What Attorneys Can Learn from Their Clients?
By Joseph DeCusati, CPA, ABV, ASA, CFE
So, you just accepted representation of a new divorce client. An immediate issue that arises is that your client cannot assist you very much with the financial background of the family, as they were not actively involved in managing financial matters. Well, where would be a good place to begin?
The personal income tax return, Form 1040, is an excellent place to start while in the initial stages of a divorce proceeding. Form 1040 can be especially useful in gaining sufficient background information before other documents are reviewed or subpoenaed. Almost all of your clients will file the form – whether or not the parties elected to file jointly or separately. Reviewing the parties’ Form 1040 can provide important clues identifying their financial position and overall lifestyle.
There is a significant amount of financial information available to the person in possession of a personal income tax return – provided you know where to look and know what the information means. Complex tax returns can be overwhelming to a “civilian.” The amount of data on a tax return can be extensive, so it is important to analyze the information, line-by-line if necessary, to absorb what it is telling us.
To help divorce attorneys better understand how to read a client’s tax return, I developed a webinar specifically devoted to these nuances. The curriculum breaks down many of the useful line items divorce attorneys should be looking at when reviewing Form 1040 and what that information means.
While the form itself has changed since 2017, almost all of the same information then is still available on the 2019 Form 1040. You just need to know where to look.
Wages, salaries and tips is often a good place to start if the taxpayer is a wage earner. That analysis provides a quick snapshot of income based on salary alone. However, it is important to request and analyze the additional documents provided to the taxpayer by their employer. This includes pay stubs, incentive compensation communications, and earnings records. Depending on the nature of the taxpayer’s employment package, a review of these documents will be telling as to whether or not you need to have discussions with (or depose) the party’s human resources representative. The needed analysis is not available from only wage-based income. A much deeper dive is usually necessary for most clients.
Your client’s (or their spouse’s) Form W-2 also provides insight such as federal and state income tax withholdings, along with Social Security and Medicare tax withholdings. You can also find out how much they are contributing to retirement plans and the value of stock options, health insurance, life insurance and more.
Schedule A can tell you a lot about someone’s lifestyle and assets. For example, substantial property taxes are usually indicative of a highly assessed valuation of real estate. Similarly, material personal property tax could indicate expensive vehicles, boats, or other “toys.” You can also see charitable gifts on Schedule A and get an idea of how much the taxpayer claims as gifts to nonprofit organizations. These items present meaningful data for your client and his/her spouse. The mortgage interest will give you an idea of the amount of the mortgage balance. Analysis of a series of years will give you an indication as to when there may have been a refinance or debt paydown; often these paydowns will coincide with the receipt of incentive-based compensation from their employer.
Page 1 of Schedule E tells you a lot as well. It educates you about any rental properties owned, along with the amount of rent collected and the address of the property or properties. The number of properties listed and the accompanying income from rent can give you an idea of the taxpayer’s wealth as well as other sources of income. I recommend the discovery of rent rolls and real estate appraisals to learn more specific details about the property assets.
The second page of Schedule E reveals even more. It identifies the taxpayer’s business ownership of pass-through entities. An analysis of Schedule E and its supporting statements, along with any applicable Schedule K-1s, can help you understand investment details. You can also learn the names and types of the business entities owned, details of the spouse’s ownership percentage, any change in ownership, and whether the investment is of an “active” or “passive” nature. These ownership interests will almost always require additional discovery requests.
Schedule B tells you about the marital estate’s investments, which generate interest and dividend income. This includes bank accounts, brokerage accounts and other investments. It also includes interests and dividend income from S-corporations, partnerships and other pass-through entities.
Understanding the fundamentals of basic tax forms can help you identify important information for your divorce cases. The information reported on these forms can serve as compelling evidence when making a case for classifying and dividing marital assets, proving the existence of hidden assets, and determining support.