THE DEDUCTIBILITY OF DEPRECIATION AS A LEGITIMATE BUSINESS EXPENSE OF SELF-EMPLOYED PARENTS
Laura W. Morgan
Child support guidelines separately define income for self-employed parents. The guidelines generally provide that gross income is gross receipts from rents, royalties, income from proprietorship of a business, and income from joint ownership of a partnership or closely held corporation, minus and necessary expenses required to produce such income. The question faced by many courts is whether depreciation is an ordinary and necessary expense. See generally Annotation, Treatment of Depreciation Expenses Claimed for Tax or Accounting Purposes in Determining Ability to Pay Child or Spousal Support, 28 A.L.R.5th 46 (1995).
When calculating income for federal tax purposes, an annual deduction for the portion of the cost of income-producing property is permitted as compensation for an assumed decline in the usefulness of the property. This deduction is depreciation.
Many child support guidelines specifically provide for the treatment of depreciation. Most states that have specifically considered the issue in the guidelines provide that a deduction will not be allowed for accelerated depreciation (Alabama, Colorado, Idaho, Kentucky, Louisiana, Maryland, Nebraska, New York, Ohio, Oregon, South Carolina, Wisconsin). Some states provide that no deduction is allowed for any kind of depreciation (District of Columbia, Tennessee). Some states provide that a deduction for any kind of depreciation is left to the discretion of the court (Maine, Missouri, Texas). Finally, some states, while not specifically mentioning depreciation, provide that no deductions are allowed for amounts determined by the court to be inappropriate to the determination of child support, or that deductions are allowed only for expenses related to the production of income (Arizona, California, Indiana, Kansas, Michigan, New Mexico).
In those states where the guidelines do not specifically address depreciation, the courts have similarly split on the treatment of depreciation as a deductible business expense, and taken three basic approaches to the question.
First, many courts will allow a deduction from income for straight-line depreciation but not allow a deduction for accelerated depreciation. This view was explained in Freking v. Freking, 479 N.W.2d 736 (Minn. Ct. App. 1992), a case in which the husband sought to deduct the accelerated depreciation component on his farm income. The court disallowed the accelerated depreciation but allowed the straight-line depreciation. The court reasoned that actual depreciation was appropriate, because it reflected the cost of producing income. Accelerated depreciation, however, would not be appropriate because it is more in the nature of a tax fiction. Taxable income is not always a reliable indication of net income. A total disregard of depreciation, however, is reversible error. 479 N.W.2d at 740. Accord Eagley v. Eagley, 849 P.2d 777 (Alaska 1993) (discussing law of Maine) (court has discretion to include or exclude accelerated depreciation as element of income as the case may warrant); Turner v. Turner, 586 A.2d 1182 (Del. 1991) (obligor not allowed to deduct any accelerated depreciation as business expense); In re Davis (Bievenue), 287 Ill. App. 3d 846, 679 N.E.2d 110 (1997) (dentist entitled to deduct straight-line depreciation on dental clinic); Posey v. Tate, 275 Ill. App. 3d 822, 656 N.E.2d 222 (1995) (court would allow straight-line depreciation as business expense under circumstances); In re Marriage of Maher, 510 N.W.2d 888 (Iowa Ct. App. 1993) (court required to depreciate farm equipment); In re Marriage of Lewallen, 21 Kan. App. 2d 73, 895 P.2d 1265 (1995) (it was error for court to totally disregard all depreciation); Dugdale v. Dugdale, 771 So. 2d 827 (La. Ct. App. 2000); Kovarik v. Kovarik, 287 Mont. 350, 954 P.2d 1147 (1998); Lawrence v. Tise, 107 N.C. App. 140, 419 S.E.2d 176 (1992) (accelerated depreciation is not deductible; court may, however, consider straight-line depreciation); Calabrese v. Calabrese, 452 Pa. Super. 497, 682 A.2d 393 (1996) (depreciation expense allowed where restructuring of corporation was necessary for long-term viability of business).
Second, many states have held that ordinary and necessary expenses do not include amounts allowable by the IRS for any depreciation expenses, investment tax credits, or any other paper expenses determined by the court to be inappropriate for determining gross income for purposes of child support. Typical of this view is Stewart v. Stewart, 243 Mont. 180, 793 P.2d 813 91990). In that case, the obligor parent was a self- employed builder. In determining the obligors income, the trial court disregarded business and depreciation losses as shown on the obligors federal tax returns. The appellate court affirmed, holding that under the child support guidelines, the primary focus is disposable income rather than taxable income. Legitimate business expenses do not include those losses that exist primarily on paper and have little effect upon a parents disposable income. Moreover, including depreciation deductions in calculating available income for child support gives the obligor parent a windfall; since the purpose of depreciation is to assist a person in regaining expenditures, it does not follow that depreciation is a business expense. Accord Baker v. Baker, 183 Ariz. 70, 900 P.2d 764 (Ct. App. 1995); Gray v. Gray, 67 Ark. App. 202, 994 S.W.2d 506 (1999) (adding back in straight line depreciation); Emsley v. Emsley, 467 A.2d 700 (Del. Fam. Ct. 1983) (court refused to allow depreciation of operating losses connected with real estate investments); Harloff v. Harloff, 279 So. 2d 91 (Fla. Dist. Ct. App. 1973) (ordinary expenses do not include depreciation or taxes); Reid v. Reid, 822 P.2d 532 (Idaho 1992) (self-employed farmer was not entitled to deduction of straight-line depreciation on farm equipment); In re Minear, 287 Ill. App. 3d 1073, 679 N.E.2d 856 (1997) (completely disagreeing with Posey v. Tate and adopting Gay v. Dunlap, court rejects use of depreciation as expense); Leisure v. Leisure, 589 N.E.2d 1163 (Ind. Ct. App. 1992); Cox v. Cox, 580 N.E.2d 344 (Ind. Ct. App. 1991) (depreciation was not allowable deduction); Miller v. Miller, 610 So. 2d 183 (La. Ct. App. 1992) (amounts claimed on taxes for depreciation are to be included in income); Eberly v. Eberly, 12 Md. App. 117, 278 A.2d 107 (1971); Mireille J. v. Ernst F.J., 220 A.D.2d 503, 632 N.Y.S.2d 162 (1995) (business deductions and business asset depreciations are appropriate for tax purposes, but have little bearing on parents actual income); In re Marriage of Pedersen, 261 Mont. 284, 862 P.2d 411 (1993) (noncash deductions such as depreciation are not to be subtracted from gross receipts); Barber v. Cahill, 240 A.D.2d 887, 658 N.Y.S.2d 738 (1997) (depreciation is not out of pocket expense, and thus should not be deducted; case contains good discussion of other expenses as well); Houmann v. Houmann, 499 N.W.2d 593 (N.D. 1993); Kamm v. Kamm, 67 Ohio St. 3d, 616 N.E.2d 900 (1993); Sizemore v. Sizemore, 77 Ohio App. 3d 733, 603 N.E.2d 1032 (1991) (court will not allow deduction for depreciation and other noncash items); Holland v. Holland, 444 Pa. Super. 251, 663 A.2d 768 (1995); Flory v. Flory, 364 Pa. Super. 67, 527 A.2d 155 (1987); Hopkins v. Hopkins, 1993 Tenn. App. LEXIS 273 (1993); Powell v. Swanson, 893 S.W.2d 161 (Tex. Ct. App. 1995); Houston v. Smith, 882 P.2d 240 (Wyo. 1994).
Finally, some courts allow all deductions for depreciation, including accelerated depreciation, where the court determines that the facts so warrant. For example, in In re Marriage of Gaer, 476 N.W.2d 324 (Iowa 1991), the court stated that if an obligor is compelled to expend or exhaust his capital without the opportunity to maintain and preserve that which makes his business possible, it will work to the detriment of both parties. Thus, depreciation should be deductible in the discretion of the court. Accord Ogard v. Ogard, 808 P.2d 815 (Alaska 1991) (depreciation calculated using straight-line depreciation may be excluded from income); Baker v. Baker, 183 Ariz. 70, 900 P.2d 764 (Ct. App. 1995); Stoner v. Stoner, 163 Conn. 345, 307 A.2d 146 (1972); Turner v. Turner, 586 A.2d 1182 (Del. 1991) (accelerated depreciation of florist could be deducted); R.T. v. R.T., 494 A.2d 150 (Del. 1985); In re Marriage of Looyen, 390 N.W.2d 465 (Minn. Ct. App. 1986) (court allowed depreciation and capitalization of equipment of full-time farmer whose gross income was $440 per month); In re Marriage of Glueck, 913 S.W.2d 951 (Mo. Ct. App. 1996) (it is within the courts discretion not to exclude depreciation from expenses); Sturgeon v. Sturgeon, 849 S.W.2d 171 (Mo. Ct. App. 1993).
When dealing with a self-employed parent, depreciation expenses should be carefully scrutinized in order to obtain a true picture of income.