Undistributed Income & the Burdens of Fennell
Child support has aspects of persistent chaos in a day when more and more people work in a “gig” economy and many are self-employed. As we have noted in the past, it is not common for those who are well compensated to see 20-30% or more of their income paid based on discretionary performance formulae. Then there is the nettlesome question posed by support obligors who see their compensation “deferred” to meet purported capital needs of their business.
A colleague brought to our attention a reported decision issued in March in a case called Sichelstiel. In a child support matter the father of a 17 year old child came to court professing to be a minority owner of nine (9) businesses. Three of those businesses reported a combined $23,000 in income which had been distributed. The remaining six enterprises reported $130,000 in aggregate earnings but those earnings were undistributed. Employing the precedent of Fennell v. Fennell, (753 A.2d 866, Pa. S. 2000) it appears Father produced the relevant Forms K-1 and argued that he could and should not have a support obligation premised upon reported earnings that were not distributed. The K-1s showed him to be a minority shareholder in each enterprise and that his “distributions” were indeed a fraction of the income reported to the tax authorities.
The record hearing indicates that the K-1s actually did not get into the record until several days after the actual hearing (which may have been remote given the time frame of 2020). The hearing officer wasn’t buying the Fennell argument and used the undistributed income to impose a $2,700 a month order. The reviewing trial court adopted that conclusion and affirmed the recommendation. Father appealed.
In a world where the written documents come into evidence after the record hearing is concluded, there are real problems cross examining a witness who left his or her documents at home. Meanwhile, Father’s testimony that he did not get the income he reported may be accurate. The court’s decision to remand so that the record could be corrected would seem to be a right result. But, in making that ruling, the appellate court seems to impose a burden on the obligee spouse to establish why the income should count for support. That seems a bit skewed.
The governments of the United States and the Commonwealth allow taxpayers to form subchapter S entities and thus avoid “corporate taxation.” The premise is that income flows through to the returns of the participating investors. They decide how and when income is distributed and the tax authorities have no say EXCEPT that the investors pay taxes on profits regardless of whether those profits were distributed or kept on the ledgers of the sub-S entity. You can defer distribution of your profits but not your income taxes on those profits. Why should the government have to wait?
Unfortunately, the daughter of Sichelstiels has been told she must wait for her support. Actually, since she is 17 and about to be emancipated, chances are she will never see any benefit from her dad’s $130,000 deferred profit. That money will fall into his pocket some day in the future when his child support obligation is behind him. For while the IRS and the Department of Revenue make payment of income taxes a priority obligation, the support court doesn’t follow that reasoning despite tons of cases that expressly state that child support is a “priority obligation.”
There are two sides to all stories and they both merit consideration by a support court. Many, many people are investors in small (i.e., Subchapter S) businesses. As minority investors they typically have to agree that the controlling shares decide the distributions and the basic premise of Fennell (that parents shouldn’t have to pay support on income they didn’t get) may be sound policy. But many of these enterprises are family businesses where distribution games can be played to help “friends and family” in the divorce process. And while many small businesses have difficulty borrowing capital and need to retain earnings, we have seen businesses with tens of millions in reported profits which restrict distributions to those needed to pay taxes. These businesses have ample access to outside capital either from lenders or potential investors. But they choose to withhold distributions.
So how do you parse the “investors” from the “gameplayers” who revel in not paying support? In a case such as this, the burden needs to be on the person claiming that the income is not available to show by clear and convincing evidence that there is no game underway. That would include the K-1s, the relevant portions of the operating agreement allowing income to be withheld and the documents issued by the corporation/partnership/llc explaining why the investor is not getting his share of the reported income. And, in a setting where the unavailable income exceeds the actual cash distributions 6:1, the person claiming the benefit of Fennell needs to be asked why his/her investments should be such that support for a child is eluded. A strict construction of Fennell would allow this writer to establish a fund of subchapter S businesses (call it Shifty Parents, LLP) and bury in the operating agreement a term that all profits of the investors are deferred until child support is no longer due.
To be clear, this is not intended to disparage the motives or actions of the litigants in this case. But we leave the appellate opinion not knowing who are the investors aside from father and what has been the history of income distributions. It might also be interesting for the obligee to seek production of electronic mail between shareholders regarding annual profit distributions.
There is sound reason for people to “invest.” But one is reminded of a long-ago case where one parent agreed to a $5 a week support order so that the father of the children could attain a college degree. As the Superior Court wrote in Com. ex rel Snively v. Snively: Father’s “praiseworthy ambition to obtain an education, which may well work to the eventual advantage of his child, cannot be realized at the expense of his obligation to support the child, and we agree with the court below that he cannot ‘arrogate unto himself the conditions upon which he will support this child’”. 212 A.2d 905 (1965). That Court modified the “agreement” to impose what it considered “fair” support.
The reported opinion is missing many facts. And there is another issue in the woodpile that someday needs to be addressed. Are distributions made for the purpose of paying income taxes “in” for support calculations or “out?” In theory this money is merely a pass through. But it underscores a point. There is liquidity to pay income taxes but not to fund an eighteen year child support obligation. There are no easy answers to these questions. But, when a parent appears before a court with $20,000 of acknowledged income and another $130,000 of income deferred for every purpose except payment of income taxes, close questions need to be asked. And the burden of proof needs to be placed upon the person who says the statute defining income (23 Pa.C.S. 4302) is somehow sublimated to the “policy” adopted in Fennell v. Fennell.
Sichelstiel v. Sichelstiel 2022 Pa. Super. 48
