at least the following respects:
- Search for hidden assets and/or hidden income.
- Search for inconsistencies between financial information on certain important documentation.
- Corroborate financial information with non-financial information.
- Determine and quantify personal expenses.
- Perform a business valuation.
- Calculate cash flows
- Perform tracing for the purpose of determine the separate or martial nature of property.
- Assist you in preparing document requests of the other party or other non-party witnesses of whom you need to subpoena information.
- Review the work performed by the forensic accountant working for the other party.
- Testify in Court or at depositions.
- Provide valuable input during the settlement process not only on the tax consequences of certain proposed settlement structures but also bring to the table their experience in real world transactions which can lead to imaginative and creative solutions that would occur to neither you nor your client.
- A political saying often heard in the mountains of Western North Carolina is “vote early and vote often”. With respect to utilizing forensic accountants in your family law practice I would paraphrase that statement by advising you to “hire them early and hire them often”.
Published in the Family Law Forum, an electronic publication of the Family Law Section of the North Carolina Bar, March 2010.