The recent decision of J.S vs. C.C. by the Supreme Judicial Court is noteworthy because of its discussion of the inclusion of S corporation “pass-through” earnings in the context of an award of child support. Until this case, neither the Appeals Court nor the Supreme Judicial Court had directly addressed, for purposes of determining a parent’s child support obligation, the treatment of undistributed earnings of an S corporation that are attributable to the parent-shareholder for income tax purposes. This case sets forth relevant factors, based on the particular circumstances of each case, for the determination of the appropriateness of inclusion or exclusion of “pass-through” S corporation income in setting child support. One may reasonably postulate that the same criteria will likely be applicable in determining a suitable award of alimony.

This article will not focus on other aspects of the case which include a discussion of why the Court affirmed an award of custody supported by a well reasoned and complete G.A.L. report.
At the trial level, the presiding judge included all the “pass-through” income of the S corporation in determining J.S.’s (Defendant/Appellant’s) income for calculating child support. At the time of trial, the applicable Child Support Guidelines were those in effect prior to January 1, 2009, which required the inclusion of gross income from whatever sources, including income derived from business/partnerships (Guidelines (I)(A)). Therefore, the presiding judge took into consideration all income actually paid to the Defendant/Father and the anticipated profits/retained earnings of the S corporation. The judge, after noting that the corporation had not filed tax returns for the relevant year (2005), based the Defendant’s total available income on his testimony that the 2005 profits were likely to be $400,000 to $500,000. As the Defendant was a 65% owner of the corporation, he would be reporting $260,000 to $325,000 on his individual tax return. The Defendant’s financial statement erroneously represented his total gross income as only $92,001.65 – the actual salary paid to him in the course of the year. He did not list any other monies from the corporation as part of his gross income, except in an explanatory note where he stated that his tax returns reflected corporate profits or losses but he rarely received distributions from the corporation other than in the amount required to pay any tax liability attributable to the pro rata pass through of the corporation’s income for income tax purposes.

Under the Child Support Guidelines in effect since January, 2009, there is some guidance as to how to approach business income. The Guidelines provide as follows:
“Income from…joint ownership of a partnership or closely-held corporation, is defined as gross receipts minus ordinary and necessary expenses required to produce income. In general, income and expenses from self-employment or operation of a business should be carefully reviewed to determine the appropriate level of gross income available to the parent to satisfy a child support obligation. In many cases this amount will differ from a determination of business income for tax purposes.” (I)(A).

The approach of the recently enacted Massachusetts Guidelines is consonant with the ALI Principles of the Law of Family Dissolution and with a majority of decisions in other jurisdictions, all of which require a case-specific, factual inquiry.

J.S. vs. C.C. sets forth some of the relevant factors (although not an exhaustive list) that the judge should consider in determining what portion of undistributed corporate earnings should be attributable to a shareholder for establishing child support. For example, a shareholder’s level of control over corporate distributions – as measured by the shareholder’s ownership interest – is a factor of substantial importance. A minority shareholder, lacking the power unilaterally to order a distribution, may be unlikely to have access to retained income of the corporation; a majority shareholder has relatively more control over access to retained funds and may have the ability to manipulate pass-through income; and, a sole shareholder has total control over the distribution of earnings.

Second, the judge should evaluate the legitimate business interests justifying retained corporate earnings. Third, the judge should weigh affirmative evidence of an attempt to shield income by means of retained earnings. In that regard, the corporation’s history of retained earnings and distributions may be relevant. Finally, it is important to consider the allocation of burden of proof in relation to the treatment of an S corporation’s undistributed earnings for purposes of determining income available for child support. Despite the allocation of the burden of proof in some jurisdictions, the SJC held that the shareholder, regardless of the extent of his/her interest (minority or majority) is the more appropriate party to bear the burden of proof, given his/her greater access to relevant information about the corporation compared to the party who is not connected to the corporation.

The trial judge, without giving any specific consideration to particular facts and circumstances, held that Defendant’s entire taxable income was available income for measuring the appropriate level of child support. The record below showed that the parties gave no consideration to the extent of the Defendant’s ownership in the S corporation or to the history of retained earnings. The SJC remanded the instant case to the trial court, with instructions to give further consideration of the Defendant’s financial resources and to enter a child support order in light of the standard set out in this opinion (as well as the New Guidelines).

Lessons to be learned:
1. All business income reported by a litigant needs to be explored critically prior to the temporary order stage using the new Child Support Guidelines criteria.
2. Financial statements should disclose the extent of any and all business interests in the body of the statement or in the footnotes.
3. Review and inclusion of past individual and corporate tax returns are essential to proper presentation of any child support/alimony argument.
4. Legitimate expenses of the business/individual may be excluded from income, but those expenses must be historically consistent, reasonable and well documented.
5. The burden of proof of exclusion rests with the shareholder/business person.
6. The issue of available income to the payor is likely to first arise at the hearing of temporary support. This is a difficult forum in which to argue beyond or behind the financial statements as filed. Time is short and litigants are seldom asked to testify.
7. Motions for temporary support should be accompanied by memoranda if either party has any business income.
8. The memorandum creates an opportunity to present historical evidence of income distributions, relevant individual and corporate tax information, documentation – or lack thereof – of business expenses, as well as a forum to present the reasonableness of the position taken on the issue of retained earnings in light of the industry standard, total income from all sources and other factors that may be relevant.
9. The guidance set forth in the J.S vs. C.C. case and the lessons to be learned are not only applicable to child support awards but should be applied also to requests/awards of alimony.