New law on how to treat S corp’s retained earnings in divorce

A recent Michigan divorce case involving an S corporation that was separate property raised an issue of first impression in that jurisdiction. Do the company’s retained earnings represent marital income? In resolving the issue, the Michigan Court of Appeals was dead set against adopting a bright-line rule. Instead, it prescribed a multistep analysis that is applicable on a case-by-case basis.

Federal tax law irrelevant: The marriage was short. The husband entered into it with significant premarital assets, including a business that was organized as an S corp. The parties agreed the company was the husband’s separate property. However, the wife argued, successfully, that the increase in value during the marriage was part of the marital estate. She also claimed that the earnings the company had retained during the marriage were part of the marital estate, noting that, under federal tax law, the income of an S corp is taxed to the company’s owner as personal income.

The Michigan Court of Appeals rejected the tax argument. It noted that the policy considerations underlying the making of federal tax law are different from those informing domestic relations cases, which are subject to state law. The court also was opposed to a fixed rule, such as a rule that the earnings “invariably” belong to the entity until distributed or that the earnings must be included in the marital estate when the owner spouse has control over the distribution of earnings.

The court’s approach rests on the presumption that the retained earnings are not part of the marital estate. Overcoming the presumption will be difficult. For one, the court said that, while the party asking for the inclusion (the nonowner spouse) has to show that the owner spouse has control over the distribution of earnings, this showing does not necessarily mean the retained earnings should be part of the marital estate. The trial court also has to consider other factors specific to the business.
In applying its new approach to the instant case, the Court of Appeals found the trial court did not err when it refused to treat the retained earnings as marital income.