Taxes. Ugh. Everyone can, but nobody wants to, talk about taxes. Generally, discussions center on people feeling that they pay too much in taxes and dread the various filing deadlines. However, taxes are an unavoidable part of life. So, if we have to deal with them, why not understand them, and use them to our advantage? Specifically, in the domestic law arena, taxes affect the very basic agreements between a husband and wife going through a divorce. We have to consider taxes when we divide assets (and debt), and when strategizing for clients to pay down (or eliminate debt) through various transactions. Those transactions have tax effects. In support actions, our goal is to determine the net income available for support. However, determining the accurate net income available for support means that you are applying the proper federal, state, and local income tax rates to a party’s income.
For the Commonwealth of Pennsylvania, the income tax rate is simple, we apply 3.07% to the taxable income number. The local income tax rate is fairly simple because local tax rates range from 1 – 1.25%. The nuance of calculating the proper net income available for support lies in applying the proper Federal effective tax rate to the taxable income. We are all aware that in the United States, the Federal income tax system is a graduated system. The more money you earn, the higher the tax rate applied to your taxable income. Surprise!
Many practitioners use software where they input income information, and the software determines the monthly support amounts for a spouse and children. We know that when we input the income information into support software, we can enter the tax amounts, or, we can trust the software to do the job. If you have a very simple income situation, letting the software do the work may be fine. However, if you have a twist on the income situation, the software will not result in the proper calculation of the support amounts, because the software cannot apply the proper Federal effective income tax rate. I found this out the hard way.
In a particularly complex matter, I ran just about every form of support calculations that I could think of, so that we could get an offer of settlement on the table. However, the support numbers just did not seem to be correct. As it turns out, the software was not applying the proper Federal effective income tax rate, because it could not take into consideration the equitable distribution agreement that was modifying the payor’s income, and therefore, the Federal effective tax rate.
Some simple facts: One party, Mr. Baker, earns $450,000.00 gross per year. The breakdown of his income is: base salary $180,000.00; Bonus 1 $190,000.00; and Bonus 2 $80,000.00. In equitable distribution, Bonus 1 was characterized as a marital asset and divided between the parties, net of all taxes. Bonus 2 and Base were added, and used as his annual gross income. The characterization of Bonus 1 as an asset removed it from Mr. Baker’s gross income for support purposes. However, Mr. Baker was taxed on his W-2 annual gross income of $450,000.00. If you apply the tax rate for $260,000.00 of gross income, the Federal income tax rate is around 26%. If you apply the tax rate for $450,000.00 of gross income, it is nearly 31%. The difference in the support amounts in this particular situation, based on applying the conflicting Federal income tax rates is nearly $3,000.00 per month. The Federal effective income tax rate and the effect on the income available for support were key in this matter because the difference in the final support amount determined whether or not the marital residence had to be sold.
Key to determining the actual Federal effective income tax rate requires a parlay into Accounting 101. When you look at a Federal tax return, there are a multitude of line items. Important to this topic are the tax lines showing: total income, adjusted gross income, taxable income, and income tax due. Total income is the sum of all income less certain losses (the detailed discussion will have to wait for another article). Total income is the largest of the income numbers and where we begin. The adjusted gross income is the income after taking into account certain expenses, credits, and deductions. Then we have taxable income, this is income after additional allowable exemptions and deductions. This is the income on which a person is actually taxed. The Federal effective income tax rate is the rate of tax a person is actually paying on their taxable income. You determine the Federal effective income tax rate by dividing the taxable income, by the total tax due. The resulting percentage is the Federal effective tax rate, and is what should be applied to the payor’s gross income to determine the net income available for support.
In the above fact scenario, Mr. Baker is paying the higher Federal effective tax rate because of his actual income. Using the adjusted gross income line on the Federal income tax return results in a 26% tax rate which is inaccurate. Using the taxable income line on the Federal income tax return results in a Federal effective tax rate of approximately 31%. Those few percentage points can make a huge difference in what a party pays/receives in support and, as stated above, may determine the ability to remain in the marital residence. This knowledge is necessary for the parties to plan their independent financial future that is just around the corner.
Many times I run into the argument that a person must use the adjusted gross income to determine the Federal effective tax rate. This is where I suggest a conversation with an accountant because they can give you the background and principles underlying this calculation. Even though we are dealing with domestic law, and the various definitions and cases addressing the financial issues, the basics of defining the calculation for the Federal effective tax rate are clear. While there are gray areas that we must deal with, this is not one of them, and we should be prepared to perform the hand calculations necessary to guide our clients in the best financial direction possible.
A word to the wise, know the tax return and the definitions underlying the line items. Get back to basics and understand specifically how the income tax rates affect support calculations. Especially with complex income situations, if you have questions or concerns, go to an accountant for guidance. For issues like this, the time you take to understand the concept and application is worth it to your client, your practice, and projections of support that interplay with equitable distribution issues.