July 12, 2017

New Hampshire courts continue to address different issues related to the calculation of self-employment income for child support purposes.

In a recent 3JX order (Makris[1]), the Supreme Court addressed two issues involving the calculation of income to be used for child support purposes: capital gains and depreciation. The bulk of the opinion actually addressed another issue, the effective date of a recalculated child support order.  However, the income calculation issue could have broader implications.

The Court quickly affirmed its prior holdings that capital gains are income for child support purposes (citing Maves/Moore[2]).  However, the Court then dealt with the more subtle issue of the interplay of capital gains and depreciation.

The trial court had used the capital gain as reported on the father’s tax return to determine the amount of income available for child support purposes. However, the father argued that the capital gain was calculated on the tax return using the tax basis, which had been reduced by depreciation in prior years. In determining income for child support in prior years, the trial court had disallowed depreciation as an expense. The father argued, and the Court agreed, that to treat the gain attributable to the prior depreciation (“depreciation recapture”) would double count income. The deduction had been disallowed (thus increasing income) in year of occurrence, but allowed to reduce basis (increasing capital gains) in the year of the sale.

A primer on depreciation:  Unfortunately, courts have various approaches to depreciation, which is understandable given the ever changing and arbitrary rules of the Internal Revenue Code.[3] The economics can be illustrated as follows:

Assume a piece of equipment is purchased for $100,000 with a loan to be paid over 5 years at $20,000 per year in principal payments. The annual rental income generated from that equipment is $30,000 and the equipment is depreciated on an accelerated basis. In a given year, the net income and the net cash will differ.

Year Income Depreciation Loan Principal Net Income Net Cash
1 $         30,000 $         (40,000) $         (20,000) $       (10,000) $       10,000
2 $         30,000 $         (30,000) $         (20,000) $             – $       10,000
3 $         30,000 $         (10,000) $         (20,000) $         20,000 $       10,000
4 $         30,000 $         (10,000) $         (20,000) $         20,000 $       10,000
5 $         30,000 $         (10,000) $         (20,000) $         20,000 $       10,000
Total $       150,000 $       (100,000) $       (100,000) $         50,000 $       50,000

Arguably, the net income will be different each year but if the same standard is applied, over time the total will be the same.

The Court did not expressly accept or reject the add back of depreciation in calculating income in Makris; the issue was consistency. Along the way, the Court made two interesting observations:

  1. The relevant inquiry is whether the income is available to pay child support (citing the Albert case[4]).
  2. Calculating a parent’s ability to pay child support requires the deduction of legitimate business expenses (citing the Woolsey case[5]).

Albert stands for the proposition that income from a partnership or S Corporation is income for child support purposes but that the calculation of the income is made under New Hampshire domestic relations law, not tax law.  In Albert, the income reported exceeded the cash available because the underlying asset had been depreciated on a more rapid basis than the mortgage payment so now the depreciation expense was smaller than the mortgage payment. The implication is that depreciation should be disregarded; however, debt payment should also be a factor in calculating available income.

In Woolsey, the Court required that deductions be “actually incurred and paid,” as well as “reasonable and necessary for producing income”.

With Makris, the Court implicitly restates that, in calculating income, depreciation could be disregarded as an expense under the Woolsey standard of income. Additionally, capital gain is income for child support purposes. When an asset is sold, the gain is the difference between sales price and the basis, i.e. cost of the property. However, if the asset sold was depreciable property, the cost basis for tax purposes was reduced by the depreciation deduction. This depreciation is recaptured, to the extent of gain.

Going back to the example on page 2, if the asset were sold for $120,000 in year 6, the gain would be $120,000 of which $100,000 would be depreciation recapture and $20,000 would be the capital gain. Because, under the New Hampshire child support standard as applied in Makris, the depreciation expense was not a reduction of income, the capital gain income attributable to the depreciation recapture is likewise not income.

The Makris fact pattern appears to be relatively straight forward.  However, there are possible complications:

  1. What if the depreciation was deducted prior to the divorce and thus never a factor in calculating child support?
  2. What if child support had in fact been calculated by allowing a deduction for depreciation; presumably the gain attributable to depreciation would not be a double count.
  3. What if child support had been calculated by adjusting both the depreciation deduction and actual debt payments?
  4. What if the gain exceeds the available cash, e.g. the asset had been used as collateral for a refinancing loan and the sale proceeds were used for family expenses (e.g. to pay off a home mortgage); the subsequent sale of the asset generates income but the sale proceeds/income must repay the refinanced loan?

Whatever the theoretical issues, it is clear that counsel will need to have a grasp of the accounting and tax details to provide guidance to the trial court. Moreover, in cases involving long term child support, these details may need to be tracked for a long period of time.   Undoubtedly, this is an area that will have further developments in the future.

Richard J. Maloney, CPA, ABV                                       Kevin C. Kennedy, CPA, CFE                                      Jessica L. Parasco, CPA


[1] Case No. 2016-0505, In the Matter of Sonya J. Makris and Paul B. Makris, decided June 28, 2017

[2]  In the Matter of Maves & Moore, 166 N.H. 564, 567 (2014)

[3]  In Maves/Moore, the Court referred, in passing, to depreciation as one of the “…expenses that were not necessary for producing income…”  ibid. at page 569

[4] In the Matter of Albert & McRae, 155 N.H. 259 (2007)

[5] In the Matter of Woolsey & Woolsey, 164 N.H. 301 (2012)