Self-Employment Income in Child Support Guidelines: A View Across the States

Introduction

Due to the existence of mandatory guidelines in every state, the determination of child support is viewed by many as a perfunctory exercise.  And it often is, in simple scenarios, such as when both parents are W-2 employees.  While the child support formula (or worksheet) may be straightforward, ambiguity can arise in the inputs to the formula--specifically, what constitutes income and how it is measured.  Although many states have proactively reviewed and amended their guidelines to address such ambiguities, others continue to operate under generalities that can lead to inequitable results in some situations.  One such situation that is becoming increasingly prevalent is self-employment income, which includes independent contractors and small businesses.  Given the self-determined nature of such income, there is certainly an opportunity (and arguably even a tendency) for misrepresentation.  According to recent research, 44 million American workers (28.2%) were self-employed at some point during 2019.  We can only expect this to increase in the COVID-19 era as more people seek alternative work environments.

This article identifies and discusses common elements of child support guidelines across the nation, particularly as they relate to self-employment income.  The goal is to familiarize practitioners with key issues that may be addressed to a greater or lesser degree in the laws of their home states.  Either way, knowledge of the issues is necessary to determine what arguments can successfully be made and how.  I begin with a discussion of how income is defined in the guidelines, which is the primary source of disparities across the states.  I then describe how the landscape of financial reporting for self-employment leads to difficulties in quantifying said income, especially with regard to assessing the legitimacy of expenses.  The authority of tax returns with regard to self-employment income is then discussed, as well as the burden of proof for any deviation therefrom.  Finally, I identify other provisions of the guidelines that may be relevant to the determination of self-employment income.  Throughout the article, I highlight the law in my home state of West Virginia.

Definition of Income

Despite the widespread use across the country of the same theoretical framework for child support guidelines, there remain substantial differences in application.  The primary source for such variation is different definitions of income.  Most states begin with a comprehensive definition that includes almost all conceivable forms of income, whether earned or unearned (e.g., salaries, wages, commissions, bonuses, tips, profit sharing, interest, dividends, royalties, self-employment income, business income, pension benefits, insurance/annuity payments, unemployment compensation, spousal support, severance pay, gifts, lottery winnings, etc.).  Many states (approx. 36) also include in-kind payments such as business expense accounts, automobiles, and meals, to the extent they provide the parent with property or services that would otherwise be funded from personal spending.  Another common (42 states) element is the inclusion of attributed income (also known as imputed income, potential income, or earning capacity) if a parent is deemed to be voluntarily unemployed or underemployed.    

Self-Employment Income

Of the multiple income sources to be considered, self-employment income is perhaps the most difficult to accurately quantify.  Such income represents net income, that is, revenue minus expenses.  For example, consider a small lawncare business that reports revenue of $500,000 and expenses of $450,000, yielding net income of $50,000.  The company has a single owner, who does not pay himself any wages.  In this scenario, the $50,000 net income of the company flows to the owner and is considered income for child support purposes.  If the net income figure is accepted as reported, it is simply plugged into the child support formula, along with any other sources of income.  But let’s consider the possibility that the company regularly performs work for cash, some of which is not reported as revenue.  And if we look closer at the expenses, we may find depreciation (a non-cash expense), as well as expenses for the owner’s personal automobile, meals, and travel.  Perhaps the owner’s brother, who doesn’t actually work for the company, is on payroll.  Given this context, how reliable is the $50,000 net income figure?  

The point here is that two different elements must be considered, revenue and expenses, both of which are prone to misrepresentation.  Revenue can be understated or expenses can be overstated, both with the result of reducing net income.  It’s no secret that such misrepresentation occurs with self-employed persons and small businesses.  In owner/operator situations, where resources are often limited, financial recordkeeping and reporting may not be at the top of the priority list.  Moreover, when only one or a few players are involved, there may be a temptation to push the legal envelope. 

For these reasons, various safeguards are in place.  The Internal Revenue Service conducts audits of income tax returns.  Banks and other lenders commonly require reviewed or audited financial statements for business loans.  In business valuations (whether in a divorce context or otherwise), normalizing adjustments are often applied to reported revenue and/or expenses for the purpose of reflecting what valuation analysts call economic reality.  As a professional who has performed many valuations of small businesses (as well as reviewed valuations performed by others), I can authoritatively say that, in the majority of such valuations, normalizing adjustments are made.  In other words, it is determined that the reported income data does not reflect economic reality.  Stated differently, and within the child support context, reported self-employment income may not accurately reflect the parent’s ability to pay.  Importantly, per the federal guidelines, income is relevant to the extent that it represents ability to pay.  This is the appropriate benchmark by which to evaluate any item of revenue or expense.

Legitimate Expenses

From this point forward, I focus on the expense side of the net income equation rather than revenue.  While underreporting of revenue is certainly an issue, it is often difficult to prove, especially when the revenue (e.g., cash) is never deposited in a bank account.  Various methods (known as indirect methods) are used by tax regulators and others to address this problem, but they are both data- and labor-intensive (and thus expensive).  Simply stated, consideration of unreported revenue involves searching for something that may or may not exist.  In contrast, consideration of illegitimate expenses involves a clear target - the expenses actually reported. 

The key question then is:  What constitutes a legitimate expense for the purpose of calculating self-employment income for child support?  Although some state statutes fail to define self-employment income, forty states define it as gross income (revenue) less ordinary and necessary business expenses required to produce that income or required to operate the business.  The phrase ordinary and necessary is borrowed from the Internal Revenue Code, which defines tax deductible business expenses as "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business."  Although an in-depth discussion of the meaning of these terms (as established via tax court rulings over the years) is beyond the scope of this article, the general consensus is that an ordinary expense is one that is common or accepted in the industry, while a necessary expense is one that is helpful or appropriate.  So, in the context of tax, necessary does not mean indispensable, as many might assume.

Do Tax Returns Control?

As noted above, the child support guidelines of many states mandate that, in addition to being ordinary and necessary, a business expense must be required.  Under this provision, arguments can be made to exclude certain expenses that are otherwise legally tax deductible.  The issue is further clarified in twelve states, whose Codes specifically declare that:  a) income and expenses from self-employment or operation of a business should be reviewed in determining income for child support; and b) such income may differ from taxable income (emphasis added).  In these jurisdictions, where judges have substantial discretion to look beyond tax returns, attorneys (perhaps with the assistance of experts) can more easily make arguments that certain self-employment expenses should be disregarded. 

Even more helpful are statutory provisions that exclude certain expenses for self-employment income, such as accelerated depreciation (30 states), investment tax credits (18 states), and other business expenses determined by the court to be inappropriate for child support purposes (27 states).  The last category may include expenses that have a personal component, such as travel, meals, automobile, and home office.  However, the situation is challenging in states whose child support guidelines are more general in nature, lacking precise definitions for key terms.  For example, in Pennsylvania, the applicable statutory language is simply "net income from business" without further details as to what expenses can be deducted in determining the net income. Some states previously operated under such generalities before making substantive changes to their guidelines.  Jason Owens (2011) explains how this occurred in Massachusetts, where from 1988 to 2008 the guidelines "provided no definition of self-employment income beyond offering that it was among the sources of gross income for child support purposes". Effective in 2009, the guidelines for the first time contained a specific definition of self-employment income:

Income from self-employment, rent, royalties, proprietorship of a business, or 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.<\/blockquote>

Multiple other states now employ the same or similar language in their guidelines.

In contrast, a few states explicitly equate self-employment income for child support with taxable income. For example, in West Virginia where I practice as an expert witness, self-employment income is defined as "income from self-employment or the operation of a business, minus ordinary and necessary expenses which are not reimbursable, and which are lawfully deductible in computing taxable income under applicable income tax laws" (emphasis added).  As a result, income for child support is generally pulled directly from tax returns, without question.  On the positive side, this produces a simple rule that can be easily applied.  A weakness, however, is the unstated assumption that people accurately report their income on income tax returns. 

As previously discussed, it is widely known that inaccurate reporting does in fact occur, especially with self-employment income.  Nonetheless, family court judges may not want to be in the position of interpreting income tax law, and thus may be inclined to accept taxable income as reported.  Given this reality, while arguments can be made that certain reported expenses are not truly deductible under tax law, it can be an uphill battle from the start.  Moreover, such arguments generally require the involvement of an expert, which may not be possible when financial resources are limited.  The unfortunate reality is that, in jurisdictions where tax returns control, the recipient parent is at a disadvantage, especially in lower-income cases where the parent may have little recourse but to hope for action by the IRS, since an examination (audit) is the only means of definitively determining tax deductibility. 

Contributing to this disadvantage is widespread lack of knowledge regarding IRS compliance procedures, which can lend a false sense of legitimacy to income tax returns.  There seems to be a common misperception (and I've seen it argued in court) that silence on the part of the IRS constitutes approval of any reported tax deductions. This is untrue, as a tax return is nothing more than the taxpayer's own representations, and IRS audits are conducted for only a small fraction of returns.  According to IRS data, for all returns filed for tax years 2010 through 2018, only 0.60% of individual returns and 0.97% of corporate returns were audited.  The truth is that, although tax returns are not commonly disputed, they are indeed subject to dispute.  Still, the opportunity for dispute in child support actions is very limited in some jurisdictions. 

Burden of Proof

If tax returns do not necessarily control, the next question is:  Who has the burden of proof regarding the legitimacy of a claimed tax deduction?  In the tax arena, that burden clearly rests on the taxpayer, not the IRS.  In the context of child support, it's often not so clear.  In a handful of states, the statutory guidelines specify that the burden is held by the self-employed parent.  In others (including Massachusetts), the same has been established via case law.  A 2020 case in California, Hein v. Hein, addressed this issue, clarifying previous decisions in the state that seemed to present a rebuttable presumption that tax returns are correct.

The Hein court found that no such presumption exists for self-employed persons, given the potential for manipulation of income in such situations, and the burden of proof should be assigned to the self-employed parent who has control of the financial records.  This decision also addressed the deduction of depreciation, ultimately concluding that it should not be allowed for the purpose of child support.  Judicial interpretation was necessary in this regard, as California is not among the states whose guidelines specifically address the issue of depreciation. Interestingly, a footnote in the Hein decision expresses the need for additional clarity in the statutory guidelines:

Should the Legislature attempt to clarify a parent's income from the proprietorship of a business, greater clarity would be achieved if, in addition to addressing the treatment of depreciation, the subjects of (1) capital expenditures and (2) principal payments on third party debt used to acquire a capital asset were addressed.

Attributed Income

Even in states, such as West Virginia, where the child support guidelines embrace tax law with regard to self-employment income, arguments can still be made under provisions for attributed income.  While attorneys are likely familiar with the existence of these provisions, they should take a closer look at the precise language.  In West Virginia, attributed income is defined as "income not actually earned by a parent but which may be attributed to the parent because he or she is unemployed, is not working full time or is working below full earning capacity or has nonperforming or underperforming assets".  The term underperforming assets here offers a framework for challenging certain business expenses.  The asset is the business, and the deduction of certain business expenses may result in net income that constitutes underperformance.

Consider, for example, accelerated depreciation.  Businesses are more than willing to report this deduction on a tax return but are probably less eager to do so on a loan application.  In the latter context, the business owner would argue that the reported net income does not really represent the performance of the business, given the discretionary and temporary nature of accelerated depreciation.  Similar arguments can be made for a number of different expenses.  With regard to accelerated depreciation, the issue is one of timing - whether the deduction is concentrated in a shorter period of time or extended over a longer period of time.  Although timing is not as important to the IRS (all the income will eventually be taxed), it is important in the context of child support, because children age out of this benefit. 

In some cases, the business owner may argue that the expense in question was a strategical decision to incur a short-term cost in exchange for a long-term benefit.  Such an expense could indeed be considered ordinary and necessary and would thus be deductible for tax purposes.  Even so, this constitutes a voluntary action leading to underperformance of the business asset during the time period relevant for child support.  Even if the business owner benefits down the road, the child will not, which is an inequitable result.  Yet another argument to be considered in such a situation is that of deferred income, if there is sufficient basis in the statutory or case law.  In other words, the business expense in question may constitute the deferral of income to a later time when it would not be subject to child support, thereby artificially reducing the self-employed party's income for the purposes of the current child support calculation.

Conclusion

Child support is determined "by formula" in all states, based on a common theoretical framework.  Still, the details of the formula vary across states, and inputs to the formula often vary within states.  As such, the calculation of child support should by no means be treated as a mechanical element or afterthought.  This is especially true when one or both parents are self-employed, which introduces additional complexity.  All practitioners in family law (attorneys and experts) should review the guidelines and case law in their home states, with attention to issues such as:

1. What types of income are included for child support?
2. What qualifies as a legitimate expense for self-employment?
3. Are any specific expenses excluded in the guidelines or case law?
4. What discretion do judges have to disregard expenses that are not explicitly addressed?
5. Do tax returns control for self-employment income?
6. Who has the burden of proof with regard to legitimacy of a reported self-employment expense?
7. Can arguments of equity be made under other provisions, such as attributed income?

When the answers to these questions are unclear, it may be helpful for practitioners to support their arguments with prevailing law in other states, as summarized in this article.  Across the nation there has been a progression in the child support guidelines from generalities to specifics, giving judges clear guidance for common situations yet allowing them to exercise discretion when necessary to preserve equity.  Still, amendments to the guidelines, such as the amendments in Massachusetts, are arguably warranted in a number of states and should be considered as part of the required quadrennial review.