Reading glasses on newspaper open to mutual fund page.

The Colorado Court of Appeals just considered an issue of first impression, whether unrealized gains or dividends income in an investment account count as income for purposes of calculating child support and maintenance.

And the answer to that was “no”, as mere “paper gains” are not included in a party’s gross income.

Investment & Dividends Income Counts for Family Support

In Schaefer, the trial court included in the wife’s income an imputed 5% rate of return on her investments, or $16,666/mo, which was the low end of the range testified to by the husband’s expert, based upon historic rates of return for the S&P 500, Vanguard and TD Ameritrade. Significantly to the appellate court, neither the expert nor the trial judge distinguished between realized gains and unrealized gains.

There is nothing unusual about this – when a spouse or parent has significant investment accounts, courts typically include as income the party’s actual earnings. And when the money is tied up in unproductive accounts or in a shoebox, courts even impute a reasonable rate of return to that party. Zisch.

Whether or not the party actually pulled the dividends income out (i.e. realized the gains) was not a factor in whether it counted as investment earnings counted as income. Until now.

Appellate Court – Only Realized Gains Count as Income

The wife appealed, and the court of appeals reversed, finding critical the distinction between realized gains actually pulled out of the account, and unrealized gains left in it:

“We hold that unrealized capital gains in an investment account are not income for maintenance and child support purposes.”

Schaefer, ¶ 14.

Income Includes Capital Gains, Interest & Dividends Income

The court first noted that Colorado law does include investment earnings as income for purposes of family support:

For a more detailed discussion of how courts treat investment income in a wide variety of circumstances, see our Investment Earnings article in the Colorado Family Law Guide.

However, whether an account had dividends, interest or capital gains was not the end of the inquiry for the Schaefer court. What matters now is whether the earnings are simply reinvested so the investment value grows (not income for family support purposes), or are the investment earnings being withdrawn and actually spent?

Other State Treatment of “Paper Gains”

The Schaefer court noted that whether to treat an investment account’s unrealized gains as income for purposes of family support had not been addressed at the appellate level in Colorado, so looked to see how other states have addressed the issue.

In general, the few cases discussed in the opinion held that mere “paper gains”, which increased the value of an investment without resulting in actual income the party could spend, should not be treated as income. Only once the funds were withdrawn from the investment account and spent (i.e. the gains were “realized”) would they be treated as income. ¶¶ 16-18.

Colorado Treatment of Other “Unavailable” Funds

The discussion of out-of-state cases was somewhat scant, but a review of analogous cases from Colorado was much more instructive.

While Colorado courts had not yet ruled on the specific issue of whether unrealized investment gains count as income, in a wide variety of situations appellate courts have excluded as income payments which benefitted a party, but were not available to the party to spend or increase their standard of living:

  • Inheritance. Per AMD, the principal portion of an inheritance only counts as income if the recipient actually uses it as a source of income for living expenses.
  • Deferred Compensation. Per NJC, deferred compensation which only grew a parent’s assets instead of being used as a source of income was not treated as income. (See also our blog post discussing NJC, deferred compensation and child support).
  • GI Bill Tuition Assistance. Per Tooker, (see our blog post on GI Bill BAH counting as income or our Post-9/11 GI Bill article in the Military Divorce Guide for a more in-depth discussion of how family law courts treat GI Bill benefits).
  • Employer Retirement Account Contributions. Per Davis and Mugge, the employer contributions to a party’s retirement account did not count as income if the employer did not have the option to take the funds in cash instead.
  • Employer-Sponsored Health Insurance. Per Davis, not income for family support purposes.

The Court of Appeals applied the same rationale to unrealized gains in an investment account:

“We are persuaded that the unrealized, “paper only” gains in an investment account are not income for maintenance and child support
purposes unless the gains are realized and therefore can be used to meet living expenses, pay discretionary expenses, or increase the recipient’s standard of living.”

Schaefer, ¶ 20.

So in the present case, for example, the parties had not traditionally withdrawn funds from the investment accounts during the marriage, treating them more as a “nest egg” than a source of income to meet their living needs. The court of appeals remanded back to the trial court to determine whether this was still the case or if the wife was actually using the investments for her living needs.

How About So-Called “Phantom Income” from a Business?

Invisible Businessman

It’s curious that the court did not mention one common source of unrealized income which the law does count for purposes of child support and maintenance – business earnings a party receives on a Schedule K-1 from a closely-held business, even if they are undistributed. Both the child support and maintenance statutes include as income:

“Income from general partnerships, limited partnerships, closely held corporations, or limited liability companies. However, if a parent is a passive investor, has a minority interest in the company, and does not have any managerial duties or input, then the income to be recognized may be limited to actual cash distributions received.”

C.R.S. 14-10-115(5)(a)(I)(W) (Child Support) and C.R.S. 14-10-114(8)(c)(I)(W) (Maintenance)

Business income counts if the earnings are reflected on a K-1, unless the party is only a passive investor with no ability to decide whether to receive the income or keep it in the account. See our blog post on Phantom Business Income for more details.

But in Schaefer, the party had the option of withdrawing the unrealized dividends income, and merely chose not to – so we have an apparently inconsistent result that control over whether to withdraw the funds matters for business earnings, but not for investment income.

Discretion to Count Unrealized Gains if Equitable

While unrealized dividend income is not generally income, a court still has the equitable authority to include even unrealized dividends income on a case-by-case basis to avoid an unjust outcome:

“Although unrealized gains in an investment account are not income, maintenance and child support are inherently equitable determinations, and the court has discretion to make those awards based on the specific facts of the case.”

Schaefer, ¶ 22.

One example cited where equity may be appropriate would be if a party was using an investment strategy to deliberately shield income to avoid a support obligation.

Conclusion – Less Income Now Considered for Family Support

The maintenance and child support statutes have a pretty expansive definition of income, generally standing for the proposition that if it’s not explicitly excluded, then it counts as income. But there has been an increasing trend in recent years to look beyond whether payments benefit the party, and instead disregard funds which the party does not have the unfettered discretion to spend.

So a GI Bill may save a person $20K/yr in tuition, but it’s not income. Or deferred compensation or 401(k) matches may enrich a party by tens of thousands per year, but not by providing funds which can reasonably be used immediately.

My takeaway? The more courts start to exclude from income benefits a party receives which demonstrably benefit that party by increasing their net worth, the more likely self-employed and high-income earners with more bargaining power are to structure their investments and compensation in a way that sees only a fraction of it count as actual income.

And this is already happening – in the NJC case discussed above, the father’s salary was $150K, but his additional $200K of deferred compensation, negotiated with his boss (who happened to be his brother), was excluded from his income.

Finally, all was not lost for the husband. The wife also appealed the trial court’s inclusion of straight-line depreciation as a business expense from his rental income, and the Court of Appeals approved that holding, though it did remand the decision back to the trial court for more specific findings on the nature of the depreciation being deducted. See our blog post on depreciation and rental income for a discussion on this aspect of the ruling.

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dividends income

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