Many different definitions of income can be used in family law cases. Local law will play a big part in defining income, but in more complicated cases, other definitions may come into play. The financial expert can help the attorneys and the court understand the various types of income and why they should be included or excluded from income calculations in a family law case.
Internal Revenue Service Definitions
The Internal Revenue Code is often a starting point for defining and quantifying income in family law cases. Experienced family lawyers know this is only the tip of the iceberg and does not cover many of the unusual situations arising in cases with complicated financial scenarios. However, because the Internal Revenue Service definition of income is so heavily relied upon in many divorces and child support cases, it must be addressed.
Following are items found on a personal federal income tax return. For more information on what these items of income can tell us about an individual’s income or assets, refer to the more detailed discussion in Chapter 6.
The format of income tax returns changed slightly with the Tax Cuts and Jobs Act of 2017. A sample of a 2017 personal income tax return (Form 1040) is included in Appendix A to illustrate the format prior to the tax law change. A sample of the 2018 form is also included to show the new format. Form 1040 is much shorter in 2018; the new Schedule 1 was introduced to capture all the other sources of income that were removed from Form 1040. You may notice the line numbers on the new Schedule 1 correlate to the line numbers on the old Form 1040, presumably to reduce confusion.
Items of income on a personal income tax return are defined briefly here. Later in the book we will discuss how they are analyzed in the context of divorce and a lifestyle analysis. Items on Form 1040 include:
- Wages – This item includes compensation such as wages, salaries, tips, commissions, bonuses, fringe benefits, and other earnings reported to an employee on a W-2. The figure shown here is typically gross wages less deductible contributions to a retirement plan like a 401(k). Double check this to determine the true gross wages. If there have been deductible contributions to a retirement plan, the gross wages would be the wages on the income tax return plus the contributions.
- Interest – Both taxable and tax-exempt interest are reported on an income tax return, although only one type will be taxed. Both types of interest should be included in calculations regarding income, regardless of the taxability. Be sure, however, that the distinction between taxable and tax-exempt is noted when attempting to estimate income taxes to be paid in the future.
- Dividends – Stock dividends received via brokerage accounts or directly from individual investments will be reported here. The income tax return will note “qualified dividends,” which is a portion of the total dividends receiving more favorable tax treatment. The figure that matters for income calculations in divorce is the total dividends received.
- IRAs, pensions, annuities – This item includes both early distributions and normal distributions after retirement. Both taxable and nontaxable distributions will be reported, and both are important for the income calculations related to divorce. If there was a lump-sum distribution, it should be determined how the funds were used or where the funds currently are.
- Social Security benefits – The total Social Security benefits and the taxable portion are reported on this line.
Items on Schedule 1 include:
- Taxable refunds or credits for state and local income taxes—This item might provide useful information during the lifestyle analysis but is typically not included in a calculation of income for support purposes. It may factor into an analysis of before-tax and after-tax income.
- Alimony received – This item will likely not be a factor in a current divorce. Under the new tax law, alimony is neither taxable to the recipient nor deductible by the payer. However, if a spouse was party to a divorce finalized before 2019, there may alimony reported here.
- Business income or loss – Net income from a sole proprietorship or single member limited liability company (LLC) is reported here, with more details about income and expenses on Schedule C.
- Capital gain or loss – Gains from the sale of stock or other investment property are included here, with the details on Schedule D.
- Other gains or losses – This item includes the sale of property in a business, with the details reported on Form 4797. Since a sale of business property involves the disposition of assets, it may not be clear whether it is relevant to income calculations. However, it may be very relevant if the asset was depreciated in the past, thereby reducing historical income.
- Rental real estate, royalties, partnerships, S corporations, trusts – Net income from rental real estate or royalties is reported here, with the details of income and expenses on Schedule E, page 1. An owner’s share of income from business ventures established as partnerships or S corporations is reported here, along with income from trusts. Additional details about the income are reported on Schedule E, page 2.
- Farm income or loss – Net income from farming activities is reported here, with the details of income and expenses reported on Schedule F.
- Unemployment compensation – Taxable unemployment compensation is reported here.Other income—A variety of items could be reported here, with some of the more common ones including gambling winnings, prizes and awards, and jury duty pay.
Also included in this chapter:
Reduction of Living Expenses
Statutes Defining Income
What Is Not Income?
Historical Earnings Analysis
Adjustments to Income
Cash Flow Versus Income
Earning Capacity and Imputed Income