The Court of Appeals held that distributions made by an S Corporation to a shareholder, specifically for the shareholder to serve as a conduit to relay the funds to another business entity for the S Corporation’s legitimate business purposes are not the shareholder’s income for calculating child support and spousal maintenance.  Courts must look at the corporate motive for paying out retained earnings—if there is a legitimate business purpose and the transfer is not found to have been made to avoid paying spousal support or maintenance, then the court should not include the distribution as income.  The Court of Appeals noted that this was a close question of first impression in Minnesota.

Also, distributions from an S Corporation to a shareholder solely for the shareholder to pay his or her share of the S Corporation’s tax liability on retained earnings are ordinary and necessary business expenses, rather than the shareholder’s income for calculating child support and spousal maintenance.  The court of appeals found that because tax expenses are both ordinary and necessary expenses for operating a business, a portion of distributions to an S Corporation shareholder made to cover taxes on his or her share of the S Corporation’s retained earnings is an ordinary and necessary expense required for “self-employment or operation of a business.” As such, reimbursing or paying an S Corporation shareholder for the tax liability associated with the shareholder’s share of corporate income for taxation purposes does not reduce the shareholder’s “personal living expenses” and is not therefore a reimbursement or in-kind payment which should be counted as income under Minnesota statutes.

As a result of the Minnesota Court of Appeals’ legal analysis, it reversed the District Court’s determination and remanded the case for determination of the proper child support payment.  It is unknown at present whether this case will be reviewed by the Supreme Court.  [ed. update:  On July 17, 2012, the Minnesota Supreme Court granted Mr. Haefele’s petition for further review.]

Andrew M. Tatge is a business and family law attorney with Gislason & Hunter LLP (www.gislason.com) and can be reached at atatge@gislason.com or (507) 387-1115. This information is general in nature and should not be construed as tax or legal advice.