Imputing Retained Earnings of a Sub-S Corporation for Purposes of Support

The issue of whether a certain type of business profit should be considered personal income for support purposes has always been a difficult one.  A recent Illinois Appellate Court decision may have clarified the issue.

By way of background, a sub-S corporation is a pass-through entity often utilized in small businesses for federal tax purposes. The business does not pay income taxes at the corporate level. Instead, the income is directly passed through to its shareholders based on their ownership interest and the shareholders pay taxes on their allocated portion of the earnings.  The tricky part, however, is that the shareholders pay taxes irrespective of whether the income is actually distributed to them. Making things more complicated, it is not uncommon for sub-S corporations to make distributions in an amount necessary only to cover the tax liability since taxes are owed irrespective of whether a distribution is made.

The inherent challenge with closely-held companies where one of the litigants is a majority owner, however, is that there is arguably an ability of the owner to manipulate income and hold back earnings in the business in an effort to reduce his or her support obligation, which is exactly what the mother argued in the recent case of In re Marriage of Moorthy and Arjuna, 2015 IL App (1st) 132077, when she sought an increase in child support eight (8) years after the original divorce. Specifically, the mother argued that the profit the father kept in the business year after year (retained earnings) should be imputed to him as income.  In contrast, the father argued that historically he never made any distributions except to pay taxes and that he needed the funds as working capital to keep the business afloat.

In a case of first impression, the Moorthy Court held that a fact-specific analysis should be done in each case in order to determine whether retained earnings should be imputed to the sole or majority shareholder for purposes of calculating child support.  Id. at 14, ¶ 64.  Accordingly, when doing this analysis, the court should evaluate the following factors:

1.  The extent of the obligor’s ownership share in the corporation.

2.  The obligor’s ability to decide whether corporate earnings should be retained or distributed.

3.  The corporation’s history of retained earnings and distributions, in comparison to post-divorce corporation activities.

4. Whether the retained earnings are excessive.

5.  Where there is evidence that income is actually being manipulated.

Applying these factors in Moorthy, the Court ruled that a company’s retained earnings should not be imputed as personal income to the father – and thus, he was not required to pay child support on those earnings.