Business Income & Colorado Family Support

Business Income Counts for Child Support & Maintenance

If a parent or spouse owns a business, the income from that counts for purposes of child support and maintenance. That makes sense - dividends from owning shares counts as income, so why not income from a smaller business which is not publicly traded? But while the general principle is simple, applying it to real world cases is more complex, and has resulted in changes to the statutes over the years trying to close “loopholes.”

Business Payment of Expenses

The first provision in the statutes covers using business funds to pay personal expenses by including as income:

Any moneys drawn by a self-employed individual for personal use that are deducted as a business expense, which moneys must be considered income from self-employment

C.R.S. 14-10-115(5)(a)(I)(O) (Child support) or C.R.S. 14-10-114(8)(c)(I)(O) (Maintenance).

This provision is roughly analogous to a provision in the statute which counts as income expense reimbursement which reduces personal living expenses. However, that other provision is aimed at a normal employee whose employer reimburses for some expenses, thereby reducing the employee’s personal expenses. This provision addresses a practice not uncommon in a closely-held business where the owner “blurs” the distinction between business and personal expenses - for example, using the company credit or debit card for groceries or (personal) gas, perhaps reconciling those purchases as draws later on, or perhaps not.

Graham.Law has seen several cases where a closely-held business owner will use business funds to pay legal fees during the divorce - these personal expense payments are most assuredly included as income.

Note that there are gray areas - a business trip to a conference at a beach resort may have a legitimate purpose, but it is also clearly fun, so depending upon the work/fun ratio, some of those travel expenses may be added back as income. A good CPA can work with the parties to help figure this out.

And as with any company reimbursement, to the extent that a business reimbursement reduces personal living expenses, those payments too will somewhat count as income. Examples of this may be payment for a home-office, providing a mobile phone, providing a company car, etc.

What Is Business Income

While payment of personal expenses is something that most people can readily identify as legitimate income, the next provision is harder for a small business owner to accept - income may include funds he/she never even saw. Income includes:

Income from general partnerships, limited partnerships, closely held corporations, or limited liability companies. However, if a parent is a passive investor, has a minority interest in the company, and does not have any managerial duties or input, then the income to be recognized may be limited to actual cash distributions received.

C.R.S. 14-10-115(5)(a)(I)(W) (Child support) or C.R.S. 14-10-114(8)(c)(I)(W) (Maintenance)

Passive Investor - Only Distributed Funds Are Income

The statute quoted above is really two different clauses in one - first, the general rule is that income from a partnership or closely held business counts. However, a party who has no say or control over the business, and is akin to someone who owns shares in a publicly-traded company may only see actual distributions included as income.

As with owning shares in Apple, only your actual dividends are income to you, not whatever billions Apple makes as profit for the year but chooses not to distribute.

Finally, note that this is not automatic - the court has discretion (“may”) to exclude earned, but undistributed business income from a party’s income, but is not required to do so.

Active Participant - Undistributed Funds Are Income

While a passive, uninvolved investor will see only distributed earnings included as income, the same is not true for a majority shareholder or party who actively participates in a business. In that case, the party’s income means whatever the business reports as earnings a Form K-1.

A real world example (which predates the most recent change to the statute clarifying this point)  illustrate what this means. A husband who was the sole owner of an S Corporation paid himself combined salary and draws of about $10,000/mo. However, when his K-1 earnings were combined with his salary, he actually had about $20,000/mo of earnings.

The husband argued that he was operating on a shoestring budget, and prudence dictated that he build up a several month float in his business account, so he could not withdraw the funds. While the court agreed that this was probably sensible, income was income, and the fact that the husband chose not to receive the earnings he was legally entitled to should not reduce the support available to the wife. Much to the husband’s shock, maintenance and child support was based upon all $20,000 of earnings. In reality, since he paid taxes on $20K of earnings, this outcome should not have been surprising to him.

If you look at a profit & loss statement, or a business tax return, profit includes earnings which were used to pay down the principal balance on a loan. And so does income. Another example - a business is paying a $5000/mo mortgage on property it owns, of which $2000 is interest and $3000 is paydown of principal. Only the $2000 interest  is a business expense - the remaining $3000/mo payment towards principal increases the owner’s net worth, so counts as income on both his tax return, and for purposes of family support. A forced investment is still income.

In In re: Marriage of Karsten (Colo.App. 2020) (Unpublished decision), the husband controlled a business and had discretion how much to pay employees, and how much to draw in earnings. The trial court nonetheless only included as his income the draws he chose to pay himself, and not the full earnings of the business, finding that the husband reasonably chose to reinvest the earnings in material, vehicles, real estate, etc. This had the effect of reducing his income, and the maintenance, by 50%. The wife appealed, and the Colorado Court of Appeals reversed:

Because husband is self-employed and his income is derived from his business, of which he is the only owner, his income is not automatically limited to the salary that he chooses to pay himself. Rather, the court was required to calculate husband’s income from self-employment by using his business’s “gross receipts minus ordinary and necessary expenses… That formula recognizes the fact that a self-employed spouse can manipulate his or her own compensation to avoid paying maintenance. 

Karsten, ¶¶ 16-17.

Deduct Business Expenses From Gross Earnings

While a regular salaried employee will see her full, gross income count for purposes of child support and alimony, a business has costs involved with earning the money. If a store sells a widget for $100, the store’s costs include its own cost of the widget, salary for the staff, rent on the store, advertising, etc. In the end, that $100 of revenue provides only a small fraction in actual earnings.

All of those business expenses are deductible on the business owner’s taxes, and are also excluded from the definition of income for Colorado’s family support statutes:

For income from self-employment, rent, royalties, proprietorship of a business, or joint ownership of a partnership or closely held corporation, “gross income” equals gross receipts minus ordinary and necessary expenses, as defined in sub-subparagraph (B) of this subparagraph (III), required to produce such income.

C.R.S. 14-10-115(5)(a)(III)(A) (Child support) or [sv slug="crs-14-10-114"](8)(c)(III)(A) (Maintenance).

And while the IRS may allow certain deductions, such as accelerated depreciation, Colorado is not bound by what the IRS treats as income, and will not deduct some otherwise legitimate expenses from income:

“Ordinary and necessary expenses” does not include amounts allowable by the internal revenue service for the accelerated component of depreciation expenses or investment tax credits or any other business expenses determined by the court to be inappropriate for determining gross income for purposes of calculating child support.

C.R.S. 14-10-115(5)(a)(III)(B) (Child support) or C.R.S. 14-10-114(8)(c)(III)(B) (Maintenance).

Business Expenses Not Available As Income To Pay Support

In a contempt case, the trial court found that a business owner who paid his business expenses from his gross business receipts had the resources to pay support, as child support took precedence over business expenses. The business owner appealed, and the Court of Appeals reversed, making it clear that business expenses come first, or else you kill the goose that laid the golden egg:

We are unable to find any support for such a rule. To the contrary, it can be said that, with regard to a parent's ability to pay support, the net income after reasonable and justifiable business expenses should be the primary consideration.

To embrace such a rule as that announced by the trial court could create the untenable situation that the expenses associated with the production of income be held in abeyance until the child support is paid. The inevitable result of such a disposition of resources, in circumstances such as are present here, would be the eventual loss of all income when the business reached the point where it was no longer a viable, going concern.

While we decline to adopt a rule which allows payment of all business expenses before the payment of child support, we hold that obligations relating to reasonable and necessary expenses associated with maintaining the structure and solvency of a business or the production of income can be satisfied before payment of child support.

In re: Marriage of Crowley, 663 P.2d 267, 268-69 (Colo.App. 1983) (Cleaned Up).

However, the rule is not absolute - it’s possible that some business expenses were not truly necessary, and may have a lower priority than child support:

This is not to say that all business expenses claimed by the obliged parent are reasonable or necessary. This should be for the trial court's determination, and whether child support should and could have been paid before non-essential business expenses is within the trial court's discretion.

Crowley at p.269.

Self-Employment Tax as Business Expense?

A self-employed person must pay both his own personal FICA taxes (Social Security & Medicaid), plus pay the employer contribution as a “self-employment tax” - a tax which a salaried individual does not have. Normally under Colorado law, gross income is used, not after-tax income (C.R.S. 14-10-115(3)(c)), however the self-employment tax is arguably a cost of doing business, not a personal tax.

Several state guidelines allow deduction of the self-employment tax from a self-employed person’s gross income as a business expense, but Colorado’s guidelines are silent. Similarly, there is no Colorado case on this point, and scant authority in the U.S. as a whole. There are numerous cases from other states where appellate courts approved a trial court’s child support calculation which included deducting the self-employment tax (e.g. In re: Marriage of Sims, 309 P.3d 974 (Kan.App. 2013) and A.L.B. v. A.L.B., 18 N.Y.S.3d 508 (Sup. Ct. N.Y.  2015)), but since these cases do not discuss the issue, nor quote the guidelines, it is unclear whether their guidelines are even analogous to Colorado’s.

Business Income From 2nd Job Counts As Income

Normally in Colorado, income from second jobs or voluntary overtime which causes the party to work more than 40 hours per week is excluded from that party’s gross income::

“Gross income” does not include… Income from additional jobs that result in the employment of the obligor more than forty hours per week or more than what would otherwise be considered to be full-time employment

C.R.S. 14-10-115(5)(a)(II)(C) (Child support) or C.R.S. 14-10-114(8)(c)(II)(C) (Maintenance)

However, this exclusion does not apply to business income from a second job. In In re: Marriage of Upson, 991 P.2d 341 (Colo.App. 1999). the husband had three sources of income: (1) salary from full-time, 40 hours/wk employment, (2) salary from working 10-15 hours/wk at a closely-held S Corporation he owned, and (3) earnings from the business. The Court of Appeals held that while the husband’s salary from his second job should be excluded from income, the earnings from owning that same S Corporation where he worked part-time did still count.

Double-Dipping - Business Income As Both Property & Income

A common method of valuing a business is to capitalize earnings over a period of time, after normalizing a spouse’s income. That has led to complaints of double-dipping - a business owner not only has to buy out her spouse based upon the earnings of the business, but she pays alimony based upon those exact same earnings.

To illustrate this example, assume an attorney owns a small firm, paying himself a salary of $100,000/yr. But that same attorney is also well-known in the community, and based upon that goodwill, actually earns $150,000/yr - the additional $50,000 of earnings are solely based upon her owning the business. Those $50K in earnings are used to calculate the value of the business - and assuming a capitalization rate of 33%, that $50K would result in a business valuation of $150K (divide $50K by 0.33). And in a marital property state like Colorado, that results in the wife having to pay her husband $75,000 to “buy out” his half  of the business. So far, so good.

The problem for the wife is that the same $50K in earnings used for the business buyout also counts as income for purposes of maintenance. And if a court were to apply Colorado’s advisory maintenance guidelines, that $50,000 of business income adds about $16,000/yr in tax-free maintenance to her maintenance obligation (32% x $50K). Over a 3-year period, the wife is therefore paying $48,000 more in maintenance than she otherwise would have paid without the business income.

Add the $75,000 business buyout to the $48,000 in additional maintenance, and over a 3-year period that $150,000 of business income costs the wife $123,000 in payments to the husband. In short, thanks to the same money being used for both property and maintenance, the husband receives 82% of the $150,000, and the wife receives just 18%.

While some states protect business owners from this “double dip”, Colorado is not among them. In In re: Marriage of Huff, 834 P.2d 244 (Colo. 1992), the husband faced this exact dilemma, and argued that it was “double-dipping” to require him to pay both maintenance and a property payout to his wife based upon the same pool of future earnings.

The Colorado Supreme Court rejected his argument, because the excess earnings method used by the trial court (a different income method than capitalized earnings) utilized his past earnings to value the business, not his future earnings:

The husband also argues that the district court's use of the excess earnings method results in a "double dipping" by the wife into the husband's income. The husband contends that the excess earnings approach converts his future income into property which is then divided between the spouses. He contends that "double dipping" occurs because that same future income is the source from which the wife's maintenance is paid. The husband contends that the wife receives double benefits from the same source: the husband's future income. We disagree.

As stated above, the excess earnings approach is a valuation method which capitalizes the excess earnings based on a comparison of the husband's past earnings to the past earnings of an attorney in the same area with the same education, experience, and capabilities. Based on these historical earnings, this method provides a valuation which represents the present value of the husband's partnership interest. The excess earnings approach does not convert the husband's future income into property; on the contrary, it avoids valuing a business or partnership on the basis of postdivorce earnings and profits.

Huff at p.257.