3 Secrets to Proving Self-Employment Income for Child Support in California [In re Marriage of Deluca & Hein]

Tricks and Tips to Proving Self-Employed Income for Child Support That Your Ex Doesn’t Want You To Know

Walking into a family law courtroom and swearing up and down that your ex makes more money than he/she claims is easy enough; but I have yet to see a court order that reads: “Party A shall pay amount X to Party B as and for support each month because Party B is 100% sure Party A makes a lot of money, and Party B seems pretty cool.”

Family courts in California may get a bad reputation for being loose with the rules as courts of equity, but if you plan to contest the opposing party’s claims regarding his/her income, you will quickly learn that even family court still requires a little thing called evidence.

How Do I Prove the Opposing Party’s Income When They Own Their Own Business?

This issue is highly litigated in California family courts, and the laws relating to the issue are continually changing. In the year 2020, two (2) major cases came down affecting how income from self-employment is treated in California family courts in the context of spousal and child support: In re Marriage of Deluca (2020) 45 Cal.App.5th 184 and In re Marriage of Hein (2020) 52 Cal.App.5th 519.

Whether these cases have made it easier for litigants, courts, and attorneys to calculate support is an issue for another day. The fact remains, these new cases (along with other landmark cases decided in recent years), provide the current landscape of the law in this area.

3 Common Problems When One Party is Self-Employed in Family Law – And How to Solve Them

1) Depreciation Deductions on Income Tax Returns

To start, Asfaw v. Woldberhan (2007) 147 Cal.App.4th 1407 provided a rather lengthy analysis of the issue of whether depreciation of rental property is deductible in calculating child support. That court began its analysis with the underlying premise that the amount of child support to be paid is determined by a formula, the components of which require the computation of each parent’s annual gross income and annual net disposable income. (Mejia v. Reed (2003) 31 Cal.4th 657, 669).

Annual gross income is generally defined in Section 4058 as “income from whatever source derived.” (In re Marriage of Henry (2005) 126 Cal.App.4th 111, 118). Net disposable income, in turn, is computed by deducting from annual gross income amounts actually attributable to certain specified expenses. (Cal. Fam. Code § 4059).

The Asfaw court went on to identify various indicators the Legislature has placed in the Family Code which provide insight into the underlying principles of child support in California. In its broadest formulation, “California has a strong public policy in favor of adequate child support.” (In re Marriage of Cheriton (2001) 92 Cal.App.4th 269, 282-283) More specifically:

• “The guideline seeks to place the interests of children as the state’s top priority.” (Cal. Fam. Code § 4053 (e))
• “A parent’s first and principal obligation is to support his or her minor children according to the parent’s circumstances and station in life.” (Cal. Fam. Code § 4053 (a))
• “Each parent should pay for the support of the children according to his or her ability.” (Cal. Fam. Code § 4053 (d))
• “Children should share in the standard of living of both parents. Child support may therefore appropriately improve the standard of living of the custodial household to improve the lives of the children.” (Cal. Fam. Code § 4053 (f))

Family Code Section 4058 & 4059 – Calculating Gross and Net Income in Family Court for Depreciation Deduction

Whether depreciation is deductible in calculating net disposable income implicates essentially an income statute (§ 4058), and an expense statute (§ 4059).

The inquiry begins with Section 4059 since its “net disposable income” is an element of the actual child support formula. Section 4059 lists a number of items that are to be deducted from annual gross income in determining net disposable income: tax payments, FICA contributions, union dues and retirement benefits, health insurance premiums, other child support, job-related expenses, and hardship deductions.

Depreciation does not fall within any of these categories, thus, if statutory support for the deduction of depreciation is to be found, it must come from that part of section 4059 which refers to “annual gross income.” The inquiry thus turns to Section 4058, for it is there that “annual gross income” is given meaning.

With one exception, Section 4058 defines “annual gross income” as “income from whatever source derived.” It identifies “rents” as one of 16 examples of income (§ 4058 (a)(1)).  Also relevant is subdivision (a)(2) which states that income includes: “Income from the proprietorship of a business, such as gross receipts from the business reduced by expenditures required for the operation of the business.” There is no mention of depreciation.

From this scheme, it is clear that depreciation is not a “[j]ob-related expense” (§ 4059 (f)). This category appears to be reserved for those expenses actually incurred by an employee (Stewart v. Gomez (1996) 47 Cal.App.4th 1748, 1755 [tools, uniforms, on-the-job parking expenses, transportation and mileage for commuting to and from work, and other un-reimbursed costs that would not be incurred but for employment]).

Since rental income is expressly included as “annual gross income” under Section 4058 (a)(1), and business operating expenditures are deductible under Section 4058 (a)(2), the final question is: Does depreciation of rental property constitute an “expenditure required for the operation of this business?”

Although “income” is broadly defined in the statutory child support scheme, deduction provisions are specific and narrowly construed. The Legislature’s choice of the words “expenditure,” “required,” and “operation of the business” in Section 4058 are words of limitation. “Expenditure” suggests an actual outlay of cash or other consideration.

Depreciating an asset does not involve a reduction of cash available for child support. Nor is depreciation “required” for the operation of a business. A proprietor cannot operate a business without inventory, without employees, without paying taxes, and so forth. A business can be conducted without a deduction for depreciation. Therefore, the Asfaw court concluded that “operation of the business” means ordinary and necessary business expenditures directly related to or associated with the active, day-to-day conduct of a business.

Following the Asfaw case, in 2018 the California Appellate Court rocked the family law community with In re Marriage of Rodriguez (2018) 23 Cal.App.5th 625, 635. In the decision, the Rodriguez court held that a self-employed parent’s depreciation deductions for motor vehicles did not constitute “expenditures required for the operation of the business” for purposes of Cal. Fam. Code § 4058 (a)(2).

The Rodriguez court affirmed the order by the Superior Court of Stanislaus County directing the husband to pay wife child support for their three children. The Rodriguez court held that the trial court properly followed the Asfaw case by disallowing husband’s deduction of depreciation because depreciating an asset did not reduce available cash for child support, and asset depreciation was not among specific deductions permitted by statute (Cal. Fam. Code §§ 4058, 4059).

What was the factual analysis provided by the Rodriguez court? Good question. So what in the world does the Rodriguez decision mean? Are all business depreciation deductions disallowed? Is the decision limited to auto depreciation deductions? Or is the finding specific to disallowing this depreciation deduction for Mr. Rodriguez?

It is with the Asfaw and Rodriguez decisions in mind that the California Appellate Court made its recent findings in the Hein case.

In re Marriage of Hein (2020) – Business Depreciation Deductions May be Disallowed

In this case, the Fifth District clarified some of the questions that the Rodriguez case created regarding a self-employed parent’s depreciation deductions.

On appeal, the mother contends that the trial court did not properly determine the father’s annual gross income under Family Code 4058 and thus erred in calculating the amount of child support owed. After the trial court issued its decision, the Court of Appeal decided the question of statutory construction involving depreciation in the Rodriguez case.

In Rodriguez, the court held that a self-employed parent’s depreciation deductions for motor vehicles did not constitute expenditures required for the operation of the business for purposes of section 4058, subdivision (a)(2).

The Hein court extended the statutory interpretation for motor vehicles to depreciation deductions for equipment and other assets used in the self-employed parent’s businesses. The court explained that the term “expenditures required for the operation of the business” for purposes of Section 4058 (a)(2) describes an actual outlay of cash. The court held that claiming a depreciation deduction on an income tax return does not require an outlay of cash and, thus, does not reduce the funds available for child support.

This appeal raises issues about a self-employed parent’s annual gross income for purposes of determining child support under the statewide guideline. The mother contends the trial court did not properly determine the father’s annual gross income under Family Code section 4058(1) and, thus, erred in calculating the amount of child support owed.

First, the trial court allowed the depreciation deductions claimed on the federal income tax returns of the father and his corporations to reduce his income available for child support. Second, the court presumed the income and expenses reported on the father’s individual and corporate tax returns were correct and, thus, assigned the mother the burden of proving the reported amounts were incorrect.

Stated from another perspective, we do not conflate (1) the outlay of money used to purchase a capital asset with (2) the accounting entries, such as depreciation, that occur after the acquisition of the asset and do not involve the actual outlay of funds in future years.

What this court is saying is that, especially beginning in year two and moving forward, the depreciation is artificial and is not deductible for purposes of calculating support because the items were acquired previously. It is an artificial paper deduction, not funded in cash outlay.

Note: The Hein decision did not address the issue of a Section 179 depreciation deduction (26 U.S.C. § 179). Section 179 allows a massive $1,000,000.00 depreciation deduction for one year as an income tax incentive to buy equipment. It is a tax deduction for actual expenditures in the year of claiming, and not based on economic reality.

See Imputing Income to a Parent via California Family Code 4058

The Hein court further recognized the limited application of its decision in footnote 11: “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 address the treatment of depreciation, the subjects of (1) capital expenditure and (2) principal payments on third party debt used to acquire a capital asset were addressed.”

The Hein decision went on to make a largely agreeable decision regarding another hotly contested issue when calculating support in family court when one party is self-employed.

2) There May Be No Rebuttable Presumption That Tax Returns Are Correct [Burden of Proof]

The misnomer that a rebuttable presumption that the gross income on most recent tax returns is correct was found in the case, In re Marriage of Loh (2001) 93 Cal.App.4th 325, which found that:

A parent’s gross income, as stated under penalty of perjury on recent tax returns, should be presumptively correct. (See In re Marriage of Scheppers (2001) 86 Cal.App.4th 646, 650, 103 Cal.Rptr.2d 529 [‘Although federal law is not conclusive on the interpretation of section 4058, it is persuasive….’].) Returns are, after all, ultimately enforced by federal and state criminal penalties. Hence it is not surprising that tax returns are the core component of determinations under the guideline formula.

However, the Hein court clarified this misnomer as follows: “In Loh, the court’s statement that ‘[a] parent’s gross income, as stated under penalty of perjury on recent tax returns, should be presumptively correct’ (Loh, supra, 93 Cal.App.4th at p. 332) was dicta because none of the father’s post-separation income tax returns were part of the record.

As a result, Loh is not authority for the principle that gross income declared on an individual income tax return is correct, much less that the corporate income tax returns of a C corporation and an S corporation owned entirely by a self-employed parent are presumed correct. (See Riverside County Sheriff’s Dept. v. Stiglitz (2014) 60 Cal.4th 624, 641 [it is axiomatic that cases are not authority for propositions not considered].) ”

On the question of the burden of proof and the rebuttable presumption that the gross income stated on a parent’s tax returns is correct, the Hein court concluded such a presumption, if it exists, does not extend to the tax returns in this particular case. Here, the self-employed father’s businesses are organized into two wholly owned corporations (one taxpaying entity and one flow-through entity), the corporations’ operations are intertwined, and their total assets exceed $5 million.

In such circumstances, the burden of proving that the expenses claimed on the tax returns constitute “expenditures required for the operation of the business[es]” is properly allocated to the self-employed parent who controls the corporations.

The Hein court concluded,

…the policy that seeks to advance children’s interest and considerations of fairness to the parents who are litigating the issue weigh in favor of giving Martin the burden of proof on the question of his business income and expenditure under section 4058 subdivision (a)(2). This conclusion recognizes that ‘a spouse who is the owner of a successful business and who has control of his or her income can structure income and the payment of expenses to depress income.’ (In re Marriage of Chakko (2004) 115 Cal.App.4th 104, 109.)…

We conclude that considerations of public policy and fairness, informed by the judicial system’s experience in the cases involving the income and business expenses of a self-employed party, weigh in favor of assigning Martin the burden of proof on the factual questions that must be resolved to determine his business income and expenditures under section 4058 subdivision (a)(2).

3) Deductions for Principal Payments on Business Debts Are Sometimes Allowed

The relevant issue raised in In re Marriage of Deluca (2020) 45 Cal.App.5th 184, is the father’s contention that the trial court erred by failing to reduce his income available for support by the amount of monthly loan principal payments he is required to make on his income-producing properties. He argues the court abused its discretion by “imputing” the amount of his monthly loan payments to him as “phantom income” and awarding mother monthly spousal support of $7,500, despite finding that the maximum monthly income available to him to support the children after making his loan payments was $7,281.