Small Business Owners Must Justify Their Business Deductions To Claim Reduction of Income Available for Child Support

In 2020 the California Appellate court held that a trial court erred by allowing depreciation deductions taken on equipment and other assets used in self-employed husband’s businesses (as listed on his income tax returns) to reduce amount of income available for child support. The court stated the burden was not on the wife to show that those amounts were incorrect. The case is In re Marriage of Hein.

Takeaway for people involved in a California divorce in which the spouse owns a small business: If your spouse claims a significant income decrease due to business expense deductions when determining child support, the burden of proof is on the owner spouse to prove the court should accept the deductions. The owner spouse’s tax return is not dispositive. In these cases you will likely need a forensic accountant: someone with specific expertise and knowledge regarding the corporate tangles, the money involved, and the complexity of the issues to work with your divorce lawyer.

Case History:

During Martin and Jessica Hein’s marriage, Jessica earned $9,086 a month as a physical therapist. Martin was self-employed as a farm owner and manager. He was also the president and sole shareholder of two corporations. The assets of the corporations included four ranches totaling 110 acres; he managed more than 6,000 acres of trees and vines. Martin also owned other companies and real estate. He reported wages and salaries of $7,760 a month on his income tax returns.

Jessica filed for divorce in May 2003 and their dissolution judgment was entered in November 2004. It included provisions for joint custody of their two daughters but did not order either parent to pay child support. On February 28, 2014, Jessica filed a request for modification of child custody and child support and for attorney’s fees and costs. After trial, the court issued a statement of decision that, among other things, determined that it was appropriate to deduct from Martin’s gross income depreciation deductions taken by the two corporations on equipment and other assets used in his businesses, that Martin’s federal tax returns were presumed correct, and that Jessica had the burden of showing that the returns were incorrect. The court also rejected her request for attorney’s fees, finding that an award would not be appropriate because there was no disparity in the parties’ incomes.

Jessica appealed, and the Fifth District reversed and remanded in a partially published opinion.

The income issues here involve the provisions of Fam C §4058(a)(2) and (a)(3), which list income sources of funds available for child support. Pursuant to subdivision (a)(2), these sources include income generated from the proprietorship of a business, such as gross receipts reduced by operating expenses; subdivision (a)(3) states that, at the discretion of the trial court, self-employment benefits may be included. Jessica contended that it was error for the lower court to allow depreciation deductions related to corporate expenses to affect the amount of income Martin had available for child support. In the trial court, Jessica had relied on Asfaw v. Woldberhan (2007) 147 Cal.App.4th 1407, 55 Cal.Rptr.3d 323, 2007 CFLR 10553, 2007 FA 1281, which held that depreciation of rental property could not be deducted from gross income for child support purposes. However, the lower court had reasoned that Asfaw applied only to rental income, whereas here, the deductions were related to equipment and vehicles, which clearly were expenditures required for the operation of a business. When the justices focused on the reasoning in Asfaw, they noted that there, the court had specifically stated that it did not consider the type of depreciation applicable to equipment. And, in In re Marriage of Rodriguez (2018) 23 Cal.App.5th 625, the justices had found that the same reasoning applied to motor vehicles. Here, the panel saw no reason to depart from the treatment of depreciation assets set forth in Asfaw and Rodriguez in determining whether depreciation from equipment and other assets used in a self-employed parent’s business should be deducted from income available for child support. After all, the justices pointed out, “claiming a depreciation deduction on federal tax returns does not involve an outlay of cash with a corresponding reduction of cash available for child support.” Summing up, the panel held that the depreciation and section 179 expenses that Martin and his corporations claimed should not have reduced his income available for child support.

The panel then turned to Jessica’s contention that the trial court erred by placing the burden on her to show that the income tax returns considered by the trial court were incorrect. That was so, she argued, because Martin was the one who had access to and knowledge of the information needed to determine whether or not the returns were correct. When the justices looked further, they could find nothing in the Family Law Code or Family Law rules that answered the question of who had the burden of proof. Generally speaking, they found that the Evidence Code places the burden of proof as to each fact on the party who seeks relief based on the validity of the fact. That would mean, the panel continued, that Jessica had the burden re the tax returns, unless some exception applied. Their analysis, the justices said, was influenced by the fact that Martin was self-employed and the issues involved two corporations.

The panel looked to prior decisions for the principle that income tax returns are presumptively correct in child support proceedings. When they reviewed cases such as In re Marriage of Loh (2001) 93 Cal.App.4th 325, 112 Cal.Rptr.2d 893, 2001 CFLR 8869, 2001 FA 1023, and County of Orange v. Smith (2005) 132 Cal.App.4th 955, 117 Cal.Rptr.3d 383, 2005 CFLR 10086 2005 FA 1212, they found that neither case held that the income tax returns of a self-employed parent’s wholly owned entities are presumed correct. And, in In re Marriage of Alter (2009) 171 Cal.App.4th 718, 89 Cal.Rptr.3d 849, 2009 CFLR 11153, 2009 FA 1380, the court did not specifically support the presumption of correctness, but instead, found that any such presumption could be rebutted. Having found no definitive case law on the issue, the panel proceeded to review what a trial court must consider in determining which party has the burden of proof.

The judges first considered which party had greater knowledge of the particular fact in question. Here, it was Martin. Then, they looked to see to which party the evidence was more readily available. Again, that was Martin. Next, the justices reviewed the public policy underlying the issue. The policy here was advancing children’s interests, along with fairness considerations. Given all that, the panel concluded that, on these facts, Martin should bear the burden of proof as to the correctness of the tax returns, since he had greater knowledge of the businesses and has control over their financial records; the presumption of correctness did not apply. Accordingly, the justices reversed the trial court’s ruling and remanded for further proceedings in line with this opinion.

This edited synopsis is from the California Family Law Report.