How Lifestyle Analysis Can Reveal Unreported Income

Divorce and separation proceedings are a stressful challenge, and that stress can be magnified when a spouse isn’t truthful or forthcoming with financial information regarding their earnings.

Child and spousal support is typically based on the income of each spouse, as determined in accordance with the Federal Child Support Guidelines. Each spouse must give detailed information about their income in their financial disclosure. Examples of disclosure required may include tax returns and notices of assessments, pay stubs from employers, financial statements of any business they own, statements for employment insurance, and pension income or worker’s compensation statements.

However, financial documents do not always show the whole picture. It may be the case that money was received in cash by a business or self-employed individual, but not reported for tax purposes. And, while couples may benefit from illicit tax savings, unreported income and expenses certainly pose an issue when determining the respective income of each spouse as it relates to child and spousal support payments.

In determining the amount of unreported cash earnings, evidence should be obtained and presented. This is where a Lifestyle Analysis through forensic accounting comes into play.

A Lifestyle Analysis generally includes:

1. Analysis of personal and business tax returns. Most individuals fear the consequences that may come of tax evasion, as it is illegal. Thus tax returns should, in theory, be prepared accurately. If there is suspicion of fraud, interviewing the spouse’s accountants, business partners and financial advisors may be useful in uncovering the facts.
2. Bank deposit transaction analysis will work to the extent that any unreported cash is deposited. It involves reconstructing a spouse’s income by analyzing bank statements and credit card statements, as well as tracing deposits to the verifiable source.
3. Expense method involves gathering details on annual expenditures such as food, clothing, utilities, etc. and comparing them to income earned. If the spouse hasn’t incurred debt or inherited gifts, it may indicate that there is a lifestyle that simply cannot be afforded with the reported income earned. In addition, in the event that cash was used to pay for major capital expenses such as renovations, or perhaps major vacations, there should be proof of receipt from the vendor.
4. Asset method involves analyzing bank and brokerage statements, real estate records, and loan and credit card applications at different points in time. The idea is that if there is a substantial increase in assets, it should correspond to a similar increase in earnings net of expenses, gifts and inheritances, in order to be able to fund those asset purchases.
5. Industry analysis and research studies on unreported cash sales by industry can be used as means to estimate the likelihood of cash sales for the industry the spouse operates in.
6. Statistical data can indicate cash sales if the reported income is significantly lower than the average, for either the occupation or the business. An example of this might involve assessing the gross margin of a business relative to the industry. Generally, a business has an incentive to report all costs as they are a deduction to income and therefore lower taxes payable. If the gross margin is unreasonably low compared to industry, you may infer imputed sales. The difference between imputed sales and reported sales may therefore represent the unreported cash sales.

The chosen analytical approach and methodology depends on the specific situation. While every method outlined could be applied, consideration of the cost versus benefit and the amount of time required to investigate must be kept in mind.

The laborious chore of locating and interpreting documents may not be attractive, particularly for those not in control of or responsible for personal finances. That’s where Davis Martindale can help, and we’d be happy to have a personalized discussion with you.