Opinion
No. 36842-4-III
11-05-2020
In the Matter of the Marriage of Marina PALOMAREZ (fka Wilcox), Appellant, v. Matthew Emery WILCOX, Respondent.
Raymond Gwyn Alexander, Halverson Northwest Law Group PLLC, 405 E Lincoln Ave., Yakima, WA, 98901-2469, for Appellant. Christopher Scott Tait, Attorney at Law, 403 W Chestnut Ave., Yakima, WA, 98902-3438, for Respondent.
Raymond Gwyn Alexander, Halverson Northwest Law Group PLLC, 405 E Lincoln Ave., Yakima, WA, 98901-2469, for Appellant.
Christopher Scott Tait, Attorney at Law, 403 W Chestnut Ave., Yakima, WA, 98902-3438, for Respondent.
OPINION PUBLISHED IN PART
Korsmo, A.C.J. ¶ 1 Both parties challenge aspects of the trial court's ruling following a marriage dissolution trial. Believing that personal expenses paid by a privately held business must be attributed as income to the working spouse, we conclude that the court significantly erred in its determination of the husband's income. We reverse and remand for further proceedings consistent with this opinion.
The husband did not cross appeal and therefore cannot receive affirmative relief from this court. RAP 2.4(a). We will address his assignments of error only as they concern issues on which the wife is entitled to relief.
FACTS
¶ 2 The parties, appellant/wife Marina Palomarez and respondent/husband Matthew Wilcox, had been married 25 years at the time of trial in January 2019, but had separated in mid-2015. Relevant highlights from the trial court's extensive findings are discussed here to place the appellate issues in context; other relevant facts will be mentioned later during the discussion of the specific issues presented.
¶ 3 The primary issues at trial involved the valuation of a power sports business owned by the community and the husband's income from operating it. The business was purchased in 2008 for $400,000 and converted to a chapter S corporation in 2014. The purchase was funded by a $300,000 loan from Mr. Wilcox's mother. A $100,000 loan by the former owner used to fund the remainder of the purchase was paid off by 2014. The competing experts for the parties used different methods to value the business.
Although there was some belief that the funds had been an advance of Mr. Wilcox's inheritance, testimony established that the anticipated inheritance only served as security for the loan.
¶ 4 The wife's expert used an equity interest valuation process to value the business at $809,000, and alternatively asserted that the fair market value was $522,000 as of the end of 2015. The husband's expert valued the business at $335,000 using an asset-based theory. Accepting the fair market value approach, with adjustments for inventory obtained later in the year, the court valued the business at $500,000 as of June 30, 2015, the time the couple separated. The court believed this approach also was consistent with the husband's expert's valuation after accounting for the fair market value of the inventory. ¶ 5 The profitability of the business factored into the court's evaluation. For that purpose, the trial court agreed with the wife's expert that Mr. Wilcox could earn $100,000 per year as manager of the business. Mr. Wilcox, however, had only reported taking $34,000 to $40,000 per year in salary after converting to the S corporation format. Tax returns showed the company making about $16,000 a month after expenses. In addition, the company paid a significant amount of Mr. Wilcox's personal expenses, as well as about $4,000 per year in community expenses.
¶ 6 The court indicated it would not overrule Mr. Wilcox's business judgment concerning the amount of income the business needed to retain from its earnings. For purposes of spousal maintenance, the trial court assigned an income of $40,000 to the husband. The court ordered maintenance of $1,000 per month until 2022. At that point, Mr. Wilcox's pension from his prior employer will be transferred to Ms. Palomarez as her separate property. The maintenance award effectively supplemented Ms. Palomarez's income until retirement became possible.
¶ 7 The court awarded the business to Mr. Wilcox and the family home, the couple's second largest community asset, to Ms. Palomarez. In the final accounting, property valued at $506,250 was awarded to the husband and property valued at $381,166 was awarded to the wife. She was also granted her outstanding attorney fees of approximately $77,000, but after credits and offsets, the final figure was reduced to roughly $27,000.
¶ 8 Ms. Palomarez timely appealed to this court. A panel heard argument by video connection. ANALYSIS
¶ 9 The sole issue addressed in the published portion of this opinion involves the valuation of the husband's income from the business. Since the husband used the business to pay community and personal expenses, the money needs to be treated as income.
¶ 10 When determining whether to impose a support obligation, the dissolution court must consider the financial resources of the party seeking support and the ability of the other spouse to meet his or her needs. RCW 26.09.090. This requires that the trial court determine the income for both parties and enter a specific finding for income. In re Marriage of Anthony , 9 Wash. App. 2d 555, 562-63, 446 P.3d 635 (2019). All sources of income are relevant when calculating maintenance and a party cannot voluntarily reduce income just to avoid maintenance payments. 20 SCOTT J. HORENSTEIN, WASHINGTON PRACTICE: FAMILY AND COMMUNITY PROPERTY LAW § 34:9 (2d ed. 2015). When a couple separates and lives apart, their respective earnings constitute separate property. RCW 26.16.140.
¶ 11 An S corporation pays no income tax, but passes its profits on to its owner(s) to be taxed at individual tax rates. Gitlitz v. Comm'r , 531 U.S. 206, 214 n.6, 121 S. Ct. 701, 148 L. Ed. 2d 613 (2001). Corporate income is calculated under the familiar formula of income minus "ordinary and necessary" business expenses. Comm'r v. Heininger , 320 U.S. 467, 475, 64 S. Ct. 249, 88 L. Ed. 171 (1943). Whether an expense is "ordinary and necessary" is a factual determination for the tax court. Id . An S corporation is permitted to retain earnings for business purposes rather than pass the funds on to the owners. 26 U.S.C.A. § 535(c)(1). The income, even though not distributed, still is reported on the individual's tax returns. E.g ., Exs. 11 (l.17); 12 (l.21). ¶ 12 In resolving a dissolution proceeding, a court may look into the structure of a wholly owned corporate entity for the purposes of ensuring a fair division of assets. W. G. Platts, Inc. v. Platts , 49 Wash.2d 203, 208-09, 298 P.2d 1107 (1956). Washington applies the rule that "a business's retained earnings should be considered income to the business's sole owner, absent a legitimate business need to retain the earnings." In re Marriage of Stenshoel , 72 Wash. App. 800, 806, 866 P.2d 635 (1993). The burden is on the business owner to demonstrate that retained earnings are solely maintained for the business. Id . at 806-07, 866 P.2d 635. However, it is not an abuse of discretion for the trial court to use the amount of money drawn by the community to calculate income if that value reflects the parties’ income and living conditions predissolution. Id.
Made applicable to S corporations by 26 U.S.C. § 1371(a).
Similarly, when a person solely owns a corporation and closely controls its assets, those corporate assets may be used to satisfy personal debts. Standard Fire Ins. Co. v. Blakeslee , 54 Wash. App. 1, 5, 771 P.2d 1172 (1989).
¶ 13 Application of these standards to the business at issue in this appeal requires some discussion of relevant financial concerns. Here, the couple's business grew appreciably as the economy rebounded from the great recession. Corporate income in tax year 2011 was $16,329 and was $75,787 in 2013. Exs. 1, 3. The corporate tax returns for the years 2014-2017 when the business elected to be an S corporation showed the business making between $52,917 (2014) and $192,760 (2016). Exs. 6, 12. Despite the dramatic increase in income, Mr. Wilcox's salary increased very little. Exs. 5, 8, 12, 14.
¶ 14 The business paid a number of personal expenses. From the point of separation in mid-2015, Mr. Wilcox paid temporary spousal maintenance in the sum of $2,500 per month, as well as child support for a brief period until their daughter entered college. He duly deducted these expenses on his income tax returns. Exs. 11, 14. The business paid many of Mr. Wilcox's other personal expenses (car insurance, gas, telephone). Ex. 39. The business also paid personal expenses of the community prior to separation and afterwards. Ex. 39. The support payments were made by the business, as were Wilcox's attorney fees and expert witness fees. Ex. 39; Report of Proceedings (RP) at 42-43. The federal income tax withholding for Mr. Wilcox's income tax was treated as a business expense on the corporate return. RP at 43-45. As stated earlier, the trial court accepted Mr. Wilcox's chosen salary as the foundation for issuing the support rulings, selecting $40,000 as his salary for that purpose. The remainder of the business profit was permitted to be retained by the business. Clerk's Papers (CP) at 112-13. Under the noted circumstances, we conclude that was error. The actual income was greater than the attributed income.
¶ 15 As noted in Stenshoel , the entirety of the retained income was available to Mr. Wilcox in the absence of a demonstrated business need. Mr. Wilcox had already paid the personal taxes on the income, establishing it as his own. His judgment about any business need for the funding was important information for the trial court to consider, but it was not dispositive. Plowing the income back into the company could serve a business purpose such as providing a corporate line of credit instead of using a commercial line of credit. Or it could simply increase Mr. Wilcox's equity in the business—a personal gain rather than a business need. The trial court needed to identify the business benefit of the retained earnings before excluding that income from its consideration.
¶ 16 Similarly, Mr. Wilcox had a substantial number of personal obligations paid for by the corporation, some of which were deducted as business expenses and some of which likely were not. However, deductibility is irrelevant to the question of whether the payments were income to Mr. Wilcox. When the corporation stepped in and paid expenses that benefited Mr. Wilcox personally, the payments were the equivalent of income. The trial court needed to account for that income when establishing maintenance.
For instance, personal attorney fees are not deductible expenses. Garcia v. Comm'r , T.C. Summ. Op. 2018-38, 2018 WL 3763347. Attorney fees spent defending against a federal investigation are a business expense. Comm'r v. Heininger , 320 U.S. 467, 474-75, 64 S. Ct. 249, 88 L. Ed. 171 (1943).
¶ 17 The 2017 tax return filed by Mr. Wilcox demonstrates the nature of the problem. Despite a personal income of $39,891, Mr. Wilcox paid $38,812 in personal income tax because the business profit of $167,390 was also included in his income. Ex. 14. The corporation recognized its profits as Mr. Wilcox's income, despite his choice to leave that money in the business. He also deducted from his income the $30,000 in "alimony" paid to Ms. Palomarez. Ex. 14. He was not capable of paying either the taxes or the spousal support based from his official salary. Likewise, the business, a community asset, paid those obligations and other personal expenses such as his personal attorney and fees.
¶ 18 We conclude that when one spouse's personal expenses are paid by a corporation, the dissolution court must attribute those payments as income when calculating a support obligation. Here, the court erred in not doing so. Similarly, when one spouse receives income from a closely held corporation under his management and returns that income to the corporation, the trial court must carefully scrutinize the decision and may only exclude from the income calculation the money legitimately needed by the corporation. Stenshoel , 72 Wash. App. 800, 866 P.2d 635. Mr. Wilcox, as manager of the business, had a fiduciary obligation to manage the community asset on behalf of the community. Whether it was appropriate to return the money to the business rather than treat the income as his separate property was a significant question for the court to answer. The court erred in failing to identify a business need for the cash. For both reasons, the income determination was erroneous and we therefore reverse the spousal maintenance award.
The trial court recognized the problem in its very detailed and thorough findings of fact, but declined to dig deeper in the absence of evidence that the corporation had disbursed additional cash to Mr. Wilcox. CP at 112 n.77. Mr. Wilcox's own testimony that the maintenance and attorney fee payments were made by the business justified looking more carefully at Wilcox's use of the business income.
We do not address Ms. Palomarez's other challenges to the maintenance award since it will have to be considered anew and the award may change on remand.
¶ 19 Reversed and remanded for further proceedings consistent with this opinion.
¶ 20 A majority of the panel having determined that only the foregoing portion of this opinion will be printed in the Washington Appellate Reports and that the remainder, having no precedential value, shall be filed for public record pursuant to RCW 2.06.040, it is so ordered.
WE CONCUR:
Siddoway, J.
Lawrence-Berrey, J.