As accountants, we are frequently asked to quantify provisions of settlement agreements. Often, this becomes necessary in post-judgment situations, when the memory of the intent of the agreement – at the time it was negotiated – has “faded” and any ambiguity can provide an opportunity for disagreement. In these situations, accountants may be asked for guidance regarding the interpretation of those agreements.
In divorce matters, attorneys generally spend a great deal of time negotiating the specifics of parenting time – down to memorializing pickup times, holidays, and grandparents birthday visits – all with the goal of avoiding future conflict. Unfortunately, for a variety of reasons, certain aspects of the financial settlement may not receive the same attention. Financial terms can be misused/misunderstood and/or not adequately defined; this very often leads to confusion, conflict, and post-judgment litigation over the original intent of the agreement. The following terms are just a few examples of language that is often used incorrectly and/or misinterpreted. By understanding the potential for misinterpretation one can design agreements that proactively address those issues that may otherwise arise down the road.
1. Net Income
“Net Income” is defined, in the most simplistic terms, as revenue minus expenses. Revenue and expenses can legitimately vary (perhaps greatly) between the books and the tax returns. Both are “correct” but each paints a different picture. We frequently see significant confusion with regard to whether “net income” – as used in the agreement – is calculated before Perks, Owners Compensation, Draws, or Distributions. Depending on the type of entity, these items (which are frequently disputed during the pendency of the divorce) may or may not be included in the determination of net income. Do not assume the parties are informed of your definition of “net income”; include a clear definition in the agreement.
A few key considerations for defining net income: Is it before Owners Compensation/Perks? If there was a valuation performed, is the net income based on the reasonable compensation adjustment used for that valuation? The difference can be substantial, and the time taken to clearly define the specifics is well worth it.
As an example, take the situation involving a buyout of equitable distribution based on a percentage of the “net income” reported by the business owner. There was a “floor” based on the prior three years of reported net income, which was clearly meant to be a safety net for the very situation that was to follow. The first year after the divorce, the owner increased his or her salary, thereby reducing net income. The spouse, who was entitled to review the annual tax returns, objected for various reasons – since net income was much lower than its historic norms. The spouse’s position was that the owner increased his or her salary solely to reduce the buyout, not to recognize any post-marital increase in responsibilities, etc. The spouse represented that they were not aware that officer compensation was deducted in the determination of net income, and that had they understood that they would not have agreed to the arrangement.
Could this situation have been avoided by using more specific language? Perhaps. Had there been a discussion regarding these very issues that the spouse simply does not recall? Possibly. The inclusion of the wording that the buyout was to be based on “net income prior to Officer Compensation/Perks etc.” would have not only removed the potential for future disagreement, but also eliminated any potential “divorce-related” incentive for the owner to increase his or her salary. The previously referenced “floor” on which the buyout was based most likely accomplished the same outcome. However, the spouse clearly did not understand that and the outcome was post-judgment litigation and additional attorney/expert fees.
2. Net Proceeds from Sale
In a situation where a residence or other asset is sold and the “net proceeds” are to be divided between spouses, there should be a clear stipulation as to specifically how “net proceeds” are defined.
For example, consider a recent case in which a vacation home that was deeded to the wife was to be sold shortly AFTER the divorce, with the “net proceeds” to be split equally thereafter. (Remember a second home is not eligible for the exclusion of the gain). In this situation, the sale would be reported on the wife’s individual tax return in the year following the divorce; as such, any potential gain would be reported by the wife as well.
The husband, based on consultation with his tax advisor, was of the impression that he would not be responsible for any tax on the potential gain because a) the sale would be reported on the wife’s tax return and b) he was not on the deed. Based on the wording of the settlement agreement which referenced “net proceeds,” that was not clear. The fact that the sale would be reported on the husband’s individual tax return is more a formality, and practitioners unfamiliar with divorce negotiations can often oversimplify the impact of the “mechanics” on the intent of the agreement. Since the tax to be paid was not insignificant, it is unlikely that the agreement did NOT intend for the “net proceeds” to include a provision for the associated tax liability as the property was going to be sold as part of the divorce and said tax was easily quantified (see below regarding situations in which this is not the case).
3. "Net of Tax"
Unlike the prior example, where the tax burden on a sale can be relatively easy to determine, other situations can pose a myriad of more nuanced issues. These situations often involve a spouse’s continued “participation” in a future benefit stream. For example, where a spouse may have stock-based compensation that will vest in the future or where they are owners in a pass-through entity from which they receive distributions. In these instances, the recipient/owner spouse will incur a tax liability that most would agree the payee spouse should share in some way. This is where very specific language can be of great benefit in avoiding future conflicts. Limiting the reference to “net of tax” can lead to a variety of interpretations and, in turn, significantly different conclusions. Will there be an agreed-upon “effective” rate used? Will there be an accountant appointed to prepare a more “exact” computation of the tax liability attributable to the specific income source to which the recipient spouse is entitled? Considering that taxes are often paid, at least in part, the year AFTER the “income” is received, is there a matching of taxes paid to income received? The possibilities are numerous, and while it is often desirable to keep things simple, the mechanism for doing that is to make sure the agreement is as detailed and specific as possible.
There is no such thing as a perfect agreement. Having your financial professionals review the language before the final settlement may ultimately save legal and accounting in the long term. If you have any questions about the financial language within a proposed or pending agreement, contact a Friedman professional today.