In Washington, child support is calculated in the first instance using a simple formula that considers the net income of the parties and the number and ages of the children. Only in rare cases does the actual child support paid deviate from the result of this calculation.
Net income starts with all sources of income and deducts certain expenses. For salary and wage earners, most of the deductions that an employer takes from gross pay are legitimate deductions for purposes of the child support calculation. Business owners may deduct “normal business expenses” from the business’s gross income. In general, a parent’s “net income” for child support purposes reflects what the parent actually receives and can spend.
However, unlike business expenses, investment expenses are not deductible. Net investment income for child support purposes does not take into account the costs of the investments that generated the income. A parent’s net income as computed in the child support formula may far exceed what that parent actually receives. In an example of “bad facts make bad law,” this is the result of Marriage of Aiken, No. 73257-9-I (Wn. App. 2016), a decision from Division I of the Court of Appeals this last May.
In Aiken, the mother petitioned to modify child support seeking, in part, to recompute support based on the parents’ current income. The father worked as an executive for a salary. As part of his compensation package, he borrowed money from the company to purchase incentive stock options. In the three years prior to the petition, the father made an average of $102,385 per year from the options. However, he paid an average of $93,139 per year in interest to the company for those three years. So his average additional income was only $9,245 per year. Nevertheless, the Aiken court held that he could not deduct the cost of the investment from the $102,385 he grossed from the investment each year. The computed child support payment that the father had to pay was much higher as a result.
The father argued that the cost of earning money should be deducted from the money earned when determining his net income. Business expenses are deducted from business income in this way. Indeed, the IRS recognizes investment expenses, including investment interest paid, as legitimate deductions from investment earnings when computing income tax. However, the Aiken court did not recognize the interest the father paid as a legitimate deduction for purposes of child support.
To be fair, the legislature has not expressly provided for an investment expense deduction. The statute specifically lists “normal business expenses” as one of many allowed deductions in the child support calculation but does not list “investment expenses” as an allowed deduction. The court rested on this omission. Did the legislature intend to exclude “investment expenses” when it allowed a deduction for “normal business expenses?”
Business vs. Investment Expenses
The meaning of the word “business” is debatable. It could include, for example, the management of rental property. If a “rental business” borrows money to purchase income-producing rental property, would not the interest paid be a “normal business expense?” How is interest paid on a loan to purchase income-producing rental property different than interest paid on a loan to purchase an income-producing equity interest?
Going too far, the Aiken court specifically called out the example of interest paid on a loan to purchase rental property as the type of expense not deductible for purposes of child support. This statement begs the question: When is interest paid on a loan for income-producing purposes a “normal business expense” under the child support statute? Will this depend on whether the parent actively works on the business as opposed to passively receives the income from the investment? The business/investment distinction is muddy.
Current vs. Future Income
Perhaps a distinction could be made between investments that produce current income and investments that produce income later in the form of capital gains. The child support statute includes current income such as dividends and interest, and capital gains, in gross income. The father’s investment in the company in Aiken appears to have had both current and future benefits. Is it fair to the child support payee for the payer to deduct the cost of an investment for purposes of the child support calculation when a benefit of that investment—the appreciation of the asset—is not yet included in gross income? Although the Aiken court briefly mentions the appreciation potential of the father’s equity interest in the company, it does not distinguish between investments creating current income and investments in an appreciating asset.
Courts make a similar distinction when deciding what to include as “normal business deductions.” For example, depreciation may be a legitimate “normal business deduction” when that depreciation represents money that a company will need to replace aging assets, but may not be a “normal business deduction” when there is no need to replace assets in the near future. Courts are certainly in the position to determine whether investment expenses should be deducted or not. The right solution would be to give courts discretion to determine when expenses should be deducted. The Aiken decision takes away a trial court’s discretion to determine what expenses may be deducted from gross income when those expenses are arguably “investment expenses.”
Whether or not the Court of Appeals correctly interpreted the statute in Aiken, the result makes no sense from a policy perspective. As a matter of fairness, a parent should be able to deduct those expenses that were incurred in order to generate income. Also, this sort of result may act as a disincentive for child support payers to maximize their income through investments. The victim would then be the children for whom support is paid.
It will be up to the Supreme Court or, better yet, the legislature to correct this problem.
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