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UPDATE: RETAINED EARNINGS OF CORPORATION

Laura W. Morgan
Family Law Consulting

In November 2002, we considered whether retained earnings of a corporation or partnership could be considered income for purposes of child support. Laura W. Morgan, Corporate or Partnership Retained Earnings as Income Under Child Support Guidelines, 14 Divorce Litig. 205 (Nov. 2002). See also M. Kyle Rominger, Note, Valuing S Corporation Earnings in Child Support Calculations, 35 U. Louisville J. Fam. L. 145, 146 (1996). Since that time, a number of new cases have addressed the issue and are worth examining.

Most recently, In re Marriage of Unruh, 32 Kan. App.2d 770, 88 P.3d 1241 (2004), stated the majority rule test for whether retained earnings of subchapter S corporation would be considered income for purposes of support. There, the court held that the 41% of subchapter S corporation’s income that was reinvested by corporation as retained earnings, rather than being distributed to shareholders, would not be taken into account when determining shareholder’s income, for purposes of determining his child support obligation under Kansas Child Support Guidelines, because (a) the shareholder was a minority shareholder who did not have the power, without the agreement of the other shareholders, to determine the amount retained in the corporation, and (b) shareholder was not manipulating the Subchapter S corporation for his own benefit and to the detriment of his minor children. If, however, the obligor was the majority shareholder who could distribute the earnings on his own choice, and if the earnings were manipulated by the obligor, then the retained earnings would be imputed. The majority rule thus focuses on control and bona fides of the decision to retain earnings. “In situations where the individual with a child support obligation is able to control the retention and disbursement of funds by the corporation, he or she will bear the burden of proving that such actions were necessary to maintain or preserve the business.” In re Marriage of Brand, 273 Kan. 346, 354, 44 P.3d 321, 327 (2002).

Taylor v. Fezell, ___ S.W.3d ___ , 2005 WL 78144 (Tenn. Jan. 14, 2005), likewise stated the issue thus:

For the retained earnings of a corporation to be imputed as income to a child support obligor who is the sole or majority shareholder of a corporation for purposes of calculating child support, there must be a showing that those retained earnings are excessive or that the income is actually being manipulated. Accord Coffey v. Coffey, 11 Neb. App. 788, 661 N.W.2d 327 (2003) (containing survey of cases nationwide that consider subchapter S retained earnings in child support cases); Roberts v. Roberts, 666 N.W.2d 477 (S.D. 2003) (former husband’s pass-through corporate income from a subchapter S corporation included on his federal income tax return should not have been included in calculating gross income for child support purposes, since husband did not actually receive income and had no control over its distribution; husband could not use income to support either himself or his children, and what husband received from corporation was not income, it was merely an obligation to pay taxes on the corporation's retained income).

The court in Laird v. Laird, 650 N.W.2d 296, 311 (S.D. 2002), also focused on control. “[T]he decision of whether to pay dividends from retained earnings is not one made exclusively by [husband]. Further, all of the bank’s retained earnings are not readily available for distribution.. . . . The real question is whether Thomas can readily receive his share of the bank’s retained earnings. It is apparent that he cannot. The trial court did not abuse its discretion in holding that retained earnings from the bank should be considered an asset rather than income and that since there is enough income between the parties to support the children, assets are not relevant.”

In Zold v. Zold, 880 So.2d 779 (Fla. 5th DCA 2004), the court focused on the question of what actually constitutes “control.” In that case, the husband was the majority shareholder. Nonetheless, the court held that he did not have the necessary “control” to make the decision to distribute earnings. Thus, the retained earnings could not be considered income.

In reaching this decision, the court noted that when a corporation has more than one shareholder, an officer and a shareholder has a fiduciary duty to all shareholders. “The corporation is not the personal piggy bank for any one shareholder simply because that shareholder may have a controlling interest in the corporation and is also the chief executive officer. Financial responsibilities to creditors and employees must be satisfied before distributions to shareholders take place if a corporation is to remain viable. Once the distributions are found to be possible, the distributions must be pro-rata in accordance with the percentage ownership of the capital stock of the corporation. Court ordered obligations in marital litigation should not place an ex-marital partner in the position of having to breach a corporate fiduciary obligation in order to avoid the possibility of a court finding that partner contemptuous.” 880 So.2d at 781. See also In re Marriage of Frett, 686 N.W.2d 235 (Table, Text in WESTLAW), 2004 WL 1073989, *2 (Iowa App. May 14, 2004) (so long as there is a legitimate history of retaining earnings, subchapter S retained earnings will not be imputed when earnings are retained, even if the earnings could be distributed).

The trend allowing majority shareholders to retain earnings based on their fiduciary duty to other shareholders seems clear. In West v. West, ___ So.2d ___, 2004 WL 2749146 (Miss. Dec. 2, 2004), the court was faced with the question of whether certain advances from the husband’s subchapter S corporation were “income” or loans. The court held that it was appropriate to consider the factors outlined in Alterman Foods, Inc. v. United States, 505 F.2d 873, 877 n. 7 (5th Cir.1974), a tax case. These factors include: (1) the extent to which the shareholder controls the corporation; (2) the magnitude of the advances; (3) whether a ceiling existed to limit the amount the corporation advanced; (4) whether or not security was given for the loan; (5) whether there was a set maturity date; (6) whether the corporation ever undertook to force repayment; (7) whether the shareholder was in a position to repay the advances; and (8) whether there was any indication the shareholder attempted to repay the advances. Although the court was not strictly concerned with retained earnings, the same factors seem applicable to whether retained earnings should be considered income.

While it is appropriate for the court to consider what constitutes “control,” it is also appropriate for the court to consider whether the obligor could possibly be aligned with other shareholders, such as family members, to shield legitimate income from child support. Thus, if the court is to consider control in such a manner, it should also more closely scrutinize whether there is a legitimate business reason for withholding earnings, or whether the decision is a scheme among shareholders to shield income from support obligations.

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