General Practice, Solo & Small Firm DivisionMagazine
Federal Tax Returns - A Discovery Tool for Family Lawyers
BY PEGGY L. PODELL
© American Bar Association. All rights reserved. Peggy L. Podell is a partner in the law firm of Podell & Podell, Milwaukee, Wisconsin. She is a member of the Council of the ABA Section of Family Law and is on the editorial board of The Family Advocate . This article is based upon an article that appeared in the Wisconsin Journal of Family Law (State Bar of Wisconsin, July 1991). The author would like to thank David Franklin and Scott Franklin of Kohler & Franklin, CPAs, Milwaukee, Wisconsin, for their thoughtful comments.
At the beginning of a divorce case, it is not unusual to have minimal information about your client’s financial situation. The parties’ personal federal tax return provides a relatively easy and inexpensive way to start the discovery process.
Lawyers can use a tax return to get a grasp on the situation and formulate a discovery plan. In more complex cases, it is always advisable to contact an accountant and have her review the returns with you.
This article focuses on Form 1040, paying particular attention to page one of that form.1 A copy of the May 21st proof was obtained from the Internal Revenue Service’s internet site—www.irs.ustreas.gov.2 Many of the entries on Form 1040 are actually taken from other forms and schedules. Thus, some of the comments will cover those underlying documents as well.
Why Use Tax Returns?
Parties usually have access to their tax returns. Either they retained a copy or can contact their tax preparer in order to obtain a copy. If neither of these options is viable, copies of filed returns can be requested from the taxing authorities.3 Returns are usually available early in the action and can help you and the client gain insight into the financial situation.4
A review of the entries on a tax return can help you to formulate a tentative list of assets, documents to be reviewed, and questions to be answered. It can also shed light on the issues of support, valuation of certain assets, and division of estate. However, you must be cautious. Do not assume that the figures you see on a tax return reflect the true financial picture. You should think of those figures as the beginning of the investigative process, not the end product. You need to know how the figures were arrived at before forming an opinion as to their accuracy. In addition, the lack of an entry on the return may not mean that the particular type of asset does not exist.
Looking back. Many lawyers and accountants recommend a review of tax returns for the previous five years. Obtaining returns for a number of years provides you with a financial history of the parties. In addition, comparing returns over a span of time may reveal an attempt at pre-divorce planning. For instance, you may see assets bought and sold or accounts reported on one year’s return but not subsequent returns.
Under certain circumstances, you may want returns covering more than five years. Depending on the issues involved, such as financial contributions to the marriage or tracing exempt property, you may want returns spanning the entire length of the marriage.
Form 1040 is a two-page form that can be thought of as the table of contents for the rest of the return. These pages provide an overview of what is to come. A quick review of these two pages will give you an idea of employment status, taxable and nontaxable income, and income-generating investments.
Income. All income is recorded on lines 7 through 22 of the first page of Form 1040.5 A great deal of information can be obtained from a review of this section.
Wages, salaries, tips. Wages, salaries, and tips are reported on line 7. Entries on this line for wages and salaries should be supported by a W-2 form. Review each W-2 form in order to determine whether there have been places of employment of which you were not aware. In addition, fringe benefits, such as contributions to a 401(k) plan and in some instances reimbursements, may be disclosed on a W-2. The income reported on the W-2 may also include the amount realized as a result of the exercise of stock options.
Interest and dividends (Schedule B). Line 8a is used to report the total taxable interest income. If the amount recorded on this line is more than $400, Schedule B must be prepared and attached to the return. Schedule B includes a list of the sources of interest income, such as bank accounts.
If taxable interest income does not exceed $400, you will find an entry on line 8a but no information need be set forth on Schedule B. If that is the case, request information as to what generated the income reported on line 8a.
Although interest income from certain investments is not included in taxable income, it still must be reported. You will find this information on line 8b. It is important to remember that an entry indicating the source of the tax-exempt interest may not appear on Schedule B. It does not have to be included, but some tax preparers include the information and note that the amount is tax-exempt. If information as to the source is not included, you will need to pursue additional discovery. When reviewing tax returns from previous years, it should be noted that there was no requirement to report tax-exempt interest prior to 1987.
As was true with taxable interest income, if the amount in this section exceeds $400, Schedule B must be completed and attached. The sources of the dividend income are reported on Schedule B. If an individual has growth stock that is not currently paying dividends, the stock will not be listed on Schedule B. Thus, even if there is no entry on Schedule B, it may be wise to inquire as to whether the individual has stock.6
Business Income/Loss (Schedule C). Line 12 is used to report business income or loss. Anyone operating as a sole proprietor must complete a Schedule C or C-EZ. The amount of the profit or loss for the operation is recorded on line 31 of Schedule C or line 3 of Part II of C-EZ and line 12 of Form 1040. If more than one business is operated as a sole proprietorship, the total for all of the businesses is reported on line 12 of Form 1040 but a separate Schedule C or C-EZ must be filed for each business.
Schedule C is used to report the income, deductions, and costs of goods sold and/or operations. When reviewing this schedule, you are looking for evidence of assets, evaluating deductions, and trying to determine available cash.
A wealth of information can be gleaned from this schedule, including the method used to calculate the closing inventory, which can affect the value of the business, and the accounting method used by the business. Lawyers should talk to an accountant or tax advisor in order to explore the ramifications of these entries and what additional information to request.
If the individual is a cash basis taxpayer, inquire as to accounts receivable. They will not appear on the tax return, but are important for valuation purposes. You will want to know the amount of the accounts receivable, what the average time period is in which accounts are paid, what the billing cycle is, and, in the case of individuals who rely on insurance for payment, what has been the experience with the amount and timing of insurance payments.
Deductions are allowed for expenses attributable to a trade or business operated as a sole proprietorship and these are reported on Schedule C. As you review the deduction section of this schedule, try to determine if the deductions are appropriate and whether they reveal any assets or personal expenses. Improperly deducted costs should be added back into the enterprise.
Examine the deduction for depreciation. This deduction can reduce the level of income reported without affecting cash flow. Review the depreciation schedule in order to identify which assets are being depreciated, and find out the cost and write-off date of each asset. Remember, the depreciated value, or book value, of an asset is seldom its true value. Also remember that there may be assets still in use that have been fully depreciated and these may not appear on a depreciation schedule.
An entry on the line for interest-mortgage indicates the existence of property. If credit was extended, was a financial statement provided to the creditor? If that is the case, compare that statement with the information you have to see whether there are any discrepancies.
If a deduction was taken for legal or professional services, determine why the services were provided and whether they relate to pending lawsuits, including the pending divorce action, or to the acquisition or disposition of assets.
Likewise, scrutinize the deduction for office expenses. Office supplies normally used within a business year are deductible. Review the expenses deducted in one year with those from previous years. Are they consistent, or does there seem to be an increase in the deduction from past years. In addition, try to determine whether there has been a "stockpiling" of supplies. Stockpiling supplies would result in increasing the deduction, which would lower the income reported, but would mean there are supplies (assets) available for use in the next year that would not be offset by the expenses for those assets in that year.
It is important to compare the net profit or loss figure reported on the current return with figures from previous years. Is the figure consistent with the pattern for those years? If it is not, is there an obvious outside economic reason why that may be the case? For instance, is the entire industry or service area suffering during a recessionary period? Care must be taken when reviewing these figures in order to determine whether there has been divorce planning to reduce the net profit of the business shortly before the divorce was filed or during the year in which litigation is occurring.
Capital gains/losses (Schedule D). Capital gains and losses from sales of investments and business-related properties and dividends distributed by mutual funds as taxable capital gains are reported on line 13. The source of any gain or loss should be thoroughly investigated.
Information derived from Schedule D (Capital Gains and Losses) is reported on line 13. Schedule D is used to report capital gains and losses that may result from various transactions, including the sale or exchange of a capital asset or exchange of like-kind property. In addition, the schedule is used to report figures from other forms such as Form 6252, Gains from Installment Sales.7
Short- and long-term capital gains and losses are reported on Schedule D for transactions involving assets such as stocks, bonds, and other securities, as well as investment real estate. A description of the assets, date of acquisition and sale, sale price and basis, and the loss or gain from the transaction must be reported on this schedule. Review the transactions and compare them to those in previous years to determine whether there is an increase that may indicate an attempt at divorce planning. The proceeds from the sale of any asset should be accounted for by the party involved in the sale.
IRA distributions/pensions and annuities. Lines 15a and 16a are used to report the total distributions received during the year from IRAs and pensions and annuities. Lines 15b and 16b are used to report the portion of the distribution that is taxable.
If the taxpayer has not reached the appropriate age for such distributions and you see an entry on these lines, inquire why a distribution was taken and where the funds are. Remember, beginning in 1998 taxpayers have the option of converting existing IRAs to Roth IRAs. Therefore, a distribution from an IRA may represent its conversion to a Roth IRA or may mean that the taxpayer took the cash and did not roll the funds over. If a Roth IRA was created, nothing may appear on future tax returns to indicate the asset exists.
Additional Sources of Information
There are a number of sources for additional information about tax returns. Package X, an IRS publication, is a two-volume set that contains informational copies of federal tax forms. In addition, the IRS has a number of free publications designed to help the taxpayer understand how various tax laws apply. Publication 910 contains a list of the other publications and a brief description of each. Individuals who contact the IRS for information about a certain area of the law, such as income reporting for a divorced or separated person, will be referred to one of these publications.
A toll-free "forms only" telephone number can be used to order tax forms and publications. The number is 800/TAX-FORM (800/829-3676).
The ABA Section of Family Law has two publications concerning tax returns. The 1040 Handbook—A Guide to Income and Asset Discovery, 3rd edition, contains an analysis of Form 1040 and related forms. Understanding Business Tax Returns: A Lawyer’s Handbook contains an analysis of corporate tax returns. Both books contain various tax forms and schedules, and provide information concerning schedules and lines of inquiry suggestions.
The lack of an entry on this portion of Form 1040 may not mean that nothing happened to a retirement account. Under certain circumstances a taxpayer may be able to get special tax treatment when cashing in a retirement account. The income would not be reflected on the front page of Form 1040 or be included in the taxpayer’s adjusted gross income because it would be computed differently. There should, however, be an entry on line 40 of Form 1040, lump sum distributions, and a reference to Form 4972, which should have been completed.
Rents, royalties (Schedule E). Revenue reported on line 17 is taken from Schedule E, which is used to report income or loss from rents, royalties, partnerships, Subchapter S corporations, and trusts and estates. In addition, beginning in 1987, Form 8582 should also be examined. This form contains information about passive loss activities that would not be found on Schedule E.
If rental property is involved, find out how many units there are, what they rent for, and how many are currently vacant. You should also try to determine whether the number of vacant units is representative of past vacancies or is something fairly new. Examine the reported expenses to be sure that they can be documented and pertain to the property in question. Review any deduction for mortgage interest. If the deduction seems large, or markedly differs from previous tax returns, determine whether refinancing has occurred or if there is a second mortgage. If either is the case and a large loan was taken, what was done with the proceeds?
Farm income/loss (Schedule F). An individual who farms or has farm-related income or loss must calculate the amount of that income or loss on Schedule F. The amount is then reported on line 18 of Form 1040. In many respects Schedule F is similar to Schedule C.
There are, however, special rules and elections that may apply to farm income, expenses, and losses. In addition, there may be special financing terms or agriculture disincentive payments that are not reflected on the return but are of benefit to the taxpayer. Thus, it is advisable to discuss entries on this schedule with an accountant or tax advisor familiar with these rules, elections, special financing, and disincentive payments.
Schedule F contains a section on deductions. Examine these with a view toward attempting to determine the reasonableness of reported expenses and their potential for bearing personal expenses. Deductions are available for items such as the cost of chemicals, fertilizers, and supplies. In addition, deductions are available for the hiring of machines and labor, depreciation, and interest. As with Schedule C, you will want to watch for items that are being deducted as expenses but really represent the accumulation of assets, such as supplies and chemicals for the farm. The same areas of inquiry noted for Schedule C for deductions are equally applicable to Schedule F.
Total income. Line 22 is used to report "total income," which reflects the total of the figures in the income section of Form 1040 with the exception of the tax-exempt interest reported at line 8b and the tax exemption portion of any IRA, pension, or annuity distribution at lines 15a or 16a. While "total income" is an important figure, you should not assume that it represents cash flow in all cases. Further investigation into cash flow will require a thorough review of the various schedules and other documents from which the figures in the income section are taken.
Adjustments to income. Lines 23 through 32 are used to report adjustments to income. These adjustments, or deductions from income, are available without regard to the individual’s eligibility to itemize other allowable deductions on Schedule A. These adjustments are sometimes referred to as "above the line" deductions. Deductions include allowable deductions for IRA contributions, self-employed health insurance deductions, Keogh deductions, penalties for early withdrawal of savings, and alimony paid.8
• IRA, Keogh, SEP, & SIMPLE Deductions. Line 23 is used to report IRA deductions and line 29 to report a deduction for a Keogh retirement plan, self-employed SEP, or SIMPLE plan contribution. An entry on either of these lines represents the existence of an asset. The lack of an entry, however, does not mean that an asset of this type does not exist.
There are restrictions regarding the deductibility of IRA contributions. An individual’s allowable IRA deduction may be reduced or eliminated entirely. Nevertheless, that person may have made a contribution or may have a preexisting IRA to which a contribution was not made. Thus, it is important to investigate the possible existence of an account.
Reviewing copies of tax returns for the past several years may reveal entries relating to the existence of an IRA, Keogh, SEP, or SIMPLE plan. Contributions may not have been made during the year in question, but may have been made in previous years.
Remember also that the Roth IRA is funded with after-tax dollars. The individual is not allowed a deduction for a contribution to a Roth IRA; therefore, you will not find a deduction listed on line 23 if a contribution was made to this type of IRA. Thus, lack of a deduction does not mean an account does not exist.
• Early withdrawal penalty. Line 30 is used to report a penalty on early withdrawal of savings. An entry here means that the status of an asset has been altered. If you discover an entry on this line, be sure to ask questions about where the proceeds are at this time and why an early withdrawal was made that would incur a penalty.
• Adjusted gross income. When all of the adjustments (lines 23 through 31a) are subtracted from the total income (line 22), the resulting figure is called adjusted gross income (AGI). The weight to be placed on AGI depends on the validity of all of the other figures in the equation.
• Refund or amount owed. This section, which is found on page two of Form 1040, may indicate the existence of an asset (refund) or liability (amount owed). The figure should be compared with those of previous tax returns to determine whether the amount and status, refund or amount due, is consistent with prior years. In addition, compare the current withholding pattern with that of previous years in order to determine whether someone is attempting to "overwithhold" in order to reduce monthly net income and generate a refund that he hopes to keep for himself or herself. If there is a refund due, be sure to check whether the taxpayer has asked that it be applied to the next year’s tax or refunded.
Form 1040 is an important tool. While it cannot stand alone, it can provide a starting point that should prove helpful to you in structuring your discovery. CL
1. References to line numbers in Form 1040 are to the May 21, 1998 proof of the 1998 Form 1040.
2. The final version of the 1998 Form 1040 may differ from the May 21st proof; therefore, when looking at the final form, focus on categories and concepts rather than numbered lines. In reviewing returns from years prior to 1998, line numbers may differ and there may be lines included on one year’s form that do not appear on another year’s form.
3. Copies can be requested from the Internal Revenue Service by using IRS Form 4506. After the form is filled out and signed by the taxpayer, it is sent to that taxpayer’s service center. It may be possible to obtain copies of returns faster from the state taxing authority and the reader is advised to check as to whether that option is available in his or her state. In some states, the federal tax return is attached to the state return when the state return is filed.
4. If you will be representing the spouse who has limited knowledge of the family’s finances, it may be advisable to have that spouse obtain copies of the returns prior to commencing the action.
5. "Total income" is reported on Line 22 of the 1998 1040 proof and is merely the sum of the figures set forth on lines 7 through 21.
6. Inquiry could be made through interrogatory questions or questions at a deposition.
7. See line 22 of Schedule D for a listing of the other forms.
8. Space does not permit a complete discussion of each line of this section, so I would like to briefly review a few areas.