If you are a business owner or you are married to a business owner, you are going to have to become familiar with the concept of depreciation.
For tax purposes, business expenses are deductible to the business owner’s regular income. Big expensive items like a building or a semi truck wear out slowly and the expense to replace them usually occurs every 10 to 30 years. The IRS allows the expense of replacing these business assets to be allocated over time as “depreciation.”
“Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property.” I.R.C. Sec. 946
“There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)—
An estimated amount of depreciation on the property or business asset will be calculated and then used to reduce the taxable income of the business owner.
The calculation of the depreciation deduction is best left to the business owners accountant not a divorce lawyer.
A business owner or a business owner’s spouse needs to know how a depreciation deduction effects their divorce. A depreciation deduction looks like a legitimate business expense on a tax return when, in reality, the business owner has spent nothing on that expense that year.
Depreciation And Income In An Illinois Divorce
In an Illinois divorce, maintenance (formerly known as “alimony”) and child support are determined by calculating each party’s incomes and then applying a formula of sorts.
“Maintenance…shall be calculated by taking 33 1/3% of the payor’s net annual income minus 25% of the payee’s net annual income…[not to exceed] 40% of the combined net income of the parties.” 750 ILCS 5/503(b-1)(1)(A)
Child support is less mathematical and requires comparing both parents incomes to a chart to determine child support.
“The court shall compute the basic child support obligation by taking the following steps:(A) determine each parent’s monthly net income;(B) add the parents’ monthly net incomes together to determine the combined monthly net income of the parents;(C) select the corresponding appropriate amount from the schedule of basic child support obligations based on the parties’ combined monthly net income and number of children of the parties; and(D) calculate each parent’s percentage share of the basic child support obligation.” 750 ILCS 5/505(A)(1.5)
More income from the payor means more maintenance and/or child support to the payee for both maintenance and child support.
The Illinois maintenance statute tells us to look to the Illinois child support statute for instructions “For purposes of this Section, the term “gross income” means all income from all sources, within the scope of that phrase in Section 505 of this Act” 750 ILCS 504(b-3)
The Illinois Marriage and Dissolution of Marriage Act’s child support section is more specific. Income for a business owner is gross receipts minus expenses.
“For purposes of calculating child support, net business income from the operation of a business means gross receipts minus ordinary and necessary expenses required to carry on the trade or business. As used in this paragraph, “business” includes, but is not limited to, sole proprietorships, closely held corporations, partnerships, other flow-through business entities, and self-employment.” 750 ILCS 5/505(a)(3.1)
As we discussed above, the depreciation expense is illusory so it is not included as a “necessary expense” to determine a divorcing party’s income.
“The accelerated component of depreciation and any business expenses determined either judicially or administratively to be inappropriate or excessive shall be excluded from the total of ordinary and necessary business expenses to be deducted in the determination of net business income from gross business income.” 750 ILCS 5/505(a)(3.1)(A)
Do NOT solely rely on your spouse’s tax return to determine what their gross or net income is!
“[T]ax-reported income does not provide conclusive evidence of either [a spouse’s] gross or net income under the [Illinois Marriage And Dissolution of Marriage] Act, which provides its own guidelines on deductions from business income that reflect different policies and purposes than the Federal tax code.” In re Marriage of Carpel, 597 NE 2d 847 – Ill: Appellate Court, 4th Dist. 1992
If you are a spouse receiving or expecting to receive child support and/or maintenance, look carefully on your spouse’s tax returns for form 4562 which will specify their depreciation deduction. Add that amount back onto your spouse’s net income to determine their income for the purposes of calculating child support and/or maintenance.
An Exception To Depreciation Not Counting As An Expense When Determining Income In Illinois
750 ILCS 5/505(a) specifically refers to “accelerated component of depreciation.” Accelerated depreciation is how depreciation is usually calculated. The first years of ownership get a bigger deduction than the later years. This makes sense as most assets depreciate faster (imagine a computer).
Some assets like land or copyrights depreciate at a non-accelerated rate. Are non-accelerated depreciation deductions a legitimate expense for determining income for the purposes of child support and/or maintenance in Illinois? Probably.
“[750 ILCS 5/]505(a)(3.1)(A) now explicitly excludes accelerated depreciation from the calculation of net business income and does not explicitly mention nonaccelerated depreciation. Id. The implication from the continued omission of nonaccelerated depreciation from the plain language of the statute is that it could still be deducted, but only if the court, in its discretion, determines it to be an appropriate and reasonable business expense that is required to carry on the trade or business.” In re Marriage of Hochstatter, 152 NE 3d 1045 – Ill: Appellate Court, 3rd Dist. 2020
Business owners are usually depreciating multiple assets. Some assets might have a not-to-be-considered accelerating depreciation schedule while others might have a can-be-but-doesn’t-have-to-be considered non-accelerating depreciation schedule.
The non-accelerated depreciation can only an allowable expense against income if the expense is necessary to keep the business running.
“[U]nder section 505, the court must first determine if any amount of the claimed depreciation is accelerated depreciation. If so, that amount must be excluded as it is not allowed when calculating income for the purposes of determining child support. Then the trial court must look at the nonaccelerated depreciation and decide as to whether the depreciation is an appropriate and reasonable business expense that is required to carry on the business.” In re Marriage of Burnett, 2021 IL App (5th) 200326-U, 2021 WL 1973586.
For an example of a necessary depreciation expense: “rents paid for farmland may be the quintessential necessary business expense to carry out a farming operation.” MARRIAGE OF KILBY AND KILBY, 2023 IL App (3d) 210566-U – Ill: Appellate Court, 3rd Dist. 2023
Depreciation Recapture In An Illinois Divorce
These depreciation deductions are not a free lunch. The businessperson has to pay them all back eventually when they sell the property after the basis (purchase price + expenses) is recomputed to include the past depreciation expenses.
“”[R]ecomputed basis” means, with respect to any property, its adjusted basis recomputed by adding thereto all adjustments reflected in such adjusted basis on account of deductions (whether in respect of the same or other property) allowed or allowable to the taxpayer or to any other person for depreciation or amortization.” 26 U.S.C. § 1245(a)(2)(A)
This is called “depreciation recapture” and it is added as ordinary income at the time of the sale of the property. After the sale, the businessperson presumably has the money to pay the government for all the prior deductions (leaving everyone, the business person and the IRS, happy)
But, depreciation recapture is illusory income for the purposes of child support and/or maintenance in an Illinois divorce.
“The sale of farms, real estate, and equipment can result in depreciation recapture, thereby creating taxable income and taxable capital gains. This taxable income does not create additional value, only additional Federal income tax. This may well be a situation where an insolvent taxpayer owes tax, while having no funds available to pay the tax.” In re Marriage of Johnson, 245 Ill. App. 3d 816, 819 (Ill. App. Ct. 1993)(citations omitted)
“[D]epreciation recapture does not represent funds that [an obligor] could have used to pay maintenance.” In re Marriage of Svigos, No. 1-18-1897, (Ill. App. Ct. 2020)
If you are a business owner or a business owner’s spouse, you need to understand how tax concepts like depreciation both work fundamentally and impact an Illinois divorce. To schedule a free consultation with an experienced Illinois divorce attorney, contact my Chicago, Illinois family law firm today.