The Continuing Role of the Forensic Accountant in Divorce Proceedings
March 14, 2019
By Hubert Klein and Kriste Rodriguez
According to statistics, 50% of first marriages end in divorce and the rate is even higher for subsequent marriages. While there are many reasons couples divorce, the process of getting a divorce can be confusing, complex and often highly emotional. As a result, having the right team of professionals to guide you through the divorce process can help ease the emotional pain, promote efficiency and timeliness, and make the process less confusing. The critical element is to have a team of experts assembled to help navigate through the process. In addition to the attorneys and parties, the team often includes real estate appraisers, mental health professionals, employment experts, parenting and custody coordinators, financial and/or estate planners, experts to value specific assets such as art, jewelry and collections, and forensic accountants. The focus of this article is on forensic accountants and the services they provide.
Forensic accounting can be described as the process of:
- Analyzing, summarizing, and presenting financial issues in a format which is understandable; and
- Supporting the data for the user in a format suitable for the court.
In the context of divorce, forensic accountants use professional skepticism and detail-oriented problem solving abilities, along with sound professional judgement, to provide valuable services to assist attorneys, clients, and the courts in working toward everyone’s ultimate goal: a final and equitable settlement of the case.
Some of the services a forensic accountant may be asked to provide in a divorce include:
- Business Valuations
- Income Determination
- Lifestyle/Marital Spending Analysis
- Marital Balance Sheet Construction
- Asset Tracing
- Impact of Tax Issues
- Analysis of Corporate Benefits
- Assisting in Deposition and Trial Preparation
- Expert Witness Testimony
It should be noted, the forensic accountant’s ability to successfully and thoroughly complete an assignment in a divorce environment is directly related to the cooperation of all those involved, including the attorneys, clients, courts, or other persons who might be called upon. Therefore, it is important for the forensic accountant to document any impediments or deficiencies that occur throughout the engagement that might affect the final results and/or conclusions.
A business or business interest is, in most instances, the largest asset in the martial estate. For purposes of our discussion, we have assumed the forensic accountant has performed the necessary inquiries and research as to the valuation date to be used, the standard of value (fair market value, fair value, investment value, etc.) and premise (going concern or liquidation) used in the state in which they are working. Equally important is the determination as to whether the state is a community property or equitable distribution jurisdiction, if the inclusion of enterprise and/or personal goodwill is permitted, plus any other nuances specific to the jurisdiction in which they are working. In performing a business valuation, the steps listed below would be performed by the forensic accountant. As every case is different, the extent to which each is performed, as well as any task that is not listed, is based on the forensic accountant’s professional judgement.
- Interview. The process begins with frank discussions with the attorneys and clients to obtain as much background information as possible, including their perspectives as to the issues in the case.
- Data Gathering. This stage should include, at a minimum, a request for specific documents, online research of the business and/or its owners, as well as economic and industry research. This phase is usually continuous throughout the case and is dictated by the review and analysis of information provided.
- Site Visit. The site visit provides forensic accountants a way to confirm the accuracy of the data they have collected in an interview, a preliminary review of documents, and/or research, or to possibly discover additional information of which they were not made aware.
- Analysis and Follow-Up. Here, the financial information as well as any other documentation is viewed with a critical eye and professional skepticism. During this phase, the forensic accountant may make inquiries of the client, their employees, or possibly those on the outside who deal with the business such as vendors, clients, and/or third-party providers. From a financial side, the forensic accountant may make adjustments on the income statement to normalize earnings and develop capitalization rates. Some examples of adjustments to normalize earnings include reasonable compensation, reasonable rent, depreciation (tax to book), and personal expenses paid for by the business, and non-recurring items. On the balance sheet, there might be adjustments to reflect excess cash, collectible accounts receivable, the removal of non-operating assets such as real estate, addition/subtraction of non-operating assets/liabilities such as related-party loans, accurate loan balances, and to reclassify shareholder loans to equity. When the analysis and follow-up are finished, the numbers are crunched and the end result is an indicated value for the business or business interest.
- Preparation of a Written Report. The conclusions of the forensic accountant are communicated in a written report in a clear, concise, and understandable manner. The written report must comply with the professional standards of a particular organization or governing body such as the AICPA, ASA, NACVA, IRS, etc., as to the content of what must be included. Many times the written report can then be used to assist in settling the case or presented at trial.
What you see is not necessarily what you get. In virtually every engagement, the forensic accountant is asked to prepare a calculation of income of the business owner spouse or both spouses for the purpose of helping to arrive at the appropriate level of alimony and/or child support. The totality of income can take many forms. When someone owns and controls a business, there is considerable freedom to intermingle business and personal affairs. While the facts and circumstances of a case dictate the extent of the forensic accountant investigation, some examples of the components as well as common personal expenses paid by a business and unsurprisingly not revealed as income include:
- Salary and wages reported on Form W-2;
- Distributions taken from the business and charged to a loan account;
- Payroll disguised as work done by family members or no-show employees, but where such work in actuality is attributable to the efforts of the business owner;
- Automobile expenses, including loan or lease payments, gas, oil, maintenance, insurance, and EZPass;
- Family dinners, shopping, gifts, and vacations;
- Personal life insurance;
- Home improvements and general maintenance;
- Non-business-related professional fees, (i.e., divorce or other personal matters);
- Discretionary retirement plan contributions; and/or
Lifestyle/Marital Spending Analysis
In addition to preparing a calculation of income for either or both of the parties for the purpose of arriving at an appropriate level of alimony and/or child support, the forensic accountant may be asked to conduct a lifestyle or marital spending analysis. This investigation requires the forensic accountant to obtain an in-depth understanding of how the parties lived. This is accomplished through interviewing the spouse or spouses and performing a detailed analysis of the personal financial records. Typically, this analysis covers a period of more than one year and usually two to three years are examined, but in some cases the period can be longer. Generally, the client interview will provide the forensic accountant with information such as how many adults and children are in the household, an overview of larger expenses such as vacations and entertainment, how nannies are employed, and the amount of savings. For the stated period, a financial records review may include, but is not limited to:
- Identifying and collecting all accounts from which marital spending took place, such as checking, savings, credit cards, investment accounts and business accounts for which personal expenses are paid.
- Classifying all expenses into the appropriate categories. This can be accomplished using Quicken, QuickBooks, or similar write-up programs. The expense categories can be tailor-made or the same as listed on forms required to be filed with the court, such as a Case Information Statement.
- Reviewing the completed classifications with the client for accuracy with corrections made, where necessary.
- Adjusting to remove non-recurring and non-lifestyle items such as home improvements, large repairs and maintenance, business expenses paid from personal accounts, savings, and income taxes. Savings and taxes are generally removed from the marital spending as savings are treated separately and income taxes are unknown until the final alimony and/or child support are determined.
- Adjustments to include marital expenses paid for by a business.
- Adjustments to include marital expenses that are paid for with cash. Often, businesses generate cash that is not deposited into bank accounts. Instead, the cash is used to pay marital expenses directly. An estimate of marital expenses paid in cash is determined based on discussions with the client and added to the marital spending analysis.
- If more than one year is included in the analysis, the annual and monthly average may not be reflective of actual monthly spending. Therefore, adjustments to normalize spending such as arriving at the actual mortgage payments, typical repairs and maintenance, furniture and equipment, utilities, phone, automobile expenses, and affected personal expenses may be required.
- Allocating total expenses to husband, wife, and children is often requested and carried out. This may assist in making a better determination of alimony and/or child support needs.
- Preparing a going-forward budget that may be based on certain levels of alimony and/or child support as well as scenarios such as at what date the marital home will be sold and when the receiver of alimony and/or child support will purchase a replacement residence at “X” price, with a mortgage of “Y.”
Marital Balance Sheet Construction
To facilitate the division of marital assets, the forensic accountant may be asked to compile a balance sheet containing all of the marital assets and liabilities. These assets may include, but are not limited to:
- Real estate
- Bank accounts
- Automobiles, boats, and related items
- Furniture, jewelry, furs, collectibles, and related items
- Investment accounts
- Retirement accounts
- Value of business or business interests
- Employee benefits such as the appropriate value of stock options, restricted stock units, performance shares, or any other long-term incentive plans received
- Liabilities, including mortgages, notes payable, personal loans, and credit card balances
Because the valuation of these assets and liabilities may vary, the forensic accountant will review account statements and may use the services of appraisers who deal in real estate, personal property, and retirement plans, or, with respect to employee benefits, human resource or employee benefit coordinators. Additionally, the forensic accountant may use services such as Kelly Blue Book or similar services to obtain values for automobiles, boats, and related items. However, the forensic accountant should not accept any third-party source information without asking questions, when applicable, and using sound professional judgement.
In cases where there are numerous accounts involved or where claims of the dissipation or wasting of marital assets exist, the forensic accountant will gain an understanding of the allegations by interviewing the appropriate individuals, assembling the documents needed, analyzing and preparing the appropriate work papers and schedules, and communicating the results. In addition, there are cases where one party either brings assets into the marriage, such as an interest in a family-owned business, or acquires assets after the marriage, such as gifts or an inheritance, that may be exempt from equitable distribution. In most jurisdictions the person claiming the exemption has the burden of proof in supporting those claims. A forensic accountant can assist in compiling and communicating the relevant information to the parties, counsel and court. Communication may be in the form of a written report or an oral presentation, if requested.
Tax issues and related financial impact of taxes are an integral part of every divorce. If not dealt with or structured properly in the Property Settlement Agreement, the long-term effects on either or both sides can be devastating. The Internal Revenue Code contains sections dealing specifically with divorce. The forensic accountant as well as other tax professionals can provide guidance and advice with respect to the tax issues that are specific to divorce. The items below are not an all-inclusive list, but provide some insight into some of these issues and considerations.
- Alimony and child support under the 2017 Tax Cuts and Jobs Act (“TCJA”) must be considered and examined differently than in the past. Effective January 1, 2019, alimony payments are no longer deductible to the payor, resulting in higher taxable income and higher tax liabilities. Similarly, alimony is no longer taxable to the recipient, reducing his/her taxable income thereby reducing his/her tax liabilities. This change will likely result in lower alimony payments going forward. The tax implications for child support remain the same under the TCJA in that the payments are not deductible to the payor and not taxable to the recipient. However, other areas of the tax law have changed that could impact after-tax income, which could then impact the calculation of child support. These areas include the child tax credit, which was modified by the TCJA; personal exemptions, which have been eliminated; and the standard deduction, which was increased.
- Structuring alimony into components other than just a cash payment, (i.e., the total alimony payment can consist of the payment of a mortgage or other expenses, plus a cash payment).
- Structuring alimony payments to avoid falling outside of IRS rules may trigger recapture for pre-December 31, 2018 agreements. Failure to properly set up alimony or those payments that may fluctuate in the first two years triggers a potential recapture that makes the payments non-deductible to the payor and not income to the recipient. While the intentions of all those involved may be for the good, the result of an alimony recapture could have a devastating impact on the income tax liabilities of the parties involved.
- Treatment of the marital residence, if one of the parties is going to continue to stay after the divorce is final. What are the tax consequences if the home is sold prior to the divorce, immediately after, or at some time in the future, as agreed to by the parties?
- Transfer of assets, other than the marital residence. The IRS has specific rules governing the taxability of assets. Failure to stay within the rules can generate an unintended tax result.
- Dividing assets, such as investment accounts, to ensure sure each side has the same tax basis. Failure to do so could result in one party having a greater tax burden than the other.
- Dividing retirement accounts to ensure they are separated correctly in order to avoid any unintended consequences.
- Providing guidance on the treatment of the taxability of employee benefits such as stock options, restricted stock units, performance shares, or the benefits from any other long-term incentive plan.
- Structuring professional fees paid in order to receive a tax deduction for the portion attributable to tax planning.
Analysis of Corporate Benefits
There are occupations such as corporate executive and investment professional where compensation is structured in various layers. These generally include base salary, cash bonus, and the receipt of certain benefits such as stock options, restricted stock units, performance shares, or the benefits from other long-term incentive plans. The forensic accountant can assist in compiling relevant data, as well as the calculation of valuation of these benefits. With respect to valuation, there are methods that employ complicated mathematical models and those that are less complex. When dealing with these types of benefits, the forensic accountant must understand and apply the methodology that is acceptable under the laws of the state in which they are working. While a full description of the more complicated mathematical models is beyond the scope of this article, a simple overview of the process followed in a less complex application is:
- Review the plan documents for each type of benefit;
- Determine if the benefits are premarital or marital based on grant dates, vest dates and performance criteria (i.e., whether benefits are granted based on past or future performance.);
- Calculate the vested and non-vested units;
- Calculate the value using the appropriate price per share; and
- Determine the tax impact of and analyze the strategies for equitable distribution, where applicable.
Assisting in Deposition and Trial Preparation
In more complex divorces, it is not uncommon for the forensic accountant to be involved in a case having a business valuation, income determination, lifestyle analysis, marital balance sheet construction, asset tracing, and an analysis of corporate benefits. In addition, we can’t forget about the always-present tax issues and considerations.
There will likely be various reports submitted by the opposing side. The forensic accountant will review these reports and identify those positions, results, and differences that are contrary to theirs and, if requested, prepare a rebuttal report. A forensic accountant can work with the client’s attorney to develop questions and strategy for taking the opposing expert’s deposition, as well as to challenge their testimony at trial. Additionally, the forensic accountant will work with the client’s attorney to assist in navigating the complex financial issues that must be addressed, also helping to formulate questions and strategy for both depositions and at trial.
If, despite all the forensic account’s efforts, a case does not settle, providing testimony at either a deposition and/or trial is the culminating service. Whether it is at a deposition, (which is less formal than in a courtroom), or at trial, testifying can be quite a nerve-racking and intimidating experience. To be effective and perform well as a testifying expert, one must be extremely well prepared. Well prepared means knowing your report(s) from cover to cover and all of the related documentation that supports your reasoning and conclusions, including any work product prepared by your staff. As part of preparation, the forensic accountant will work with attorneys with respect to formulating the questions that they anticipate will be asked under direct or cross-examination. Attorneys will also work with the forensic accountant as to courtroom demeanor, which includes the time to arrive, how to dress, what to bring, how to answer questions, and how to deal with cross-examination.
The world of divorce is adversarial, emotional, and usually filled with a never-ending supply of surprises. As can be seen from above, the forensic accountant is a key member of the divorce resolution team. From a financial perspective, a divorce can be extremely complex and expensive. As such, the forensic accountant must exhibit, among other traits, professional skepticism, close attention to detail, organizational skills, and most of all, sound professional judgement. They may be called on to perform in one or all of the areas discussed above or to take on additional tasks, such as being involved in mediation and/or negotiations, or the review of property settlement agreements. If you feel you need the services of a forensic accountant to assist you with understanding the financial issues during your divorce, you can ask your attorney or personal accountant for a referral. In addition, you can contact the local State Society of Certified Public Accountants. The best time to engage a forensic accountant for a divorce matter? The earlier, the better.