Family law attorneys routinely deal with matters that are emotionally difficult, legally complex, and financially consequential. When a divorce involves a closely held business, self-employed spouse, investment activity, rental properties, or complicated tax history, the financial side of the case can become particularly challenging.
The difficulty is not simply determining what a client earns. Attorneys may need to understand whether financial records tell a consistent story, whether business and personal expenses have been mixed, how a proposed settlement could affect future taxes, and whether financial information supplied during the case is sufficiently complete to support negotiations or litigation.
For family law practitioners, strong accounting and tax support can therefore serve an important role: turning complicated financial information into something that can be understood, questioned, and used in the legal process.
When a Tax Return Doesn’t Tell the Whole Story
Tax returns are an obvious starting point when evaluating a client’s finances, but they do not always provide the complete economic picture.
This is especially true when one or both spouses own a business.
Consider a business owner whose tax return reports relatively modest taxable income. That number alone may not reveal the owner’s actual financial circumstances. The business may be paying expenses that also provide a personal benefit. There may be depreciation or other noncash deductions affecting reported income. The owner may receive distributions that are different from wages. Loans between the business and owner may complicate the picture further.
None of these circumstances automatically indicates wrongdoing. They do, however, demonstrate why relying on a single number from a tax return can be misleading.
Depending upon the circumstances of the case, a more complete review might include:
- Personal and business tax returns
- Profit-and-loss statements
- Balance sheets
- General ledgers
- Bank and credit-card statements
- Payroll records
- Owner distributions and contributions
- Loan activity
- Fixed-asset and depreciation schedules
- Supporting documentation for significant or unusual transactions
Looking at these records together can help identify inconsistencies and, just as importantly, provide context for transactions that initially appear unusual.
Closely Held Businesses Create Special Challenges
A closely held business can be one of the most significant assets in a marital estate—and one of the most difficult to understand.
Unlike an employee who receives a W-2 paycheck, a business owner may have substantial control over how and when money moves through the company. Compensation may consist of salary, draws, distributions, reimbursements, or some combination of these.
Personal expenses can also become intertwined with business expenses.
For the attorney, the important question may not simply be, “What does this business earn?” Instead, the inquiry may include:
What financial resources does the business actually provide to its owner?
That distinction can be important when attorneys are addressing support, property division, settlement negotiations, or other financial issues.
Accurate bookkeeping becomes especially valuable in these situations. Well-maintained records create a clearer trail. Poorly maintained books can create uncertainty, increase professional fees, complicate discovery, and make it more difficult for both sides to understand the financial reality of the business.
Watch for the Difference Between Accounting Income and Cash Flow
Accounting income and available cash are not necessarily the same thing.
A business may report a profit while experiencing limited cash flow. Conversely, cash may enter the business without representing current-period taxable income.
Depreciation provides a common example. It may reduce taxable income without requiring a corresponding current cash expenditure. Loan proceeds may increase cash without constituting income. Principal payments reduce cash but generally are not treated as an ordinary business expense in the same manner as interest.
These distinctions matter because different questions require different financial measurements.
An attorney considering income available for support may be asking a different question than an accountant preparing a tax return. Similarly, an attorney evaluating the sustainability of a settlement proposal may need to understand actual cash flow rather than simply relying on taxable income.
A useful financial analysis should therefore begin with the legal or economic question that needs to be answered—not merely with whichever accounting report happens to be available.
Bookkeeping Problems Can Become Legal Problems
Many small businesses do not maintain perfect books.
Transactions may be entered months after they occur. Expenses may be placed in the wrong category. Personal purchases may appear on business credit cards. Owner contributions and distributions may be inconsistently recorded. Balance-sheet accounts may go unreconciled for long periods.
During ordinary business operations, these problems may be inconvenient.
During a divorce, they can become much more significant.
If the financial statements do not reconcile to bank accounts or tax returns, attorneys may spend considerable time trying to determine which numbers are reliable. Discovery can expand. Questions multiply. Negotiations may become more difficult because the parties do not agree on the underlying financial facts.
This is one reason cleanup bookkeeping can be valuable in a family law matter involving a business. Reconstructing and reconciling the records can help establish a more reliable financial foundation before more specialized work is undertaken.
Tax Consequences Deserve Attention Before the Agreement Is Signed
A settlement that appears equitable based on the stated value of the assets may not produce equal economic results.
Different assets can carry very different tax characteristics.
For example, two assets with the same stated value may have substantially different tax bases. The future sale of one asset could produce a significant taxable gain, while another might produce little or no taxable gain. Retirement accounts can present different tax consequences from cash or other after-tax assets.
The timing of transactions can matter as well.
That makes tax planning an important consideration before the final settlement is completed. Once property has been divided and transactions have occurred, some planning opportunities may no longer be available.
Tax questions that may deserve consideration during the process include:
- What is the tax basis of significant assets?
- Are there unrealized gains or losses?
- Could a proposed sale generate taxable income?
- Are retirement assets being compared appropriately with non-retirement assets?
- How might the timing of a transaction affect taxes?
- Are estimated tax payments likely to be necessary?
- Who will be responsible for tax filings and outstanding tax liabilities?
- Are there business-related tax attributes that should be considered?
The answers will depend upon the specific facts and applicable law, but identifying these questions early can help attorneys and clients make better-informed decisions.
The Value of Collaboration
The attorney remains responsible for the legal strategy and legal conclusions in a family law matter. The accounting and tax professional serves a different function.
An effective collaboration allows each professional to work within his or her area of expertise.
The attorney can identify the legal questions that matter. The accounting professional can organize and analyze the underlying financial information, explain accounting and tax issues, identify inconsistencies that warrant further investigation, and help quantify different financial scenarios.
That division of responsibilities can be particularly helpful when a matter involves:
- A closely held or family-owned business
- Self-employment income
- Incomplete or disorganized bookkeeping
- Multiple entities
- Rental or investment properties
- Complicated tax filings
- Significant differences between reported income and apparent lifestyle or cash flow
- Proposed property transactions with potential tax consequences
The goal is not to make the financial side of the case unnecessarily complicated. It is the opposite: to make complicated financial information more understandable and useful.
Better Financial Information Can Lead to Better Questions
Accounting support does not replace legal judgment. It can, however, help attorneys ask more precise questions.
Instead of asking why a client’s income “looks low,” the records may reveal a specific category of expenses requiring explanation.
Instead of broadly questioning where business cash went, a reconciliation may identify particular owner distributions, transfers, loan payments, or capital expenditures.
Instead of discovering after a settlement that an asset carries an unexpected tax consequence, the parties can consider that issue while alternatives are still available.
In that sense, one of the greatest benefits of good financial analysis is not merely producing answers. It is helping the legal team identify which questions should be asked next.
A Resource for Family Law Attorneys
LP Tax And Bookkeeping Pros works with tax, accounting, and bookkeeping matters and can serve as a financial resource when a family law case involves business records, tax issues, or financial information that needs to be organized and understood.
If you have a matter in which the accounting records raise questions—or you would simply like to discuss whether tax or bookkeeping assistance could be useful—contact:
LP Tax And Bookkeeping Pros
McKinney, TX 75072
303-881-9762
ralphp@lptaxandbookkeepingpros.com
www.lptaxandbookkeepingpros.com
The contact information above is taken from the LP Tax And Bookkeeping Pros letterhead provided for this article.
When the financial side of a family law matter gets complicated, the right accounting questions can help bring the picture into focus.