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By Michael W. Kalcheim

Fair GameFair GameAre a Closely Held Corporation’s

Retained Earnings

for a Divorcing Spouse?for a Divorcing Spouse?

Are a Closely Held Corporation’s Retained Earnings

When considered a nonmarital asset, the SES’ interest in retained earnings will not be subject to division as marital property.1 In or-der to bring retained earnings within the pur-view of the marital estate, the non-SES spouse must assert a claim for reimbursement.

Illinois courts have not yet decided the applicable standards, although the majority of states considering the issue have held that retained earnings are not reimbursable to the marital estate if the corporation histori-cally retained its earnings, had a legitimate business reason for doing so, and adequately compensated the SES for his services to the company. These cases recognize that corporate management commonly and pru-dently decides to retain all or a portion of the company’s earnings to assure the business’ success.2

Subchapter S retained earnings and the marital property reimbursement claim

Tax impact on shareholder’s personal in-come taxes. The amount of retained earnings, which has been defined as amounts “from the profitable operations of [a] company,”3 is reflected on Form 1120 of a Subchapter S corporation’s annual tax return. A Sub-chapter S corporation is one that has elected special tax treatment under Subchapter S of the Internal Revenue Code.4

All earnings are attributed to the S Corpo-ration’s shareholders according to each one’s ownership percentage, regardless of whether

the company actually distributes the funds.5 If the corporation does not make an actual distribution of all of its profits, the undistrib-uted amounts are accounted for as “retained earnings” or “earned surplus.”6

For bookkeeping and taxation purposes, the difference between the income on which a shareholder pays taxes and the actual income

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Michael W. Kalcheim, senior partner in Kal-cheim, Haber & Kuzniar, LLP in Chicago, practices matrimonial law exclusively, concen-trating on complex executive compensation benefits, nonmarital and marital property classification, business valuation issues, and interaction between the employee spouse and the closely held corporation’s relationship to the parties’ standard of living.

Can the non-employee spouse make a claim for reimbursement to the marital estate from the retained earnings of a closely held (i.e., Subchapter S) corporation? Are retained earnings accessible for child or spousal support? This article explores

how Illinois courts and other jurisdictions struggle with this complex issue.

uestions often arise as to whether “retained earnings” of a closely held corporation (an S Corporation) not distributed to the owner of the nonmarital shares should be considered as a reimbursement due to the marital estate

under the statute defining “marital” property (in Illinois, Section 503(a) of the Illinois Marriage and Dissolution of Marriage Act (the “IMDMA”)). The shareholder spouse is usually also an employee of the corporation (an “SES”).

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1. Internal Revenue Code, 26 USC §§1361–1378.2. Consistent with the business judgment rule which ac-

cords great deference to corporate business decisions by not holding corporate officers or directors liable for mere mistakes or errors of judgment. Selcke v Bove, 258 Ill App 3d 932, 935, 629 NE2d 747, 750 (1st D 1994).

3. Lendman v Lendman, 157 Wis 2d 606, 614, 460 NW2d 781, 785 (Wis App 1990), citing W. Fletcher, Fletcher Cyclopedia Of The Law Of Private Corporations, Glossary at 7 (rev ed 1988).

4. Internal Revenue Code, 26 USC §1366.5. See also Black’s Law Dictionary 342 (6th ed 1990),

which defines a Subchapter S Corporation as one where share-holders must report their respective pro rata share of retained earnings as annual income (or loss, deductions, and credits) on Schedule E of their individual federal income tax returns. See DeTreville v United States, 445 F2d 1306, 1309 (4th Cir 1971), cited in M. Kyle Rominger, Valuing S Corporation Earnings in Child Support Calculations, 35 U Louisville J Fam L 145, 146 (1996-97).

6. Anderson v Anderson, 60 Ark App 221, 227, 963 SW2d 604, 607 (1998). See also Hudspeth v CIR, 914 F2d 1207 (9th Cir 1990).

distributed is included in the accumulat-ed adjustments account (“AAA”).7 The AAA does not actually hold the retained funds,8 but rather serves as an account-ing tool for recording the corporation’s cumulative net income that has been taxed but not distributed to sharehold-ers.9 The net taxable value of the AAA is reported on Schedule M-2 of the Form 1120S,10 which reconciles the changes in the AAA account from the beginning to the end of the year.

Illinois evidentiary hurdles to claim-ing reimbursement. The IMDMA pro-vides that when personal efforts by an SES increase the value of a nonmarital interest during the marriage, the other spouse may have a claim for reim-bursement.11 To state a cognizable claim for reimbursement, the nonshareholder spouse must present competent evidence that (1) the SES’ non-marital interest substantially appreciated in value during the marriage; (2) the increase in value resulted from the SES’ significant per-sonal efforts; and (3) the SES was not otherwise reasonably compensated for such efforts.12

Illinois courts have not yet addressed under what circumstances this test will be applied. To assist the courts, however, there is a sufficient amount of law on the reimbursability of appreciation on one spouse’s non-marital interest that sheds some light on the analysis. The decisions indicate that the court will consider whether the appreciation of the spouse’s non-marital asset was caused by external economic factors or by internal factors (e.g. the company’s management team)13 and the extent to which the SES’ significant personal efforts caused the appreciation. It will also consider wheth-er the owner-spouse was “adequately compensated.”14

To determine the portion of active appreciation resulting from the SES’ ef-forts, the practitioner should thoroughly analyze the services provided by the SES, including the job description, re-sponsibilities either individually or in a combined capacity (e.g., president, CEO, and/or CFO working a 40 or 70 hour work week) and, if applicable, his or her contribution of ideas and concepts (e.g., unique marketing strategy, development of intellectual property, etc.). The prac-titioner should also determine whether the SES’ compensation was reasonable compared to industry peers.

In Illinois, the practitioner asserting a

reimbursement claim must demonstrate a direct quantitative connection to an in-crease in value of the non-marital inter-est, which in turn requires a valuation of the business at both the time of marriage and at dissolution. If the nonmarital in-terest increased in value over the course of the marriage, determine whether the increase was due to “active” apprecia-tion15 (which has been held to support a claim for reimbursement), “passive” appreciation16 (which has been held not to),17 or a combination of the two, in which case the appreciation should be allocated accordingly.

It must next be determined how to measure that increase for purposes of calculating the amount reimbursable to the marital estate. This requires analyz-ing three related factors: whether the increase was due to both external factors and the SES’ efforts; whether the portion of the increase attributable to the SES’ efforts can be distinguished from that re-sulting from other factors; and whether, under Frye evidentiary standards, it is possible to provide competent eviden-tiary proofs supporting an appropriate “allocation” of the increase between these two factors.

Often it is too difficult to determine whether an increase is due to active SES efforts or passive external economic factors. Passive factors include socio-economic trends within the consum-ing population, such as climatic condi-tions, trends in product popularity, and advertising. They also include invested capital and the availability of financing, the company’s ability to meet product demand, management as a whole, and other factors.18 In that case, the claim for reimbursement will usually fail, be-ing deemed too speculative under Frye19 evidentiary standards.

In Illinois, the burden of proof is on the nonowner spouse seeking reimburse-ment to establish his or her claim.20 The claimant must present evidence that the increase in value resulted in whole or in part from significant efforts by the SES and not inherent qualities of the busi-ness, the efforts of third parties, or other external factors. He or she must also show that the company inappropriately retained earnings (i.e., deviated from historical distribution patterns, had no legitimate business purpose for reten-tion, and did not reasonably compensate the SES).21

Applying the probative factors. A

recent Minnesota decision illustrates the relationship between the various factors discussed above and may provide guid-ance to both courts and practitioners in Illinois. In Gottsacker v Gottsacker,22 the Minnesota Supreme Court considered whether an SES’ minority interest in her __________

7. See Robert v Zygmunt, 652 NW2d 537, 544 (Minn App 2002), noting that the function of the AAA and retained earnings are for bookkeeping and taxation entries, rather than as an accurate reflection of surplus cash accumulated within the corporation. The Zyg-munt court noted that the Internal Revenue Code attri-butes amounts in an AAA strictly for “monitoring” and “notational” purposes.

8. Id.9. Id.10. Form 1120S also contains a Schedule L which

shows in detail the changes in the corporation’s book value from the beginning of the year to year end. Pick-rel v Pickrel, 14 Neb App 292, 717 NW2d 479 (2006). Line 24 of Schedule L titled “Retained Earnings” re-cords the changes in the book value of the retained earnings from the beginning of the year to year end. The Form 1120S Schedule M1 reconciles the net book income with the net taxable income.

11. 750 ILCS § 5/503(c)(2).12. Id. 13. See In re Marriage of Komnick, 84 Ill 2d 89, 417

NE2d 1305 (1981); Bentley v Bentley, 84 Ill 2d 97, 417 NE2d 1309 (1981); and In re Marriage of Jones, 104 Ill App 3d 490, 432 NE2d 1113 (1st D 1982).

14. See In re Marriage of Kamp, 199 Ill App 3d 1080, 1087, 557 NE2d 999, 1004 (3d D 1990) (rec-ognizing that the husband’s personal contributions to the growth of his non-marital interest had been inad-equately compensated, and remanding for determina-tion whether appreciation was due to internal or exter-nal factors); but see In re Marriage of Landfield, 209 Ill App 3d 678, 567 NE2d 1061 (1st D 1991) (focusing on reasonableness of actual compensation regardless of fact that partnership could have paid owner-spouse more).

15. Kamp at 1084, 557 NE2d at 1002. 16. Ashok B. Abbott & Timothy C. Voit, Valuing

Business in Divorce: Emphasis on Passive and Active Appreciation, Bus Valuation Alert 3 (Apr 2004) (defin-ing passive appreciation as an increase in value attrib-utable to “external factors” such as market conditions, inflation or third party sources).

17. Id.18. Swope v Swope, 122 Idaho 296, 834 P2d 298

(1992); see also Kelly v Kelly, 86 Nev 301, 306-07, 468 P2d 359, 362-63 (1970) (noting “the accretion in the value…[was passive because it] would have occurred whether the portfolio was owned by [the other spouse] or a person in a mental institution”); accord Smith v Smith, 94 Nev 249, 578 P2d 319 (1978); but see Nar-dini v Nardini, 414 NW2d 184, 186 and 194-95 (Minn 1987).

19. See Donaldson v Central Illinois Public Service Co, 199 Ill 2d 63, 767 NE2d 314 (2002); and Harris v Cropmate Co, 302 Ill App 3d 364, 706 NE2d 55 (4th D 1999).

20. In re Marriage of Eddy, 210 Ill App 3d 450, 458, 569 NE2d 174, 180 (1st D 1991) citing In re Marriage of DiAngelo, 159 Ill App 3d 293, 512 NE2d 783 (2d D 1987).

21. Eddy at 458-59, 569 NE2d at 180. See also Rob-bie v Robbie, 654 So 2d 616 (Fla 4th D 1995) (finding reimbursement to the marital estate warranted where the SES, although not the key decision maker, contrib-uted marital efforts to the overall success of a sports franchise and, therefore, to the resulting enhancement of the value of the corporation. See also Swope at 299-300, 834 P2d at 301-02 (denied the reimbursement claim because the non-owner spouse did not provide competent evidence that those retained earnings con-tributed to the enhancement in value).

22. 664 NW2d 848 (Minn 2003).

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family’s service businesses, and particu-larly the companies’ AAAs, contained funds properly characterized as assets of the marital estate.23

The non-owner spouse argued that the court should follow the Wisconsin appellate decision Metz v Keener24 and

hold that amounts in the AAAs should be deemed “income [ ] divisible as a marital asset.”25 He also argued that the court should disregard the precedent set by another Minnesota case, Duffey v Duffey,26 and find that the control ex-ercisable by his wife’s family members, who collectively owned the majority of the company, should be imputed to his wife, a minority shareholder, for pur-poses of determining her control over earnings retention.27

Rejecting both of these arguments, the Gottsacker court focused on the increase in corporate value during the marriage and found that the value of the AAAs “‘arose from the efforts of the Subchapter S corporation officers and employees, not through any of the SES’ marital efforts.’”28 The court also held Metz distinguishable because in that case the owner employee spouse was a “sole” shareholder who acted as the “sole” manager of the business, whereas the Gottsacker SES shared management and ownership with her family.29

The court found misplaced the non-owner spouse’s focus on the collective level of control exercised by the SES and her family,30 and held that the appropri-ate inquiry was the extent to which the SES’ efforts contributed to the business-es’ increase in value. In this regard, the court observed that the SES’ work

did not “contribute[] in any material way toward any increase in value in any of the business entities during the marriage,” and the appreciation of the stock was, therefore, passive….“The distinguishing factor [ ] is the retained earnings were not generated through the efforts of [the par-

ties].” ….Thus, it was not…the corporate structure that guided the court…; rather, it was whether the retained earnings, as an increase in the value of the stock, could be attributed to marital effort.31 The Minnesota Supreme Court con-

cluded that a claim for a “marital” characterization (i.e., a claim for reimbursement in Illinois) was not justified because any increase in the value of the non-marital stock was not directly at-tributable to the SES’ ef-forts; the SES did not have the management power to force a distribution from the AAA funds; and there was no assurance that the funds referenced in the AAA would ever be dis-tributed.32

Measuring the increase in value – the “all or none” v. apportionment approach. Some courts take the position that it is impossible to allocate the increase in a company’s value during a mar-riage between the SES’ efforts and the influences of passive appreciation. In Swope v Swope,33 for example, the Idaho Supreme Court held that the factors contributing to an enhancement in a business’ value could not be separately identified and any conclusion attempting to allocate the increase would be purely speculative.34

Where an increase results from both the SES’ efforts and external factors, some courts have found that the increase can and should be allocated between these factors. These courts apply various formulas to calculate the fair value of the SES’ services and the resulting increase in corporate value, thereby determining the reimbursable portion.

For example, in Cockrill v Cockrill,35 the Arizona Supreme Court found that if profits result from both the inherent nature of the business and the uncom-pensated personal services of the SES, then the incremental increase should be apportioned and both valued ac-cordingly. The Cockrill court opined that the incremental increases should be measured by either the reasonable value of the SES’ personal efforts (with any amount over this attributed to the inher-ent nature of the non-marital property)36 or by calculating a reasonable rate of return on the original capital investment and allocating any increase in value over this amount as marital property.37

Retained earnings as a basis for support obligations

Divorce litigants may also claim that retained earnings should be considered part of the SES’ income for purposes of determining his or her maintenance or child support obligation. In considering such arguments, courts initially focused on the statutory definitions of income and the degree of control exercised by the SES over earnings distribution.

However, as the law evolved, courts began concentrating on whether there is a legitimate business purpose for earn-ings retention. More recently, a compa-ny’s pre-estrangement historical pattern of retention and distribution has also surfaced as an important factor.

“Income” not always the same for tax and support purposes. In order to report its shareholders’ pro rata share of the company’s profits, an S Corpora-tion provides a schedule K-1 for each shareholder.38 The shareholder is liable to pay income tax on his or her share of the profits, whether or not funds are actually distributed, and must include such profits on his or her individual fed-eral and state income tax returns.39 An explanation and illustration of a typical Schedule K-1 is online at http://www.isba.org/IBJ/jan07j/K1explanation.htm.

There is a difference between a party’s

The majority of states considering the issue have held that retained

earnings aren’t reimbursable to the marital estate if the

corporation historically retained its earnings for legitimate reasons.

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23. Id at 850. 24. 215 Wis 2d 626, 573 NW2d 865 (1997).25. Gottsacker, 664 NW2d at 856-57.26. 416 NW2d 830 (Minn App 1988).27. Gottsacker, 664 NW2d at 857.28. Id at 858, quoting Gottsacker v Gottsacker, 2002

WL 31655186 at *3 (Minn App 2002). 29. Gottsacker, 664 NW2d at 856-57.30. Id.31. Id at 857, quoting Duffey, 416 NW2d at 832-

33. 32. Gottsacker, 664 NW2d at 857-58. Notwith-

standing the Minnesota Supreme Court’s reference to the AAA containing funds, it is clear the AAA is a book-keeping tool only reflecting cash on hand at year end on Schedule L line 1.

33. Swope (cited in note 18). See also Gapsch v Gapsch, 76 Idaho 44, 53, 277 P2d 278, 283 (1954).

34. Swope at 300, 834 P2d at 302 (FN2) (containing an excerpt of expert’s testimony opining that the fac-tors contributing to an increase in value cannot be sep-arately identified). A more comprehensive explanation is online at http://www.isba.org/IBJ/jan07j/Swope.htm.

35. 124 Ariz 50, 601 P2d 1334 (1979).36. Id at 54, 601 P2d at 1338. In Rowe v Rowe, 154

Ariz 616, 620, 744 P2d 717, 721 (Ariz App 1987), the Arizona Appellate Court affirmed the use of the first method identified by Cockrill. See also Baum v Baum, 120 Ariz 140, 584 P2d 604 (Ariz App 1978) and Nel-son v Nelson, 114 Ariz 369, 560 P2d 1276 (Ariz App 1977).

37. Cockrill at 54, 601 P2d at 1338. See also Lewis v Lewis, 2000 WL 1780330 (Minn 2000).

38. 26 USC §163(d)(5)(A).39. Gottsacker, 664 NW2d at 850.

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income for tax purposes and his or her actual cash flow. Most states recognize this distinction and have held that only the income a parent “actually receives” can be considered for purposes of deter-mining his or her “ability” to pay child support, thereby excluding the funds distributed to pay the SES’ personal in-

dividual tax obligations.40

In In re Marriage of Harmon, an Il-linois court recognized that the payor spouse’s passive income, consisting of retained (undistributed) trust income, should not be considered in calculating net income.41 The court noted that the unrefuted testimony revealed that the payor spouse did not actually receive the passive trust income, regardless of the fact that it was reported for income-tax purposes.42

In wrestling with retained earnings for support purposes, Illinois and several other states have focused on the statu-tory definition of income (in Illinois, sec-tion 505 of the IMDMA)43 and the items the statute specifically excludes from this definition. Courts often compare the analysis to decisions involving the impact of depreciation deductions44 on the income analysis, because both turn on the distinction between income as reflected on tax returns and actual cash flow.45 Thus, although Illinois courts have not tackled the issue of when re-tained earnings should be considered part of the SES’ income for child sup-port purposes, the Illinois decisions on the excludability of amounts subject to depreciation are illustrative.

Factors for determining whether re-tained earnings should be treated as income. A blanket rule that retained earnings are not to be considered as income for purposes of setting support may entice an SES to shield income by causing the entity to retain earnings the SES would otherwise receive.46 In In re

Marriage of Lendman,47 the Wisconsin Court of Appeals declined to adopt such a “bright line rule” excluding retained earnings from income, instead finding that the court should analyze whether “retained earnings [are] a necessary ad-junct of a well managed corporation or a pretext for a one-man band shareholder

to keep profits from being considered by the family court for maintenance.”48

Courts accordingly con-sider several factors to de-termine if retained earnings should be included in the SES’ income for purposes of determining his support obligation.

A key factor is whether there was a legitimate busi-ness purpose for earnings retention. Courts today in-

creasingly take this approach. In Taylor v Fezell,49 the Tennessee Supreme Court recognized that corporate capitalization is essential for future business activity. Where there is no business explanation for the earnings retention, or where the retention appears to be solely for divorce planning, the earnings should be included in the calculation of income for support purposes – and vice-versa if there is a legitimate business reason for retention.50

It makes more sense for courts to focus on whether earnings are retained for a legitimate business purpose than on the SES’ degree of control,51 and that seems to be where the law is moving. Corporations must routinely retain earn-ings to function effectively, regardless of the company’s control structure. Thus, where there are legitimate business pur-poses for the earnings retention, courts should begin with the presumption that such earnings are not includable in the SES’ income for purposes of determining child support or other obligations.52

Courts are also beginning to acknowl-edge the relevance of a company’s his-torical pattern of earnings retention.53 A Florida decision, McHugh v McHugh,54 set forth what should be the norm: where a corporation has historically distributed only amounts necessary for

Most states have held that only the income a parent actually

receives can be considered for purposes of determining his or her support obligation.

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40. Matter of the Marriage of Perlenfein, 114 Or App 588, 836 P2d 171 (1992); In re Marriage of Unruh, 32 Kan App 2d 770, 88 P3d 1241 (2004); Taylor v Tay-lor, 118 NC App 356, 455 SE2d 442 (1995); Tebbe v Tebbe, 815 NE2d 180 (Ind App 2004). See In re Mar-riage of Brand, 273 Kan 346, 356, 44 P3d 321, 328 (2002), which noted that “Taxable income of a Sub-

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chapter S corporation which is attributable to a share-holder does not reflect actual income received as a cash distribution….Individual inquiry on a case-by-case basis is necessary to ensure that the appropriate amount of income [attributable to the SES] is considered ‘re-ceived’ when determining [income pursuant to statu-tory definition of income for child support purposes].” (Emphasis added). See also, 85 Corpus Juris Secundum, Taxation §1096(c).

41. 210 Ill App 3d 92, 95, 568 NE2d 948, 950 (2d D 1991).

42. Id. See also In re Marriage of Freesen, 275 Ill App 3d 97, 655 NE2d 1144 (4th D 1995), in which the SES testifed that the passive income was retained to reduce corporate debt, presumptively a legitimate business pur-pose.

43. 750 ILCS 5/505.44. Labar v Labar, 557 Pa 54, 61, 731 A2d 1252,

1255 (1999) defined depreciation as “an accounting mechanism which allocates the original cost of an asset to the periods in which the asset is used. Depreciation does not result in income. Rather, when depreciation expense is claimed, taxable income is decreased by the amount so claimed, resulting in a ‘marginal income tax savings,’ not an increase in income.”

45. See, for example, Stewart v Stewart, 243 Mont 180, 793 P2d 813 (1990), and Stepp v Gray, 58 Ark App 229, 235, 947 SW2d 798, 801 (1997). See also Labar at 59-63, 731 A2d at 1254-56, citing Cunning-ham v Cunningham, 378 Pa Super 280, 548 A2d 611 (1988).

46. Absalom v Absalom, 1991 WL 232291 at *2 (Ohio App 1991); and Hoag v Hoag, 435 Pa Super 428, 646 A2d 578 (1994).

47. 157 Wis 2d 606, 460 NW2d 781 (Wis App 1990).

48. Id at 615, 460 NW2d at 785. A more compre-hensive explanation is online at http://www.isba.org/IBJ/jan07j/Lendman.htm.

49. 158 SW3d 352 (Tenn 2005). The supreme court held that in order for retained earnings to be imputed to a SES for a child support determination there must be a showing that the retained earnings are either excessive or there is an actual manipulation to avoid a child sup-port obligation. The supreme court, taking a practical viewpoint, expressed the following:

(a) To determine whether the retained earnings are excessive, consideration should first be given as to the level of retained earnings or capitalization maintained before the divorce; and

(b) The post-divorce corporation activities, particu-larly any unexplained increases or reductions of capi-talization or retained earnings, and whether the level of retained earnings are appropriate for the corporation to carry on its business, should be the subject of expert tes-timony. Id at 358.

50. See Labar at 62-63, 731 A2d at 1256, citing McAuliffe v McAuliffe, 418 Pa Super 39, 613 A2d 20 (1992).

51. See, for example, Riepenhoff v Riepenhoff, 64 Ohio App 3d 135, 138, 580 NE2d 846, 848 (1990); Anderson v Anderson, 60 Ark App 221, 963 SW2d 604 (1998); In re Marriage of Heck, 2000 WL 1724588 (Iowa App 2000); Mitts v Mitts, 39 SW3d 142 (Tenn App 2000). But see Merrill v Merrill, 587 NE2d 188 (Ind App 1992); Pannell v Pannell, 64 Ark App 262, 981 SW2d 531 (1998); Roth v Roth, 406 NW2d 77 (Minn App 1987); Gianniny v Gianniny, 256 AD2d 1079, 683 NYS2d 769 (NY App 1998); Anderson v Anderson, 60 Ark App 221, 963 SW2d 604 (1998); Kelley v Kelley, 656 So 2d 1343 (Fla App 1995).

52. Some of the cases in which courts have exam-ined retained earnings for purposes of determining the amount of marital property also indicate that the “legit-imate business purpose” analysis is the correct one. See, for example, Gottsacker, 664 NW2d at 857-58, Zyg-munt, 652 NW2d at 544; Fennell v Fennell, 753 A2d 866, 868-869 (Pa Super 2000).

53. Brand at 356, 44 P3d at 328 (“historical infor-mation [about earnings retention] should be consid-ered”); accord, Unruh (cited in note 40); and Pickrel (cited in note 10).

54. 702 So 2d 639, 642 (Fla App 1997).

an SES to pay his or her proportionate share of taxes, retained earnings should not be included in determining income for support purposes.55

It is not entirely clear which party bears the burden of proving that the SES has the ability to control distribution of retained earnings; and whether the retention of earnings or corporate ex-penditures are necessary and legitimate. One court has suggested that when one party is a minority shareholder, the other spouse bears the burden of proving that earnings are not retained for a legitimate reason.56 Other cases, however, place the burden on the SES to show that the retained earnings were held and invested for a legitimate purpose.57

The bottom line. The existing opin-ions are devoid of expert testimony

or exhibits explaining the relationship between the annual retained earnings and the corresponding book entry char-acterization.

An explanation of the reconciliation of the line 24 entries on a hypothetical Schedule L from a Form 1120S corporate tax return, with the relevant line item entries above line 24, is on the Web at http://www.isba.org/IBJ/jan07j/Schedule Lexplanation.htm. This sample provides a narrative summary by a hypothetical CEO and/or the company’s certified pub-lic accountant explaining the financial transactions comprising the components of the difference between the retained earnings at the beginning of the year and the end of the year. It supports the conclusion that prudent business deci-sions justify the retention of earnings for

legitimate business purposes.After reviewing at least the last five

years of Form 1120S containing Sched-ules L, M1 and M-2, Form W-2s, 1099s for compensation, Schedule K-1s and examining line 19 of Schedule L (other deductions) to determine what is truly business related and not personal, the practitioner should be able to determine the amount properly available as a basis for the SES’ maintenance and child sup-port obligation. ■__________

55. Brand (cited in note 40). See also, Hubbard v Hall, 739 So 2d 498, 499-500 (Ala App 1999), citing Klapal v Brannon, 610 So 2d 1167 (Ala Civ App 1992), but see Hubbard dissenting opinion, 739 So 2d at 500-501.

56. Bleth v Bleth, 607 NW2d 577 (ND SC 2000).57. Hubbard (cited in note 55); and In re Marriage of

Stenshoel, 72 Wash App 800, 866 P2d 635 (1993).

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Reprinted from the Illinois Bar Journal, Vol 95, No. 1, January 2007

www.isba.org