If you are involved in a case where your spouse owns an interest in a small business, one of the issues you and your lawyer will grapple with is whether the books and records of that business adequately portray its revenue and profits.

If you are involved in the day to day operations of this business you may already be aware and  benefitting from some of these games. But if you are going to separate and be divorced, chances are pretty slim that your spouse will keep you in the family business and its perquisites. Some of these may run afoul of laws requiring all revenue to be reported and only “reasonable and necessary” expenses to be deducted. And, some of these errors or omissions expose you and your spouse to civil and criminal tax laws, so you need to be careful. But what you tell your attorney is privileged and when it comes to seeing that you are fairly treated in terms of business income and valuation for equitable distribution a frank discussion is necessary.

Realize as well that whether you have familiarity with the family business or not  you may not know “all” that you should about the games people play in closely held businesses. Early in the process of divorce counsel needs to get the tax returns for the business. A relatively new wrinkle is the need for copies of all operating agreements related to the business. We are seeing more and more “creative” operating agreements which allocate corporate power, profits and sales proceeds differently than what is shown on the Forms K-1. In a recent case, husband owned a minority interest in the business (about 40%) but the operating agreements named him as the irrevocable managing member of the LLC (limited liability company) and indicated that he would receive 60% of the first $10 million in proceeds if it was sold. It was a fun debate over whether that fellow was really a minority shareholder whose interests needed to be subject to a minority discount.

Turning back to the business tax returns, on the revenue side a common game is for cash basis tax entities to defer income by delaying cash receipts. A classic example is that of the personal injury lawyer who is settling a $1 million case with a $400,000 fee in the hopper. If the lawyer separated from her spouse during Thanksgiving 2023, why not defer the settlement and receipt of the fee to January 2024. That return is not due to 2025 and even then the business and personal returns can be deferred six months to October by simply filing an extension. If you sense this game is in progress with your spouse’s business, you might want to circle back later to see what revenue looked like in Quarter 1 of 2024 and contrast that with the Quarter 4 revenue (Sept-Dec.) in the “separation year” (2023 in our example).

Next are expenses. As we wrote recently in our analysis of Reich v. Reich, the breadth of a taxpayer’s ability to conjure expenses to deduct makes the solar system seem minute. But many of the tried and true schemes remain quite popular:

Payroll: Ask for the employee Forms W-2 or the payroll ledger. Don’t hesitate to agree that it is confidential except in the pending proceedings. You may learn your kids are on the payroll. You may be on the payroll too even though you have never seen a paycheck. Then there’s the woman in Los Angeles who provides services through “OnlyFans.”  After maxing out your spouse’s credit card, she became a consultant for West Coast sales. The vast majority of employees are just doing the good work of the company. But if the receptionist is making more than some of sales reps, chances are good she is “receptive ” to things other than the customers who phone or stop by the company on business.

Form 4562: Another boring IRS form until it isn’t. Your spouse is in the printing business. He had a great year in 2023. So much so that he hired that woman on OnlyFans to help open the market in California. The business was about to report a $400,000 net profit even after your husband collected his $200,000 salary. But then, in December he met with the business accountant and leased a HP Latex 2000 Flatbed printer. The sticker price on that puppy is just under $300,000 so he financed it at $7,500 a month for four years. His cash outlay was the first month’s lease payment of $7,500 but his generous Uncle Sam at the United States Treasury is allowing him to deduct the entire $289,997 on his 2023 return. Thus, a check for $7,500 coupled with a four year lease begot a huge deduction and took a $400,000 operating profit down to $110,003. The magic begins in Part I of the Form 4562. And by the way, this is all perfectly legal, but it also completely distorts how profitable the business is for purposes of support and business value.

Travel & Entertainment: This can be messy if there are lots of people who do the entertaining. You start your focus on the family members and their credit cards. You, as spouse, might have such a card even though you don’t work at the business. That’s a little tricky but discuss that with your attorney. Clients sometimes get lost in the weeds of this trying to track down every expense. But things like stadium licenses, sports and concert tickets, trips to Aruba to attend seminars on the printing industry or to get “training” on legal issues are fun to ask about and often are treated as “perquisites” unrelated to reasonable business needs. Some of this travel can also involve people who don’t even work for the business. Always fun to ask how they were invited.

Rent: Usually this is not a place for mischief.  But in many instances there is an independent family business which owns the building where the business operates. So, Joe Jones owns Jones Printing which operates from a leased property owned by 123 Printers Lane, LLP. Who owns the LLP but Joe Jones. Many times, the reindeer games are played by the real estate arm of the business. The IRS will scrutinize lots of business expenses but whether the rent is fair or not or the expenses are directly related to the business activity is an investigative deep dive. So, the reasonable cost of renting a 5,000 square foot office is $5,000 a month. Jones Printing pays $10,000 a month but the expenses include all the expenses of the office and the residence the parties live in. It might include the house at the shore as well. Thus, expenses that you and I pay with our after tax income are actually paid by the business as part of its rent.

Other Expenses: These are separately listed on another schedule and there is no limit to what qualifies as “reasonable and necessary” to run the business. Until the IRS asks. A few classic examples include “office supplies.” IRS is thinking about copy paper, coffee pods, rubber bands and pencils. Taxpayers are thinking groceries at home, house cleaners, lawn care and let the IRS challenge the deductions. “Auto expense” is classic. You need some vans to deliver your printing products. But what’s the Corvette for? And does it need to be “detailed” twice a month so it looks clean when you put the printing product on the front seat to make deliveries. Your fleet of delivery vehicles need to be gassed. But those charges to Seaview Harbor Marina in Little Egg Harbor, NJ don’t seem to be gassing the vans in Langhorne, PA.  “Business gifts” are also fun to see although, again, the outrage often exceeds the add-back. Last Christmas Jones Printing bought three cases of Chateau Grand Puy LaCoste for $100 a bottle. Alas, two of those cases are still inside the wine cellar of the Jones residence, yet the deduction is reported as $3,600.

There is a place for forensic accountants in these cases but the first line of “offense” is often the spouse who knows the boat gas goes on the corporate card and that there are a dozen cases of pricey Bordeaux in the house “wine cellar” because the practice of “one for the business and two for the house” has been going on for years. Clients should be cautioned that $14,000 of purloined wine does not really change the case while a $300k Latex Flatbed Printer is a relatively big deal. Yet, having said that, the specter of having to explain the wine, the boat gas or the OnlyFans “consultant” often will do more to bring a case to resolution than the debate over Section 179 deductions for capital purchases.

The point is that lawyers can start the forensic analysis on the cheap by getting the source documents and sitting down with the client who lived the income and the expenses. Too often forensic experts are brought in “cold” and spend months trying to pick up the scent of financial fraud. Clients also need to be schooled on the fact that while they may have been driving the $200,000 Range Rover SL run through the company as a business expense, the impropriety of that deduction actually adds value to the business being appraised.

The blog on Reich is found here: https://pafamilylaw.foxrothschild.com/2024/02/articles/general-pennsylvania-family-law-news-updates/excess-on-parade-watch-an-entrepreneurs-expenses-catch-fire/.