Should a company’s retained earnings be included as marital income?
The Michigan Court of Appeals answered no in this case of first impression¹. Eric Larson, partner at Beene Garter, was hired to provide valuation services in this appellate ruling.
In this divorce case, the husband entered the marriage with a business structured as an S corp. Both parties agreed the business was the husband’s separate property.
Federal tax law states that an S corp’s income is taxed to the company’s owner as personal income. For this reason, the wife argued that company earnings that had been retained during the marriage were part of the marital estate.
The Court of Appeals rejected this argument because matters of domestic relations are subject to state law, not federal law.
And, the Court decided it was wrong to adopt a rule that says retained earnings are always the entity’s property until distributed. The Court thought this could encourage the owner spouse to shield wealth from his/her spouse.
However, the Court didn’t agree that an entity’s retained earnings must be included in the marital estate when the owner spouse has control over the distribution of earnings. This doesn’t take into consideration ordinary business practices.
The Court concluded that trial courts should make this decision on a case-by-case basis.
To respect the entity’s separate existence, courts should assume the retained earnings aren’t part of the marital estate. The spouse claiming otherwise must factually demonstrate that some or all of the earnings should be included in the marital estate.
Trial courts should also examine a number of factors: historical operations of the business, the business’ need for operating capital, whether the owner spouse was reasonably compensated for his/her work for the business, whether the owner spouse deliberately acted to retain funds to deprive the marital unit of income, and any other relevant factors.
If the trial courts find that the owner spouse has unreasonably withheld distribution of earnings, the trial court should treat those earnings as marital income to appropriately divide the marital estate.
In this case, the Court of Appeals agreed with the trial court’s decision – the S corp’s retained earnings were not marital income. You can read the full opinion of the Michigan Court of Appeals’ decision here.
¹Case of first impression – A case in which a question of interpretation of law is presented which has never arisen before in any reported case. Sometimes, it is only of first impression in the particular state or jurisdiction, so decisions from other states or the federal courts may be examined as a guideline.
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