Valuation Insights for Family Lawyers
Uncovering Hidden Income and Inflated Expenses in Family Businesses During Divorce
In the context of family law, accurately assessing the value and income of a privately held business is crucial for equitable property division and determining appropriate spousal support obligations. However, some business owners may attempt to manipulate financial records to understate income or overstate expenses, thereby reducing the apparent value of the business and their income for support calculations.
This blog article outlines common tactics used to conceal income or inflate expenses and provides guidance on how to identify these practices.
Common Tactics to Conceal Income
- Underreporting Cash Sales: Businesses that deal heavily in cash transactions may not report all income, leading to understated revenues.
- Delayed Invoicing or Revenue Recognition: Postponing the issuance of invoices or recognition of income until after the divorce can artificially lower income figures during the valuation period.
- Personal Expenses Paid by the Business: Charging personal expenses to the business reduces reported profits. This includes personal travel, meals, or household expenses misclassified as business costs.
- Unreported Income Streams: Income from side businesses, consulting, or rental properties may be omitted from financial disclosures.
- Sudden Income Deficit Syndrome (SIDS): A term describing the sudden drop in income reported by a spouse once divorce proceedings commence, often without a corresponding decline in business activity.
Strategies to Inflate Expenses
- Prepaying Expenses: Paying for future expenses in advance can reduce current period profits.
- Creating Fictitious Expenses: Recording expenses for services or goods that were never received.
- Overstating Depreciation or Amortization: Using aggressive depreciation methods to lower taxable income.
- Inflated Salaries to Family Members: Paying unreasonably high salaries to family members who may not be actively involved in the business.
- Non-Arm’s Length Transactions: Engaging in transactions with related parties at non-market rates to manipulate expenses.
Identifying Red Flags
- Discrepancies Between Personal Lifestyle and Reported Income: A lavish lifestyle that doesn’t align with reported income may indicate hidden earnings.
- Inconsistent Financial Statements: Variations between tax returns, bank statements, and internal financial reports.
- Unusual Transactions: Large, unexplained transactions, especially those close to the initiation of divorce proceedings.
- Lack of Supporting Documentation: Missing invoices, receipts, or contracts for significant expenses.
Case Study: Inflated Expenses in a Medical Practice
In a divorce proceeding involving a general medical practice in Surrey, B.C., the wife alleged that the husband, who operated the clinic was downplaying the company’s profitability. The company’s income appeared to show modest net earnings relative to the revenue it was generating.
However, a detailed review of the clinic’s general ledger painted a different picture. After reviewing the financial records, we noted an increase in expense categories such as dues and memberships, meals and entertainment, travel, and vehicle expenses, all significantly higher than what was expected to run a medical practice. Further investigation revealed that many of these expenditures were personal in nature, including personal vehicles, luxury hotel stays, and family vacations, all recorded as business costs.
These findings suggested that the company’s true profitability had been understated. After adjusting for the inflated and misclassified expenses, we concluded that the clinic had significantly more income and value than initially disclosed, insights that played a crucial role in determining both the division of property and ongoing spousal support obligations.
Best Practices for Family Lawyers
- Early Engagement: Involve financial experts early in the case to identify potential issues promptly.
- Comprehensive Discovery: Request all relevant financial documents, including tax returns, bank statements, and accounting records.
- Deposition of Business Owners: Question the business-owning spouse about financial practices and any discrepancies found.
- Court Orders for Disclosure: If necessary, seek court orders to compel the production of financial documents.
Engage Early for Accurate Valuations
Collaborating with a Chartered Business Valuator (CBV) early in the process can provide clarity and support in navigating complex financial landscapes. A CBV can assist in identifying irregularities and ensuring that valuations reflect the true economic value of the business.
