Finding hidden assets in divorce cases
The presence of a business in the valuation of a marital estate adds a level of complexity to the investigation because a business can be an ideal venue for keeping assets from a spouse. This is a function of size, control and source. Transactions that can have a large effect on the marital estate might be camouflaged by the large transactions that normally occur in a business. Some business owners can exert total control over the operations of a business, defeating internal controls and normal bookkeeping procedures.
Additionally, a business can be a significant source of income for a couple. Following the money might indicate where assets could have been hidden. Consequently, the presence of a business represents a high-risk situation that investigators should pursue.
Start With Banking Information
The items necessary to begin a business investigation are the same as for a wage earner — the bank statements and the check registers. The difference is that the bank statements and the check registers are needed for both the personal account of the couple and the business account. The investigator will look for how money comes into the business, inter-bank transfers and unusual bank transactions. The review of the check registers will focus on payments made to, or on behalf of, the owner; large or unusual transactions; and nonbusiness expenditures. The discovery of hidden assets seeks to illustrate that a spouse had possession of assets (including income) and that those assets have not been disclosed.
Tip: Given the opportunity (and no matter who I am working for), I will interview business owners concerning unusual transactions in the bank statements and questionable items in the check register. I can learn more in an hour from a business owner than I can through three months of discovery. I also will interview the business owner’s spouse and ask that he or she review the business bank statements and business check registers.
There are a number of very good reasons for this approach. First, the spouse might have been involved in the business and might have as much or more information than the business bookkeeper. Second, the spouse might be the business bookkeeper or might have been in the past. Third, it’s possible the spouse will recognize payments to relatives, dress shops, boyfriends or girlfriends, questionable vendors or unfamiliar credit cards that I will not. Fourth, educating the spouse on the income of the business and how it spends its money might temper the husband or wife’s claims of inappropriate disclosure. The alternative, of course, is that the spouse will discover evidence to support his or her claim. Either way, the spouse is provided with information necessary to make the decision to continue (and pay for) the investigation or to curtail it.
The investigator might meet with resistance on the part of the business owner when he or she is requested to produce the bank statements and check registers. The claims for not producing the documents range from client confidentiality concerns to undue burden to claims that the disclosure will reveal operational secrets to the business’ competitors. For example, the owner of a medical practice might express concerns related to the Health Insurance Portability and Accountability Act, which has strict patient confidentiality provisions. The counter to the claim is to point out that the bank statements and check registers normally don’t include any patient information. A claim of undue burden is countered by indicating that most businesses of any size have automated bookkeeping systems — production of the check register entails pushing a button.
Finally, while it’s true that a vindictive spouse could damage a business by revealing operational secrets, the check registers and bank statements usually don’t contain information that could be used in this manner. If the business owner illustrates that secrets could be revealed, the investigator can counter with provisions to ensure that only the investigator, and not the spouse, will be allowed access to the information.
Forcing the Issue
Investigators should note that the preceding are examples of the arguments the business owner offers for not providing the documentation requested. They often have very little to do with the real reason the owner doesn’t want to disclose the records. Investigators might expect that the owner has claimed personal expenses as business expenses or has unreported income. This puts the business owner in a position of revealing questionable tax reporting. If this is the case (and the investigator might suggest to the business owner that it is), assurances of confidentiality can go a long way toward obtaining the records. The investigator also might expect that the owner has expenditures or income that he or she doesn’t want to reveal to his or her spouse. In that case, assurances of any type are unlikely to move the business owner.
The resistance in and of itself can be a clue that something is amiss in either the disclosed income or the assets of the business owner. Further pressure can be exerted by use of a basic computation.
+ Net Business Income
– Personal Expenditures
= Missing Income
The net business income comes from the tax return. The personal expenditures are determined by a review of the couple’s personal checking account as described in “How to Discover Personal Assets” (November/December 2008 LAT). The difference is missing income that might exist in the form of assets. The amount of income is known; the amount that was spent is known; the figure that has to be explained by the business owner (or the investigator) is the difference.
Businesses also have a component that can be used to further develop a formula that might call into question the books and records of a company. Depreciation is a noncash expenditure. That is, it’s an expense that the Internal Revenue Service recognizes that doesn’t require a cash expenditure. The expense is allowed because most businesses must have assets to operate, and the expense allows them a means of recognizing the cost. However, if a business owner doesn’t replace assets, then the cash is available to be spent. The depreciation expense claimed by the owner is taken from the tax return. The formula used to indicate that the owner has this cash available (which might be missing) is:
+ Net Business Income
– Personal Expenditures
= Missing Income (Assets)
It’s important for investigators to recognize that during the course of normal business, owners will replace assets and that over time the cost of buying assets and the associated depreciation will be similar. In addition, if business owners delay replacing assets so that they can keep the cash, there is a basic assumption that they will pay for it later. Therefore, except for the effects of accelerated depreciation, investigators might not find a supportable adjustment to income or assets by presentation of this formula. However, the point is to force the owner to disclose the operations of the business, which might lead to those adjustments.
Another means of forcing the hand of the owner is to apply a certain amount of logic to the situation in combination with the personal knowledge of the spouse. For example, the wife knows that she and her husband went on a vacation two years ago. The wife knows that the cost of the vacation was not paid for through the personal account of the couple. Therefore, the business had to pay for the vacation. The husband is forced to show that the amount was assigned to him as compensation, or that the cost was recorded in the travel expenses of the business. Either way, the investigator has learned something. Either the husband has considerable control over the amount of income he receives from the business, or personal expenses are being claimed for tax-reporting purposes. Both can be used to adjust the income the husband has available for child support or alimony, and also can provide a source for assets that have been hidden.
Businesses and Child Support
Parents sometimes own their own businesses. Income from these businesses is an economic resource and is includable in income for the determination of child support. Significant adjustments to the reported income and expenses might have to be made to reflect the true economic benefit the parent is deriving from the business.
Normally, historic business income is analyzed to enable an investigator to predict future business income. Since income from a business operation can vary considerably from year to year, part of the analysis usually entails averaging a number of years of operations. The number of years averaged might be mandated by local rules, but generally the results of five years of operations will provide an investigator with enough information. It should be noted that although five years of operations is recommended, the investigator might find that the use of all five years isn’t appropriate. For example, assume that in the first year of operation a business incurred a big loss, but subsequent years were profitable. The first year of operation isn’t a good indication of future income. The investigator might consider eliminating that first year of operation from the average to produce a more equitable result.
Tip: A business operation normally will generate (or report) less revenue in its last year of operation before a divorce when compared to other years of operation. Most child support calculations are performed in conjunction with a divorce. Divorces, for numerous reasons, negatively affect business operations. For example, a business owner, instead of doing business, is dealing with his or her divorce. He or she takes time away from work to deal with the attorney, the experts and the soon-to-be ex-spouse. The owner also can become super mom or dad, leaving his or her business to maintain a bond with the children of the marriage. New romantic partners also can distract a business owner. On the darker side, the business owner intentionally can reduce the income of a business by refusing contracts or putting business off to future periods (sandbagging). Owners also can claim (or increase their claim of) personal expenses to reduce the income of a business, or might fail to report revenue that was reported in previous periods. The incentive for these activities is high. Not only is child support based upon the income of the business, but the marital estate value of the business also can be based upon the income of the business.
Investigators should be aware of this nearly universal phenomenon and take steps to compensate for it. These steps could include putting into play investigative procedures to identify differences between the last year of operation and other years. For example, an investigator might compare the expenses claimed in the last year of operation to the previous year on a line-by-line basis, and review in detail the causes of significant differences. The investigator also might consider removing the last year of the business’ operation from the average as not being representative.
Nicholas L. Bourdeau has been practicing in the area of forensic accounting since 1986, and has appeared in court over 150 times on issues associated with the valuation of marital estates, businesses, child support, maintenance, pensions, fraud and damages. He is the author of “The Determination of Income for Child Support” (www.jamespublishing.com or (800) 440-4780), from which this article is excerpted.