Using the Net Worth Method of Proof to Determine Income in a Divorce Case

iStock_000019355019XSmallHow can income be calculated in a divorce case when a spouse refuses to produce documentation or is suspected of concealing sources of income? One way is through the Net Worth Method of Proof, which is used to analyze income and assets when detailed documentation is not available, either because the opposing spouse is obstructing efforts to get data and documents, or because data and documents are legitimately not available.

This method of determining income is used by the federal government in criminal income tax cases. Because it is accepted in federal criminal cases, family courts often will accept this as a reliable method for calculating income.

A detailed analysis of expenditures is performed using any documentation available. Each expenditure for the period under review is captured from bank, brokerage, and credit card statements, and each item is categorized so that totals can be accumulated for the period under analysis.

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Finding Hidden Income and Assets

Divorces and child support cases often focus heavily on financial issues. Whether the parties to a case are of modest means or great wealth, both sides want their own version of what is fair. Unfortunately, this can lead one or both parties to hide income and assets. With the help of a financial expert, counsel can identify income and assets that might otherwise go undiscovered, and hopefully reach an equitable end to a divorce or child support case.

Sources of income and assets owned can be identified with the right documentation. Attorneys need to be familiar with some of the most common financial documents so they know what to request. Attorneys with financial knowledge can also help identify issues that may need further analysis in a family law case.

Records Needed

When attempting to determine if there are hidden assets or undisclosed sources of income, the basic investigative process involves tracing funds. The income tax returns of an individual (and a business, if it is owned by one or both of the parties to the family law case) are the most basic documents needed to analyze the finances. While tax returns are not always accurate, they still give us a starting point, and may later be used to impeach the credibility of the opposing party if found to be inaccurate.

Further analysis of the financial situation requires statements from bank accounts, brokerage accounts, and credit cards. These third party records are generally deemed to be a reliable source of information. Barring any unusual opportunity to influence the recordkeeping process of banks or brokerage firms, these statements will be proof positive of the flow of funds.

If money is being hidden, how will you know if you have all the relevant account statements? The starting point will be all known accounts. Both parties should be asked to disclose all bank, brokerage, and credit card accounts. As those records are analyzed, other accounts may come to light. A transfer between accounts, a check written from one account to another, or other transaction could provide a clue that other accounts exist.

For example, a check written out to a municipality could point to real estate owned. A transaction with a marina or boat storage company may suggest a boat is owned. Even when trying to hide income or assets, parties are not always careful and may engage in a transaction that helps identify a previously unknown bank account or valuable asset. The financial investigator must track down all of these leads to determine whether additional accounts exist.

Determining Income

There is a reasonable chance that one of the parties to a divorce or child support matter is going to obscure income through and intricate web of accounts, transactions, and misinformation. A forensic accountant is the logical choice to help reconstruct financial records, estimate earnings, and analyze fine details of financial documents to prove or disprove income claims.

Tracing money into and out of bank accounts and brokerage accounts helps determine the source and use of funds. This type of analysis may be called a cash analysis, a cash in / cash out analysis, a source and use of funds analysis, or a cash flow analysis. Whatever it is called, the attorney should be clear about what information is sought so the analysis is completed correctly.

During a cash analysis, we may become aware of additional sources of funds, and must analyze them to determine whether they constitute income or something else. We may also discover clues to assets that were previously undisclosed, such as real estate or vehicles.  The details in a cash analysis can provide many clues to the larger financial picture, and that is why it is so important.

A closely related analysis is the lifestyle analysis, which is sometimes called the “expenditures method” for calculating income. This type of financial examination is used to prove an individual’s income, particularly when there are allegations of unreported income. It focuses on a person’s spending patterns relative to known sources of income. Differences between apparent living expenses and the person’s known or reported income can be attributed to concealed income.

The basic methodology for a lifestyle analysis includes adding known expenses such as a mortgage, groceries, automobile expenses, insurance, dining out, income taxes, vacations, and the like. We carefully consider all spending, making reasonable estimates where documentation is not available.

The total spending is then compared to known sources of funds including wages, bonuses, interest, dividends, loan proceeds, gifts received, and the like. Again, we must carefully consider all sources of income, including estimates when hard numbers are not available.

If spending during the period under analysis exceeds known sources of funds, then it is likely that there is another source of income that has been concealed. The logic behind this analysis is simple. The money being spent has to come from somewhere. The forensic accountant may continue to search for documented sources of income that could explain the difference. Any remaining unexplained difference likely represents unreported income.

Winning in Court

There are very often no winners in family law cases. It is usually more about limiting the pain or the perception of loss. Without a competent analysis it will be very difficult to know if a settlement in a family divorce matter is fair or in the best interest of the client.

As important as the analysis itself is the presentation of the findings. Non-accountants must be able to understand the numbers, so the financial investigator must tell a story that is easy to understand. It should include charts, graphs, and exhibits when they are helpful to understanding the conclusions. After all, a complex analysis and conclusion that is helpful to your case is not worth anything if the trier of fact can’t understand the opinions and how they were reached.

The Forensic Accountant as Consultant

Forensic accountants are usually retained in family law cases as expert witnesses, with the intention that they will provide expert opinions and testimony on behalf of the client. Although retention as a consultant is less common, it is an important option to consider. Sometimes, the work of the consultant can be even more important than the work of the testifying expert. The consultant may be able to dig deeper into sensitive issues because there is no fear of testimony or of disclosing the consultant’s work.

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Determining Support in Family Law Cases

Spousal support and child support can be calculated using a number of different factors. The relative importance of the factors may be laid out in local rules, but often the factors are simply listed and defined with little other guidance.  Considerations may include:

  • The actual earnings of each person, including wages, investment income, and other sources of income
  • The earning capacities of each party, both independently and relatively
  • Future earning capacities of the parties
  • The value of the assets divided, and the ability of those assets to produce income

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How a Lifestyle Analysis Can Be Used in a Divorce Case

A lifestyle analysis is the process of tabulating and analyzing the income and expenses of the parties. The lifestyle analysis is then used to determine the standard of living of the parties, which will influence support calculations, and possibly property division.

Calculating the lifestyle of the spouses prior to separation can provide insight into the lifestyle the married couple enjoyed and the cost of that lifestyle, as well as the income that was or is required to fund the lifestyle of the married couple. The results may be used to prove a spouse’s financial needs following divorce. In other words, a detailed analysis of the spending during the marriage can be the basis to calculate the funding the spouse needs to maintain a similar lifestyle after divorce.

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Red Flags of Fraud in Divorce

The vast majority of family law cases are settled without trials. However, a client should not enter into a voluntary settlement if there are significant concerns about the truth of the financial disclosures and indications that assets or income may be hidden. The first step in determining whether a forensic accountant is needed to evaluate the finances of the parties is the identification of “red flags” of fraud. A red flag is simply a warning sign or an unusual item or circumstance.

Attorneys often use their instinct to determine when a forensic accountant is needed in a family law case. If something does not feel right, it probably should be investigated.  A client is often suspicious of the spouse even before they are separated. The spouse may even be known to manipulate the money.

Beyond using intuition to determine if something is wrong, there are plenty of warning signs that indicate the finances should be evaluated carefully. These red flags by themselves do not mean that money has disappeared or the finances are being manipulated. But they are signs that an investigation is warranted. Because divorce is so adversarial, it is likely that one or both of the spouses will conceal or manipulate financial facts.

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Lifestyle Analysis in Divorce Cases: Investigating Spending and Finding Hidden Income and Assets

The second edition of Lifestyle Analysis in Divorce Cases: Investigating Spending and Finding Hidden Income and Assets, has been published by the American Bar Association. It is the only book available on the topic of lifestyle analysis in divorce cases. While there are plenty of excellent books on financial issues in divorce, none of them focuses on the lifestyle analysis, how it is done, and how the results may be used in court.

This book focuses solely on the lifestyle analysis in the family law case, although other services from a financial professional may also be needed in a case. The lifestyle analysis is the process of tabulating and analyzing the income and expenses of the parties. The lifestyle analysis is then used to determine the standard of living of the parties, which will influence support calculations, and possibly property division.

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Income Tax Information Used in Family Law Cases

Income tax returns and supporting information such as W-2s and pay stubs are the most common and basic documents which evidence income in family law cases. This article discusses the sources of income that are disclosed on a personal income tax return (Form 1040), and some ways the items can be evaluated to search for hidden income and hidden assets.

  • Wages – The figures reported on the income tax return should be matched to the W-2. The W-2 and the pay stubs will provide additional information on the employers, pay rates, total pay, certain benefits, and taxes withheld. Additional analysis may include tracing bank deposits to ensure that all wages were used for the benefit of the family.
  • Taxable Interest and Tax Exempt Interest – These items of income must be considered when calculating income available for support. They are also important because they can point to bank, investment, and brokerage accounts that may not have been specifically disclosed in the family law case.

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Calculating Income in Family Law Cases

forensic-accountingThere are four widely recognized methods of calculating income in family law cases. These four methods have been developed for use by the Internal Revenue Service in calculating unreported income in tax cases, and are the primary ways a lifestyle analysis can be completed.

Specific Items Method
One of the most straightforward ways to complete a lifestyle analysis is through an analysis of specific items of income. This method is possible when there are substantial documents detailing cash inflows, and is considered a “direct method” of verifying income.

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