If you look just at financial statements for a business involved in a divorce, you might not see where all of the parties’ money goes. To get a clearer picture, you may need to determine whether they pay for expenses in cash or charge any personal expenditures to the business. As you dig deeper, you could find some assets that the business owner may be trying to shield from division. Let’s uncover some of the clues that can be easy to overlook in tax returns, the balance sheet, and other financial data.
A business tax return could show that it averages about the same income level from year to year, however, the parties’ financial disclosures may reveal that they spend more than that after taxes. You may wonder where the money comes from, whether it’s through the other spouse’s job, financial gifts from loved ones, or if the couple is borrowing money or selling assets to maintain their lifestyle.
The business may pay some expenses regularly, such as utilities, that are also for the residence. The owner could also be deducting business expenses that don’t fully meet IRS standards or aren’t deductible. A valuator can add non-deductible expenses to the owner’s taxable income and business profits and remove them from expenses to balance the average ongoing cash flow as part of the valuation.
A forensic accountant will try to determine which expenses do and don’t qualify for deductions. There may be some valid reasons to charge apparently personal expenses to the business. For instance, a sculpture in the home might not appear among the parties’ personal financial statements. Though it’s not among the business financial records, the company could own it and classify it under “other assets,” though it’s really a “non-operating” asset.
Tracking Hidden Assets
Non-business-related expenditures can lead to disagreements in divorce cases. One spouse may accuse the other of earning more than the records show. The other spouse might not be involved in the business or know how the owner handles the expenses, whether they pay them through a personal or business checking or credit card account.
Overall, an analyst examines an average of several years of revenue and expenses to determine the “normalized” income. To follow the trail, valuation experts will look at such documents as real estate records, loan and credit card applications, bank deposits, and financial statements. They may also analyze undeposited receipts, sudden changes in sales or expenses, and other cash sources beyond reported income to find missing links.
Business owners may practice common forms of creative accounting to try to change valuations. If, after looking at cash sources among business and personal expenses, the owner tends to spend more than he or she earns or suddenly shows a higher net worth without an apparent source, they may not be reporting all income. Such tactics can include paying taxes ahead of time, compensating people they know for work they may not have actually done, or selling a partnership interest in the business at below market value to a friend or family member. Including personal expenses in financial reports can also be a way to falsely lower a business valuation.
When a business is marital property in a divorce, family law attorneys should know where the cash comes and goes to find out if personal and business expenses mix and if someone is up to old tricks to change the valuation. Learn about business valuation and other complex financial aspects of divorce in our CFL™ course. Find out more in our free information packet today.