December 2014 : Michigan Court of Appeals Rules on Availability for Support of (1) Undistributed S Corporation Earnings and (2) S Corp Distributions to Cover Taxes on Undistributed “Pass Through” Income: DIEZ V. DAVEY, Mich App No. 318910 (10/23/14)

Michigan Family Law Journal : TAX TRENDS AND DEVELOPMENTS Feature

by Joseph W. Cunningham, JD, CPA

Excerpt:

Facts

  • The case, involving unmarried parents (Dad and Mom) of three children, was focused on child support, custody, and parenting time.
  • Dad is the sole owner of SGC, a manufacturer of equipment used in the aerospace industry.
  • SGC is operated as an S Corporation for federal tax purposes – that is, its income is “passed through” and taxed to Dad individually, whether actually distributed to him or not.
  • The Friend of the Court (FOC) conducted an evidentiary hearing and made a recommendation based on testimony of Mom’s CPA expert regarding Dad’s “money … available for support.”
  • Included in the FOC’s determination of Dad’s funds available for support were:
    • His W-2 income;
    • Various perks paid by SGC on his behalf;
    • All distributions he received from SGC, some of which were, evidently, made to provide Dad funds to pay the tax on undistributed SGC income; and
    • SGC’s “excess working capital” – that is, funds retained by SGC in excess of what the company needed to operate the business. The excess working capital was determined by application of (1) a formula used in some federal tax cases and (2) the CPA’s judgment.
  • The trial court adopted the FOC’s recommendation.
  • Dad appealed objecting, in pertinent part, to the inclusion of funds he allegedly had available for support as (1) excess working capital and (2) SGC distributions to pay tax on undistributed income, for the following reasons:
    1. Excess Working Capital – SGC was “capital intensive” and had to regularly purchase new equipment to remain competitive. Historically, such purchases were made with cash retained by the company. The amount of cash maintained by SGC was approximately the same year to year. Thus, the so-called excess working capital in fact consisted of funds that would similarly be used to acquire new equipment, continuing a long established SGC operating practice.
    2. Distributions to Pay Tax on “Pass-Through,” Undistributed Income—Distributions to pay tax on SGC income taxable to—but not received by—Dad were simply not funds available to him for support. Since the money was paid to federal and state tax authorities, it clearly was not “available” to him.

Court of Appeals Decision

In a published split opinion, the Court of Appeals (Court) agreed with Dad on the two issues noted above.

Excess Working Capital

The Court referenced the Michigan Child Support For- mula Manual (MCSFM) in which it is stated that “income (or losses) from a corporation should be carefully examined to determine the extent to which they were historically passed on to the parent.” (Emphasis added.)
……

Continued in PDF file below… “Michigan Court of Appeals Rules on Availability for Support of (1) Undistributed S Corporation Earnings and (2) S Corp Distributions to Cover Taxes on Undistributed “Pass Through” Income: DIEZ V. DAVEY, Mich App No. 318910 (10/23/14)”
View / Download December 2014 Article – PDF File

Complete Michigan Family Law Journal available at: Michigan Bar website – Family Law Section