Case Review: Self-Employment, Tax Deductions & Child Support Calculations

Cite: In re the Marriage of Jessica R. and Martin H. Hein (Cal.App., July 21, 2020, F076581)

Full text here.

Holding:

In this case, the Fifth District reversed a Kern County trial court’s determination of a self-employed payor’s income for child support purposes. It held that the trial court improperly placed the burden of proof of showing that the business deductions H reported on his income tax returns to W, concluding “that considerations of public policy and fairness, informed by the judicial system’s experience in the cases involving the income and business expenses of a self-employed party, weigh in favor of assigning Martin the burden of proof on the factual questions that must be resolved to determine his business income and expenditures under section 4058 subdivision (a)(2).”

Summary of the Facts

Jessica and Martin divorced in 2004. At the time, both of their daughters were minors. In February of 2014, Jessica filed an RFO to modify child custody and child support and for attorney fees and costs. It took three years to bring the matter to trial and for the court to issue a ruling, which it did on May 18, 2017. By then, both children were adults.

Jessica has a Ph.D. in physical therapy and, at the time relevant to this proceeding, worked as a self-employed physical therapist three days a week. The parties stipulated that Jessica’s income was $9,086 per month, which included $7,172 per month in wages and salary and $1,914 in self-employment income.

Martin is a self-employed farm owner and manager and has been licensed as a commercial pilot for over 20 years. He is the sole shareholder and president of Hein Ranch Company (HRC) and Martin Hein Ranch Company (MHRC). The parties stipulated that Martin’s average wages and salary for 2013 and 2014, as reflected on his personal income tax returns, was $7,760 per month, not including any contributions to a pension plan or employee benefits. The parties disagreed about the amount of additional income that should be included in his net disposable income for purposes of calculating child support.

Martin’s Corporations

Through HRC, Martin owns four ranches, which total 110 acres. Martin testified that HRC did not have any employees that he was aware of, other than himself.

HRC is a C corporation with a fiscal year ending June 30th. As a C corporation, HRC pays income tax. HRC’s federal income tax returns on Form 1120 (U.S. Corporation Income Tax Return) for 2010 through 2013 were introduced into evidence. HRC’s gross receipts or sales for fiscal years 2011 through 2013 were reported as $4.18 million, $4.14 million, and $4.34 million. For those fiscal years, the total depreciation claimed by HRC on line 20 of its Form 1120 was $971,894, $747,193, and $701,870. The taxable income HRC reported on Line 30 for those years was a loss of $47,658, $0, and a gain of $152,678.3 At the end of HRC’s 2013 fiscal year (i.e., June 30, 2014), its total assets were $3,387,982 and its retained earnings were $1,736,522. HRC had no loans from its shareholder, Martin.

MHRC is a subchapter S corporation4 formed on October 31, 2008. MHRC provides farm management services for the ranches owned by HRC and for properties owned by third parties. Martin estimated that MHRC manages more than 6,000 acres of trees and vines. MHRC does not handle annual row crops. The services provided include planting, pruning, irrigation, fertilizing, pest control, and harvesting. Martin described the services provided as everything required from farm to table.

…MHRC’s income is reported by Martin by attaching Schedule E to his federal income tax return on Form 1040. For the years 2011 through 2013, Martin reported S corporation income from MHRC of $20,758, $122,268 and $178,846. For those years, MHRC took depreciation deductions of $58,769, $6,037, and $265,922.5 At the end of 2013, MHRC’s total assets were $2,137,227, its retained earnings were $491,500, and its liabilities included loans from Martin totaling $424,349.

…On May 18, 2017, the trial court issued a 16-page written ruling on Jessica’s request for an order modifying child support. The court determined the depreciation deductions taken by HRC and MHRC were an appropriate offset to gross income. The court also determined the federal income tax returns of Martin and his corporations were presumed correct and Jessica bore the burden of proving the tax returns were incorrect.

The court concluded Jessica failed to carry that burden on many of her challenges to business expenses reported on the tax returns. Based on its determination of Martin’s income, the court determined the guideline child support Martin was required to pay for three periods from March 1, 2014, until the youngest daughter reached the age of majority. That date had passed by the time the court issued its statement of decision.

Result on Appeal

On Jessica’s appeal, the Fifth District reversed the trial court’s deduction of Martin’s depreciation expenses claimed on his tax return from his income for child support purposes and placing the burden on Jessica to overcome a presumption that the tax returns were correct. First, it held:

An important component of the formula used in the statewide uniform guideline for determining child support is the “total net monthly disposable income of both parties.” (§ 4055, subd. (b)(1)(E), italics added.) Monthly net disposable income is usually computed by dividing the parent’s annual net disposable income by 12. “The annual net disposable income of each parent shall be computed by deducting from his or her annual gross income the actual amounts attributable to” items listed in the statute. (§ 4059, italics added.) Those deductions include (1) state and federal income tax liability, (2) contributions to the Federal Insurance Contributions Act (FICA), (3) amounts paid for retirement benefits if participation is required as a condition of employment, (4) health insurance or health plan premiums for the parent or any children the parent is obligated to support, (5) spousal or other child support actually being paid, and (6) certain job-related expenses. (§ 4059, subds. (a)–(f).)

Section 4058 defines a parent’s “annual gross income” to mean income from whatever source derived, except child support payments actually received and income derived from any need-based, public assistance program. (§4058, subds. (a), (c).) The nonexclusive statutory list of income sources includes compensation in the form of salaries, wages, and bonuses. (§ 4058, subd. (a)(1).) It also includes investment income such as rent, dividends and interest. (§ 4058, subd. (a)(1).) The income generated by a parent’s ownership of a business is included pursuant to subdivision (a)(2) of section 4058, which provides: “Income from the proprietorship of a business, such as gross receipts from the business reduced by expenditures required for the operation of the business.” (§ 4058, subd. (a)(2), italics added.) Besides the money from a business’s gross receipts less required operating expenditures, a business owner might receive other things of economic value through the business. Subdivision (a)(3) of section 4058 addresses such items by providing that income includes, “[i]n the discretion of the court, employee benefits or self-employment benefits, taking into consideration the benefit to the employee, any corresponding reduction in living expenses, and other relevant facts.” (Italics added. In this case, Jessica’s arguments about Martin’s income available for child support pertain to his ownership (i.e., proprietorship) of his businesses and, therefore, involve the application of paragraphs (2) and (3) of subdivision (a) of section 4058.

W argued that in analyzing the trial court’s computation of Martin’s income available for child support, the trial court abused its discretion by failing to include depreciation deductions claimed on the HRC and MRCH income tax returns in the funds available to Martin for child support. In her view, the depreciation deductions claimed do not constitute “expenditures required for the operation of the business” for purposes of subdivision (a)(2) of section 4058. She supports this view by referring to the statutory interpretation adopted in Asfaw v. Woldberhan (2007) 147 Cal.App.4th 1407 (Asfaw). In Asfaw, the court considered the statutory text and concluded that depreciation of rental property may not be deducted from annual gross income when calculating child support. (Asfaw, supra, at p. 1425.)

The trial court’s statement of decision acknowledged Jessica’s argument “that the Court should ‘back out’ certain claims for depreciation made on the corporate returns and attribute that as income available for support” and her reliance of Asfaw to support this treatment of depreciation. The court noted the depreciation deduction in Asfaw related to rental real estate and the present case involved deductions for the purchase of vehicles and equipment. The court stated that Jessica “has not cited, nor has the Court found[,] any subsequent California decision that expands the holding of Asfaw beyond the specific facts of that case.” The trial court stated the decision in Asfaw impliedly recognized the distinction between real property depreciation and equipment depreciation. The court explained the importance of this distinction:

“Simply stated, the deduction of depreciation for equipment and vehicles is the recognition of an actual expenditure made by the tax payer. While the deduction of the depreciation over the useful life of the asset allows the ‘smoothing’ of the expense it nevertheless represents an actual payment of money by the taxpayer. For these reasons, the Court declines to expand the holding of Asfaw to this case.”

Accordingly, the trial court rejected Jessica’s argument that the depreciation deductions were not “expenditures required for the operation of the business” for purposes of subdivision (a)(2) of section 4058.

In reversing, the panel noted that in Asfaw, “(t)he Second District expressly limited its statutory interpretation to depreciation deductions from rental income, stating it did not consider ‘other types of depreciation, such as for equipment.’ (Asfaw, supra, 147 Cal.App.4th at p. 1426, fn. 12.) In addition, the court did not consider whether depreciation of an asset could be considered ‘special circumstances’ under sections 4052 or 4057, subdivision (b)(5). (Asfaw, supra, at p. 1426, fn. 12.)” It then cited In re Marriage of Rodriguez (2018) 23 Cal.App.5th 625, which was decided after the trial court’s decision in the case. It said that in Rodriguez, (w)e concluded a self-employed parent’s depreciation deductions for motor vehicles did not constitute “expenditures required for the operation of the business” for purposes of section 4058, subdivision (a)(2). We now extend that statutory interpretation from motor vehicles to depreciation deductions for equipment and other assets used in the self-employed parent’s businesses. The term “expenditure” describes an actual outlay of cash. Claiming a depreciation deduction on an income tax return does not require an outlay of cash and, thus, does not reduce the funds available for child support.

…The statutory interpretation adopted in Rodriguez for deducting motor vehicle depreciation appears to apply to the equipment, vehicles and Cessna airplane at issue in this case. The parties’ appellate briefing, however, does not address how this court’s interpretation and application of section 4058 to depreciation in Rodriguez affects depreciation deductions claims by Martin and his corporations. Rather, Martin’s brief quotes the trial court’s statement that Jessica did not cite, and the trial court did not find, any subsequent California decision expanding the holding of Asfaw beyond the specific facts of that case.

Although Martin’s counsel attempted to distinguish Rodriguez during oral argument, she has not persuaded us that subdivision (a)(2) of section 4058 should be construed differently depending on whether the depreciation relates to rental real estate or to vehicles and equipment. Furthermore, we have not identified any reason to deviate from our analysis and decision in Rodriguez. (See generally, 2 Hogoboom & King, Cal. Practice Guide: Family Law (The Rutter Group 2020) ¶¶ 6:246.11-6:246.12, p. 6-178.)

Thus, we continue to interpret “expenditure,” as used in subdivision (a)(2) of section 4058, to mean the actual outlay of cash or other consideration. (Rodriguez, supra, 23 Cal.App.5th at p. 634, quoting Asfaw, supra, 147 Cal.App.4th at p. 1425.) In addition, we continue in the view that depreciating an asset on a company’s books and claiming a depreciation deduction on federal income tax returns does not involve an outlay of cash with a corresponding reduction of cash available for child support. (Ibid.) Stated from another perspective, we do not conflate (1) the outlay of money used to purchase a capital asset (i.e., a capital cost or expenditure) with (2) the accounting entries, such as depreciation, that occur after the acquisition of the asset and do not involve the actual outlay of funds in future years. (See Owens, supra, 16 Suffolk J. Trial & App. Advoc. At p. 195 [“a tax deduction for depreciation does not represent an out-of-pocket expense in the years following a capital purchase”].)

Consequently, we conclude the interpretation of section 4058, subdivision (a)(2) adopted in Asfaw and Rodriguez should be applied to the depreciation deductions involved in calculating the income Martin had available for child support. These deductions include expenses under Internal Revenue Code section 179 (26 U.S.C. § 179).

…In summary, the depreciation and section 179 expenses claimed by Martin and his corporations should have not reduced his income available for child support. (See County of Kern v. T.C.E.F., Inc. (2016) 246 Cal.App.4th 301, 316 [abuse of discretion standard does not allow trial courts to apply incorrect rule of law].) As a result, the matter must be remanded to the trial court to recalculate Martin’s gross annual income and redetermine his child support obligation. (See Code Civ. Proc., §§ 43, 906 [appellate relief].)

Next, the panel discussed the burden of proof of the correctness of numbers on a tax return. It said that the trial court reached three legal conclusions related to the burden of proof. First, income tax returns are presumed to be correct. Second, the presumption of correctness is rebuttable and may be overcome by sufficient evidence demonstrating the tax return is incorrect. Third, in this case, Jessica had the burden of proving that the income tax returns of Martin and his corporations were incorrect. The court applied the presumption of correctness not only to Martin’s returns on Form 1040 (U.S. Individual Income Tax Return), but also to HRC’s returns on Form 1120 (U.S. Corporation Income Tax Return) and MHRC’s returns on Form 1120S (U.S. Income Tax Return for an S Corporation).

In addressing these issues, the panel first discussed the general burdens of proof and said that “Evidence Code section 500 contains the general rule of law used to allocate a burden of proof: “Except as otherwise provided by law, a party has the burden of proof as to each fact the existence or nonexistence of which is essential to the claim for relief or defense that he is asserting. … Consequently, if the general rule were applied to the issue of Martin’s income available for child support, Jessica would have the burden of proof as to that issue because it is raised by her request for a modification of child support.”

However, it also said that the normal burden of proof is not appropriate for all issues. In resolving an issue of the proper allocation of the burden of proof and presumptions, said the panel, “we conclude the specific issue about the burden of proof presented by the facts of this case has not been resolved in a published opinion. Therefore, we proceed to the second category of issues—that is, the issues a court must resolve when deciding whether to alter the normal allocation of the burden of proof.” It did so, and concluded that the policy that seeks to advance children’s interest and considerations of fairness to the parents who are litigating the issue weigh in favor of giving Martin the burden of proof on the question of his business income and expenditure under section 4058 subdivision (a)(2). This conclusion recognizes that “a spouse who is the owner of a successful business and who has control of his or her income can structure income and the payment of expenses to depress income.” (In re Marriage of Chakko (2004) 115 Cal.App.4th 104, 109.) This concern about the manipulation of income by a self-employed parent is shared by courts in other states.

…We conclude that considerations of public policy and fairness, informed by the judicial system’s experience in the cases involving the income and business expenses of a self-employed party, weigh in favor of assigning Martin the burden of proof on the factual questions that must be resolved to determine his business income and expenditures under section 4058 subdivision (a)(2).

…On balance, we conclude the factors weigh in favor of shifting the burden of proof to Martin. As the sole shareholder and president of both corporations, his knowledge of the expenditures required for their operations and the gross receipts they generate and his access to evidence are vastly superior to Jessica’s knowledge and access. Furthermore, considerations of public policy and fairness support allocating the burden of proof to him. Consequently, we conclude there is no presumption of correctness that applies to Martin’s individual tax returns and the corporate tax returns of HRC and MHRC. Instead, Martin has the burden of proving the amount of the gross receipts of the businesses and amount of the expenditures required for the operation of the businesses.

Accordingly, the question of Martin’s gross annual income under section 4058, subdivision (a) must be remanded for further proceedings in which he bears the burden of proof. In those further proceedings, a presumption that his individual federal income tax returns and the corporate income tax returns of HRC and MHRC are correct does not apply. As to the category of expenses that provide self-employment benefits to Martin, those benefits and the question of whether they increase his gross annual income must be resolved in accordance with subdivision (a)(3) of section 4058. That subdivision provides that Martin’s income includes, “[i]n the discretion of the court, employee benefits or self-employment benefits, taking into consideration the benefit to the employee, any corresponding reduction in living expenses, and other relevant factors.” (§ 4058, subd. (a)(3).) It is improper to exercise this discretionary authority by referring to a presumption that tax returns are correct. In other words, the fact the amounts paid by the corporations to provide a particular benefit was properly reported as a deduction on the tax returns is not a “relevant factor” to that benefit’s impact on the recipient’s income pursuant to subdivision (a)(3) of section 4058.

Finally, the panel remanded the trial court’s refusal to order Martin to pay any part of Jessica’s attorney fees and costs, noting that its determination to do so “was based on its determination of Martin’s and Jessica’s income for purposes of calculating guideline child support. Because the determination of Martin’s income has been reversed, we also vacate the trial court’s denial of Jessica’s request for attorney fees. On remand, the issue of attorney fees will be ‘at large’—that is, it should be treated as if it had not been addressed and resolved in the statement of decision.”