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| Using Retained
Earnings of a Closely Held Corporation as a Factor in Child Support Payments |
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| We, as an accounting
firm, on several occasions have been asked to testify regarding retained earnings as a
factor in child support payments in South Dakota. There seems to be significant confusion as to what exactly retained earnings is, how it is calculated, and how retained earnings would be used in child support calculations. Generally accepted accounting principals define retained earnings as: The undistributed earnings of an entity. Changes in retained earnings are generally limited to:
Please note that Item (C) above is usually defined as an extraordinary item. You can see that the retained earnings of a company are basically the undistributed profits of the corporation. Using the ending balance sheet amount of retained earnings for current year child support calculations is not correct, as retained earnings represents the accumulation of many years earnings. Using the change in retained earnings from the beginning to the end of the year is still not reasonable because usually the corporation is not in a position to pay out 100% of its earnings and still finance the continuing business operation. The concept of dividend paying capacity is a more reasonable approach to use for calculating child support payments. Dividend paying capacity is a measurement of the amount of funds available to be paid out as dividends to corporate shareholders. We have developed a worksheet to calculate the dividend paying capacity of a corporation. The purpose of measuring the capacity of a corporation to pay dividends is that many closely held corporations pay little or no dividends, sometimes for tax reasons. If you were evaluating a corporation paying all of its profits out as dividends, this calculation would not be needed. |
Much of the theory
of dividend paying capacity has been developed in litigation by the Internal Revenue
Service in pursuing a penalty tax imposed upon corporations which accumulate earnings,
rather than pay them out to shareholders, with the purpose of avoiding taxes on
shareholders. Our dividend paying capacity worksheet basically follows court developed concepts taking into account:
The concepts adopted by the courts in the Internal Revenue Service litigations take much, but not all, of the subjectivity out of calculating the dividend paying capacity of a corporation. In order to help understand why dividend paying capacity is more relevant than corporate net income or retained earnings, it is important to point out that often the value of corporate stock is being used as a property settlement item at the same time that child support is being considered. The earning capacity or net income is an important factor in determining the value of a company. It would be inequitable to determine the value of a company based largely on earnings and then prevent the company from maintaining that value by forcing 100% of net income to be paid out as dividends. The courts have recognized this in litigation with the IRS and have developed the concepts that provide the basics of our dividend paying capacity worksheet. If the retained earnings of a closely held corporation is an issue in a child support case you are involved in, please contact us to discuss these matters. By consistently using the same concepts and worksheet, it gives the court an unbiased baseline to use in child support decisions.
--Casey Peterson & Associates, Ltd. |
