In TN Child Support Retained Earnings Must Be Manipulated to Be Income

Tennessee law case summary on income determination. Absent a showing that the retained earnings were excessive or that an obligor was actually manipulating his or her income, the retained earnings of an S corporation should not be imputed as income to the sole or majority shareholder in calculating a child support obligation. Tennessee child support law from the Tennessee Court of Appeals.

Taylor v. Fezell – Tennessee child support case summary on retained earnings as income.

Douglas Fezell and Angela Daniels were married in 1986, and had two children. The couple divorced in 1999.  In their Marital Dissolution Agreement (MDA), Mrs. Fezell was designated as the primary residential custodian of the two minor children. The MDA also provided that Mr. Fezell was to have visitation time greater than the standard amount contemplated by the Tennessee Child Support Guidelines (guidelines).  In consideration of Mr. Fezell’s additional visitation and the establishment of a trust fund for the children, the parties agreed that Mr. Fezell would pay child support in the amount of $1,000 per month until July 31, 1999; after that it would increase to $1,300.  The MDA also provided a method to calculate Mr. Fezell’s contribution to the trust.

Mr. Fezell’s child support obligation was based, in part, on his income from Professional Vending Services (PVS).  At the time of the divorce, Mr. and Mrs. Fezell were the sole shareholders of the company, each owning a 50% interest.  The Fezells agreed in the MDA that Mr. Fezell would continue to run PVS as the sole shareholder and president, and that he would pay his ex-wife $310,000 in exchange for her half of the company.  Mr. Fezell completed the purchase of this stock and was the sole shareholder of the corporation at the time of the appeal to the Tennessee Supreme Court.

On appeal, the supreme court was asked by Mr. Fezell to determine whether the retained earnings of an S corporation should be treated as income to the sole or majority shareholder of the corporation for the purpose of calculating child support in accordance with the guidelines.  The court concluded that absent a showing that the retained earnings were excessive or that an obligor was actually manipulating his or her income, the retained earnings of an S corporation should not be imputed as income to the sole or majority shareholder in calculating a child support obligation.  Because there was no showing that the retained earnings were excessive or that Mr. Fezell manipulated the funds of the S corporation to reduce his child support obligation, the high court held that the trial court and the court of appeals erred by imputing to him as income the company’s retained earnings.  In addition, the supreme court held the lower courts erred by failing to include the economic value of the Mr. Fezell’s company car in its calculation of income.

PVS was vending machine service company and also worked with auxiliary equipment in various commercial locations. The business was very capital-intensive.  To be competitive, PVS had to purchase and maintain state-of-the-art vending equipment for its commercial users.  The company from its creation until 2001, was registered with the State of Tennessee as an S corporation.  An S corporation’s income passes through that corporate entity to the individual shareholders in proportion to their stock ownership. This passing through of income takes place for federal income tax purposes, regardless of whether the earnings of the corporation are retained to enhance the corporation’s capital position.  As a result, the shareholders of an S corporation are required to pay taxes on their apportioned shares of the corporation’s earnings, regardless of the actual sums they are paid.  In 2001, following the divorce, Mr. Fezell changed the corporate status of the company from an S corporation to a C corporation. This change in corporate status meant that Mr. Fezell’s income for tax would no longer contain earnings that had been retained by the corporation.  At that point, the trial court increased Mr. Fezell’s monthly child support payment to $1,576.

The trail court first determined Mr. Fezell’s income to set his child support obligation.  That court credited to Mr. Fezell the company’s retained earnings as an S corporation.  Although the trial court acknowledged that PVS was a capital-intensive business, it concluded that Mr. Fezell maintained the ability and authority to control his annual salary, with the potential to manipulate his income by allowing the company to accumulate profits through retained earnings.  It also found that Mr. Fezell converted PVS from an S corporation to a C corporation for legitimate business purposes and on the advice of his accountant.

The trial court then averaged Mr. Fezell’s income for the three years prior to the trial, using his 1999, 2000, and 2001 individual federal income tax returns.  The 1999 and 2000 returns showed the pass-through income of the company which had been attributable to Mr. Fezell as sole shareholder of an S corporation; but the 2001 tax return reflected wages paid to Mr. Fezell by the corporation as a C corporation in a W–2 form.  After averaging the three incomes, the court ended up with an annual income of $107,433 for the purpose of the guidelines.  Applying 32% according to the regulations, the trial court arrived at a monthly child support amount of $2,012.  At that point in the calculations, the trial court reduced that sum to reflect the excess visitation exercised by Mr. Fezell and concluded that the appropriate child support after a credit of $435 was $1,576 per month.  The trial court failed to consider the economic benefit of the personal use of his company car in its calculations.

Mr. Fezell appealed to the Tennessee Court of Appeals, which affirmed the trial court’s decision.  He then appealed to the supreme court.  Mr. Fezell argued that the trial court erred by imputing to him the retained earnings of his S corporation for purposes of calculating his child support obligation.

The guidelines, when applied to an obligor such as Mr. Fezell, whose income was derived from a salary and an occasional bonus or dividend—in the high court’s view—amounted to an easily quantifiable child support amount.  Once the income was determined and the guidelines applied, the calculation of a spouse’s child support was made with certainty, predictability, and precision.  However, this calculation was much more difficult and much less precise when the obligor was self-employed.  The self-employment guidelines were drafted in such a way as to allow the trial court to address the potential of a self-employed obligor to manipulate his or her income for the purpose of avoiding payment of child support.  Because of this, the supreme court stated, in certain situations, a court may impute income to a sole owner of a business.  A child support obligor who is the sole or majority shareholder of a closely-held corporation did not fit particularly well into either of the child support guideline models mentioned by the court.  A shareholder such as Mr. Fezell in the C corporation possessed the power over income that an ordinary corporate employee does not possess.  By contrast, a corporation which is not a sham is considered a separate entity, and its existence is dependent on its compliance with corporate law and its capitalization for maintaining its credit-worthiness.  This separate identity status is characterized by a capital structure which is sufficient to meets its ordinary expenses and to provide the capitalization necessary for its business purpose.

A majority shareholder in a corporation is similar to a sole proprietor in that the potential for manipulation of income exists.  After carefully considering the issue which the supreme court had not addressed in the past, it concluded that for the retained earnings of a corporation to be assigned to the sole or majority shareholder of a corporation, there must be a showing that those retained earnings are excessive or that the income is actually being manipulated.  This approach required trial courts to recognize the independent entity status of a corporation that is properly run by its shareholders, which will, in turn, require child support determinations to be based on the obligor’s actual income and benefits while at the same time guarding the corporate entity’s existence.

When determining whether the earnings of an obligor’s corporation are excessive, the trial court is to consider the level of retained earnings or capitalization maintained in the closely-held corporation before the divorce occurred.  The pre-divorce level of corporate capitalization and the practice of retaining corporate income for future capitalization gives the trial court a baseline for the expectations of the obligor’s income and a recognition of the corporate capitalization necessary for future business activity.  The supreme court said that expert testimony could be relevant to prove the level of retained earnings, and the court is also to examine the activities of the corporation after the divorce.  This is especially important where there are any unexplained increases or reductions of capitalization or retained earnings.  To determine if a sole or majority shareholder is manipulating income, the court should closely look at the personal expenses and economic benefits provided to the obligor by the corporation and should include the value of those extraordinary benefits in the obligor’s income calculation.  Further, the supreme court said that the trial court should consider any other factor that bears on whether the obligor is manipulating his or her income in an effort to avoid the proper payment of child support.

In the case of the Fezells, the trial court’s averaging of the federal taxable income for the years 1999-2001 in determining the obligor’s income, which imputed the retained earnings of PVS to Mr. Fezell in 1999 and 2000, may have distorted his income for the calculation.  Because there was no evidence that PVS’s retained earnings were excessive or that Mr. Fezell actually manipulated his income to avoid paying child support, the trial court erred in imputing the retained earnings of his corporation to him for the purpose of determining his child support obligation.

Taylor v. Fezell, 158 S.W.3d 352 (2005).

See original opinion for exact language.  Legal citations omitted.

For more information, see Self-employed Parent’s Income Determination in Tennessee Child Support.

Memphis divorce attorney, Miles Mason, Sr., JD, CPA, practices family law exclusively with the Miles Mason Family Law Group, PLC. To learn more about Tennessee child support laws and guidelines, read and view:

A Memphis child support attorney from the Miles Mason Family Law Group can help you with Tennessee child support issues including setting or modifying child support. See our Consultation and Fees page and call 901-683-1850.

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