D-I-V-O-R-C-E may actually spell F-R-A-U-D: Underreported income in a divorce

 Spouses may try to hide funds during divorce proceedings in several ingenious ways to improve the share of the ultimate financial settlement. Here are some of the methods and how to catch the offending parties. 

Bart and Alice were the seemingly perfect couple - married 32 years, four grown children, six grandchildren. Bart had built Bacme Electric into a multimillion-dollar business and provided well for his wife and family. He had provided well for his mistress, too. A mutual friend had told Alice about Bart's dalliance and before long Alice had filed for divorce. Bart wasn't going to split without taking some big bucks, however. For years he had been hiding away funds in secret accounts, with cooperative relatives, and through illegal and dubious business practices.

But Melanie, an astute fraud examiner and forensic accountant retained by Alice's lawyers, thoroughly examined Bart's finances. She discovered the hidden accounts and investments, and his other illegal money arrangements. Bart now had to give up thousands of dollars in assets with penalties, answer the charges of a criminal investigation, and endure his kids' rejection. Oh, and his mistress left him. (1) 

Every couple wants a successful marriage, but sometimes the dream becomes a nightmare when events lead to a failed relationship culminating in one party filing for divorce. Due to the lead time usually associated with a deteriorating marriage, one or both parties may engage in varying degrees of "divorce planning." Tactics may range from setting aside liquid assets to cover necessities during the divorce proceeding (including professional fees), to outright fraud, all of which improves one party's share of the ultimate financial settlement.

Either spouse may engage in tactics designed to result in a greater monetary award even though only one spouse may be in a moneyed ("independent") position. As a result, family law practitioners, fraud examiners, and forensic accountants should never forget that information received from either party may be intentionally misstated and/or manipulated.

It's important to address the issues encountered during the income, or support, aspect of a case. Be cognizant that a spouse may legitimately be so distraught by the deteriorating marriage that he or she is distracted from his or her otherwise lucrative and successful livelihood to the point where income suffers. At the same time, however, there may be other reasons for the sudden decline in income available to support the family and so it's necessary to look at the financial representations with a critical eye.

1 This fictitious case is for illustrative purposes. 

Defining underreported personal income
A basic definition of underreported personal income is net cash flow of a legal or illegal nature, which a party failed to disclose to a third party in accordance with that party's reporting criteria.

Either unreported or understated income may be referred to as "underreported" income. Underreported income may be attributed to direct as well as indirect sources. When an individual gains financial advantage - with or without an apparent, positive impact on cash flow or liquidity - this is said to create an indirect source of income available for support by virtue of the benefit received.

One must understand and accept a few truisms before being able to understand how income is underreported:

Defining income available for support
"Income available for support" generally includes income from all sources and may include something called "potential income" when allegations of voluntary or intentional impoverishment are involved, which is discussed on page 63.

Sources of income available for support must be identified before they can be quantified. Where does one look for this income? Forensic accountants and fraud examiners are specially trained to recognize information that's omitted, as much as they are skilled in examining facts provided. A common mantra is that it's as much about what you don't see as it is about what you do see. For instance - when reviewing marital bank accounts, are all expenses that you'd expect to see accounted for? If not, why not? Here's a simplistic illustration of the thought process: one spouse may disclose income of $100,000 yet at the same time claim expenses of $125,000. How did the couple make ends meet? The answer may be as innocent as an error (reporting something twice), or as sinister as the existence of a complex scheme in which unreported income is deposited into hidden bank accounts to fund expenses or investments that may also be undisclosed.

If it's suspected that one of the individuals was contemplating separation or divorce prior to the actual event and therefore had ample time to plan the financial separation, additional work will be required to ensure that all income sources are captured and assets are counted. This expanded scope may mean analyzing additional historical years of the marriage, applying supplemental procedures to the base information, or including third parties in the discovery process.

Identifying income
A good starting point in identifying income sources, marital assets, and liabilities, (3) is to review information previously reported to third parties for purposes unrelated to the divorce. These data points provide a benchmark reality check from a time when "things were good" and often predate a spouse's urge to manipulate actual finances or financial reports, at least with regard to the domestic situation.(4) Be careful to keep these data points in perspective, however, because the requirements for the referenced report may differ from those of the court. Thus, it's entirely possible that the amounts previously reported won't agree to "reality" as defined by the family court, for any number of legitimate reasons.

Earnings, or compensation for services, are the most common form of income. Are earnings always considered "income" for family court purposes? Well, it depends. Earnings generally can be included in support calculations when they become accessible (that is, available). When compensation for services rendered consists of something other than cash wages, an appropriate line of inquiry and analysis may include the following questions: When does the right to the income become absolute and unrestricted? Does the spouse have the ability to designate an alternate payee? Can the spouse influence the timing of the payment? As these questions demonstrate, one spouse may be able to defer some elements of income until after a date of particular significance in the divorce proceedings. The facts and circumstances of a particular case may indicate that a proper line of inquiry includes future expectancies as well as other known sources of income.

Future expectancies, or income that might be anticipated to be received in the future, include such items as personal performance bonuses, large contract awards to a business (which impacts the business owner or executive's compensation), or other business opportunities. This may represent present earnings, which are beyond the predicted or normal compensation stream. As a result, it may be possible to manipulate apparent receipt of this income by diverting it to a trusted source while the divorce winds its way through the legal system. For example, one spouse may earn money that's entrusted to a sibling who then uses the funds to surreptitiously pay certain expenses on behalf of the concealing spouse. The result is "parked" income resting with a co-conspirator during the pendency of the divorce action, possibly used to fund lifestyle expenses or start-up business ventures, which are then concealed from the court. Opportunities to engage in this conduct are greater when a business enterprise is involved; as a result, a forensic accountant or fraud examiner will probably need to examine the relationship between the business' income and expenses and those of the marital unit.

Other common sources of income available for support, besides compensation, may include:

Other sources of cash flow may or may not generate income available for support based on the facts of a particular case. These fact-sensitive sources are outside the scope of this article, but include stock option awards, retirement benefits, trust distributions, and gifts. Instinctively, one may presume the character of these items isn't "marital"; however, in certain situations this may not be the case.

Finally, be aware that income reported may have been "puffed," or overstated, if it served in the best interests of the individual. For instance, a loan application or personal financial statement submitted to a bank in connection with a request for financing will usually contain a section asking for details on the applicant's income. That individual may believe that to secure the necessary financing some aggressive (and fictional) arithmetic is in order.

Closely held business considerations
If one spouse is a principal or key executive in a business enterprise, there are unique opportunities to manipulate his or her personal income due to the direct relationship between the business' income and that of its owners. When a business has a good year, the presumption is that its principals and key executives receive larger bonuses, and the opposite is true as well. It follows then that by artificially deflating a company's profitability, one can create the illusion of having less income available to an individual attributed to that business - conveniently in the period of or immediately preceding separation.

The most common scenario occurs when the business pays personal expenses on behalf of the independent spouse and fails to include the amount(s) paid in the spouse's income (that is, treats the expenses as ordinary and necessary business expenses). When the business pays personal or other discretionary expenses for the independent spouse, this creates income attributable to that person for purposes of calculating support, irrespective of its inclusion in income reported for tax or any other purpose. The mere payment of personal expenses through a related business isn't what is objectionable; the objection arises from the business' failure to account for the payment as part of compensation.

One should be aware that it is possible that the business included those items, which were personal in nature and paid directly by the business, in the individual's compensation. Thus, one should not assume that payment of personal expenses by a business is improper on its face. One must determine if the expenses were attributed to the individual and included in his or her compensation. If the items are accounted for by the business as advances or loans to the individual, or as business expenses, then it's likely that the individual's personal income will be underreported for income tax if not other reporting purposes. If there are elements of "personal income" improperly characterized by the business, these items may be either considered additional income available for support, or "normalizing adjustments" for purposes of an associated business valuation - but not both. (6) 

Manipulating or accelerating expenses of a company subject to one spouse's control is another way to adjust personal income, this time by reference to business income. The business income, which otherwise would be available for distribution to its principals, is intentionally and falsely diminished to decrease the apparent income available for distribution and therefore, support. Common schemes may include:

Unfortunately, it's also conceivable that persons other than the involved spouse may cause a dip in the business' operations thus depressing the business income available for distribution to that spouse. For instance, if a trusted executive is embezzling, less income will be available to the owner-spouse due to situations beyond his control. If this occurs, the two spouses may need to work together - first to resolve the embezzlement through proper legal channels, including prosecution and restitution (if available), and then adjusting the financial analyses. At the end of the day, the subject company's results of operations and financial position should be as close to economic reality (pre-event), for both the inevitable business valuation and the evaluation of income available for support without penalizing either spouse for the misdeeds of the third party.

As this discussion indicates, direct or indirect sources of income may escape detection unless a forensic accounting and/or fraud examination is conducted.

Assume nothing
One shouldn't assume that a single instance of underreported income for a particular purpose creates a reporting pattern consistent among all interested parties and reports issued to them. The same person who engages in underreporting for income tax and/or divorce purposes may also over report his or her income when applying for loans or disability insurance. It's imperative that as many available data points as possible be sought out and corroborated. Any inconsistencies, no matter how slight, need to be investigated.

The financial discovery process may take on a feeling similar to that of a federal tax authority investigation. This is because understatement of income available for support has a motive comparable to understatement of taxable income - "less is more." In both cases, underreporting enables the reporter to keep more and part with less income. As a result, a "divorce planning" technique may only reflect changes in the magnitude of possibly already existing tax fraud. (7)  

Due diligence required
How does one determine whether income is properly represented to the court? A forensic accountant or fraud examiner will usually conduct an initial interview with a client about lifestyle issues and possibly review reports prepared for the court detailing the marital lifestyle. (8) The next step will likely be inspection of preliminary documents secured by the attorney early in discovery, such as financial statements and tax returns for the individuals and any business entities associated with them. These documents provide insight into the finances of the parties, including the expected or potential sources of income and possibly an otherwise undisclosed business enterprise in which one of the parties has a financial interest.

Some of the fundamental sources of information to request access to include:

Glaring errors, irregularities, or possible frauds may be discovered in the tax returns, financial statements, and applications. These are the same documents whose accuracy was attested to in a sworn statement by at least one party if not both spouses, and possibly by a third-party preparer.

When these errors, irregularities, or possible frauds occur, the impact on the divorce proceeding isn't clear.

In some jurisdictions, special masters or judges may halt proceedings and, off the record, urge the parties to settle the case rather than disclosing on the record and in meticulous detail the nature of the improprieties to the detriment of both spouses. Others tend to "let the chips fall where they may." These "chips" may include intervention from tax authorities as the result of a revenue agent discovering the improprieties by reading family law decisions. The federal tax authority's actions may be warranted; for instance, a cash hoard containing excessively high amounts of unreported income may be uncovered, or there may be a substantial amount of personal expenses (in one case, 90 percent) deducted as business expenses on the business' income tax returns. If tax authorities become involved, either because a revenue agent discovered improprieties by reading published cases or because another party contacted the agency, then in most cases neither spouse will benefit.

Obviously, the spouse who engaged in underreporting taxable income will have financial consequences that may be severe. The other spouse, who may or may not be an "innocent spouse" according to tax statute, will also feel the repercussions in the way of reduced income available for support or fewer assets available for distribution.

The biggest question is whether the documents and other evidence provided by each party for examination by the other spouse's experts will support the other information provided and that which the forensic accountant or fraud examiner is able to discern using specialized methodologies. The business and personal records produced through discovery are examined for consistency with what the forensic accountant or fraud examiner is able to learn from the attorney and the attorney's client as well as the financial disclosures, which may have occurred prior to the accountant's or fraud examiner's involvement. Information gleaned from these primary documents, and other documents and information requested, is corroborated with information obtained by interviewing the independent spouse and his/her partners if any, the business' accountant and other financial advisors, and if appropriate, former spouses.

So I recomputed income - now what?
The computation of income available for support is compared to the lifestyle reported by the respective spouses. The result of each computation needs to be evaluated with a discerning eye. The question here is whether the income is sufficient to support the reported lifestyle. If not, there may be legitimate explanations, which of course will need to be validated. Some of these answers include bona fide loans, inheritances and gifts - all of which carry their own implications in the context of a divorce, beyond the scope of this article. Or, there may be other sources of income which have yet to be discovered and it may be time to dig a little deeper. In most cases, the effort is worth it, to root out the fraudulent practices often inherent in "divorce planning."

1 This fictitious case is used for illustrative purposes.
2 Most individuals use the "cash method" of reporting income, where cash inflow becomes income as received. Other methods available typically apply to businesses.
3 Searching for hidden assets and liabilities in the context of a matrimonial proceeding usually occurs as part of a forensic accounting examination, simultaneous with the search for unreported or underreported income. Special considerations when searching for hidden assets are beyond the scope of this article.
4 Unfortunately, this isn't always the case. Matrimonial forensic examinations frequently uncover such things as bank fraud, insurance fraud, or even tax fraud - things which one spouse may not be aware of.
5 There are other issues and considerations associated with the compensation of a closely held business owner beyond the scope of this article. The primary concerns are tax implications and the impact of the compensation on the value of the business.
6 "Normalizing adjustments" are changes made to the subject company's books for analytical purposes, to more closely reflect the company's true economic financial position and results of operations on a historical and current basis.
7 Tax fraud, for purposes of this article, is the affirmative act of intentionally filing an improper tax return(s) with a taxing jurisdiction, creating a substantial deficiency in tax liability.
8 The propensity of one or both spouses to overstate marital expenses is also a concern but is outside the scope of this article.  

Cheryl B. Hyder, CFE, CPA, CVA, is a senior forensic accountant with the Forensic Accounting and Dispute Analysis team of Klausner Dubinsky + Associates in Bethesda, Md. Most of her professional career has been devoted to forensic accounting, primarily in the niche of high-profile, high net-worth matrimonial litigation. She is program director for the Metropolitan Washington, D.C., Chapter of the ACFE.