Three Common Approaches for Determining What Constitutes Legitimate Business Expenses for Child Support Purposes

By Board Certified Las Vegas Divorce Attorney Vincent Mayo

Nevada has a child support formula that makes it relatively easy to predict an obligor’s child support obligation based on gross monthly income. NRS 125B.070. This simple formula, however, becomes much more difficult to calculate with self-employed parents. The problem stems from trying to justify a self-employed parent’s claimed business expenses. Many states have established laws in regard to what constitutes income for self-employed parents. Unfortunately, given the varied treatment of this principle from state to state, attempting to establish a national consensus in regard to valid business expenses is of little help. Worse yet, Nevada has not articulated what constitutes justifiable business costs. NRS 125B.070(1)(a) merely states that a business expense must be “legitimate” in order for it to be deducted from the computation of gross income. The Nevada Supreme Court has not directly elaborated on this concept.

Fortunately, a better understanding of the reasons why courts choose to accept one business expense as legitimate and another as not legitimate can make addressing these issues easier on the family law practitioner. A review of sister-state opinions reveals three factors, or approaches, commonly taken into consideration by courts when making their determinations on what constitutes a legitimate business expense. These factors are: (1) whether the business expense is necessary to produce income; (2) whether the business expense is primarily a payment of a personal expense; and (3) whether the business expense unnecessarily reduces the income available to support a child.

Is the Business Expense Necessary to Produce Income?

This factor is perhaps the most widely used. According to the “necessary to produce income” approach, if an expense is not necessary to generate income, it is not a legitimate business expense. This factor typically comes into consideration when dealing with deductions that exists “solely on paper” for tax purposes and do not directly reduce an obligor’s available income.

The most common “paper deduction” is depreciation of a business asset. Some courts recognize depreciation as a legitimate expense, depending on its purpose. For example, in Freking v. Freking, 479 N.W.2d 736 (Minn. Ct. App. 1992), a child support obligor sought to deduct accelerated depreciation (which allows greater deductions in the earlier years of the life of an asset) from his farm business. The Minnesota Court of Appeals permitted straight-line depreciation (which allows for a yearly deduction of the useful life of the asset) but not accelerated depreciation. The court reasoned that accelerated depreciation is in the nature of a tax fiction, unrelated to the useful life of an asset and intended only to generate tax savings. Id. at 740. See also Turner v. Turner, 586 A.2d 1182 (Del. 1991). Based on this reasoning, accelerated depreciation is not necessary to produce income. On the other hand, the court recognized straight line depreciation as being appropriate since it more fairly reflected the cost of producing income. See also In re Marriage of Davis, 679 N.E.2d 110 (Ill. App. Ct. 1997).

Other courts have been more restrictive on the definition of “necessary” to produce income and have not permitted any expense that does not actually reduce the obligor’s disposable income. The Supreme Court of Montana in Stewart v. Stewart, 793 P.2d 813 (Mont. 1990), held that depreciation losses could not be deducted as business expenses since depreciation for tax purposes is intended to assist an individual in regaining their expenditures. Therefore, it does not follow that it is a business expense necessary to produce income. Id. See also Asfaw v. Woldberhan, 55 Cal. Rptr. 3d 323 (Cal. Ct. App. 2007).

In contrast, expenses that can be shown to directly result in the production of income are considered necessary and, therefore, are commonly allowed. In Bower v. Bower, 697 N.E.2d 110 (1998), the Court of Appeals of Indiana held that the obligor’s promotional, travel, and accounting expenses directly resulted in an increase to his income. The Court reasoned that as the obligor’s income would not have been what it was without the costs, it would be unjust to not allow the obligor to deduct them. Id. at 115. See generally In re Marriage of Davis, 679 N.E.2d 110 (Ill. App. Ct. 1997) (which considered, as part of evaluating whether an expense is necessary, whether the expense was also reasonable). Critical to the court’s approach in Bower was the question of whether the expenses would not have been incurred “but for” the employment. Id. at 115.

There are a vast array of other potential deductions to be claimed (business loans, principal and interest on mortgage and assets, initial acquisition costs of new venture, insurance premiums, etc.). Analyzing whether these, as well as other costs, are a legitimate deduction can be accomplished by use of a “necessary to produce income” approach.

Is the Business Expense Essentially Payment of a Personal Expense?

This factor is also widely recognized. The “personal expense” approach is similar to the “necessary to produce income” approach yet differs from it in that courts will focus on whom the deduction primarily benefits, not on how necessary it is to generate income. In other words, although a personal expense can also be used to generate income, if its use is primarily for payment of a personal expense, it is not considered an appropriate deduction of gross net income to the obligor.

The Alaska Supreme Court’s reasoning in Coghill v. Coghill is a classic example of this principle. In Coghill, the Alaska Supreme Court upheld the decision of the Superior Court when it found that business expenses were primarily for the benefit of the parent, not the business. 836 P.2d 921 (Alaska 1992). In Coghill, the obligor claimed his meals and clothing expenses were necessary to operate his business. The Alaska Supreme Court stated that although such costs can constitute a legitimate business expense, the obligor’s expenses were not legitimate since the meals were consumed by the obligor alone and since the type of clothing purchased by obligor was not significantly different from the clothing purchased by most Alaskans. Id. at 926.

Other states have compromised in determining whether such expenses are legitimate by approaching the deductibility of a personal expense from a comparative view point. In other words, if the personal expense benefits the obligor while simultaneously benefitting the company, it will be apportioned so part of the cost is deductible and part is not. This was the case in Reinhart v. Reinhart, 963 P.2d 757 (Utah Ct. App. 1998). In that case, the Court of Appeals of Utah allowed only half of the obligor’s claimed educational and travel expenses as they significantly benefited the obligor himself in addition to the business. Id. at 759. This comparative reasoning, however, may not be deemed valid in Nevada based on the fact NRS 125B.070(1)(a) directs that personal expenses must be excluded from calculating gross income.

Will the Expense Unnecessarily Reduce the Income Available to Support a Child?

This factor tends to center on the overall fairness of the deductions to the child, not whether the deductions are necessary or personal in use. The “reduction of income available to support a child” approach focuses on the fact that although it may be fair to allow the deduction as necessary or that a personal expense also benefits the business, the overall effect is that the deductions come at the expense of the child’s financial welfare. Use of this factor typically comes into play when an obligor has wide discretion in manipulating deductions to set their own salary or when deductions in essence leave little funds available for child support.

In Rauch v. Rauch, 590 N.W.2d 170 (Neb. 1999), the Supreme Court of Nebraska recognized that although the obligor’s farming losses and use of funds to reinvest in his farm could constitute a necessary expense, “It would be unfair for Donald [the obligor] to benefit from his choice to incur debt and build equity in his farm at the expense of his children.” Id. The court stated that, “[t]he support of one’s children is a fundamental obligation which takes precedence over almost everything else.” This reasoning was also used by the Indiana Court of Appeals in Merrill v. Merrill, 587 N.E.2d 1888, 189 (Ind. Ct. App. 1992). In Merrill, the court acknowledged that a self-employed obligor has the discretion to defer current income by incurring debt, and there could be situations in which there would then be very little income to be considered available for determining child support. Id. at 189.

Although the foregoing three factors are far from all inclusive, they are the foundation upon which most requests for deductions are made. Being familiar with and further researching these approaches will typically result in requested deductions that are not only well-reasoned but the most just to self-employed obligors as well as to their children.