From a Reader:

Subject: Child support as a form of income tax

 

[Please post the following with no email address]

 

Attitude aside, MarianContrarian has a legitimate point about children being entitled to some lifestyle component of child support.  The amount is subject to political tug-of-war, but the principle is thoroughly established by now.  At the percentages typically assessed these days, this rule has the effect of turning child support into an 18-year stream of alimony for upper income fathers paying support.  (There are essentially no custodial fathers who have high-income ex-wives and who did not waive child support in order to win custody.)

 

Agree or disagree with the wisdom of this system, those are the facts. What should interest a tax guru is that the computation of child support strongly resembles an income tax system.

 

In the case you cited, a payer of child support was assessed a flat percentage of AGI.  You claim that this was not fair if the income was on paper rather than in cash.  I respectfully disagree on that point. If one has control of the Sub-S corporation, one can control the timing of distributions, delaying them until child support is no longer due at all.  That would be a huge loophole.  If you are going to have an income-based assessment, it must be based on economic income, meaning change in net worth.  AGI is a reasonable, albeit imperfect, proxy for economic income.

 

In an attempt to be more fair, some states assess child support as a percentage of after-tax income rather than AGI.  Take a moment to think about that.  Do you see the problem?  Neither did I at first.

 

Congress generally gives you a tax break in recognition of an expense that has some socially redeeming value.  Medical expenses, mortgage interest, local taxes, whatever.  The more breaks you get, the more expenses you had, and... the more child support you pay!  Under a child support system based on after-tax income, someone with a $3000 per month mortgage can pay $500 more child support than someone with a fully paid-off house.  That's an absurd and indefensible result.  For this reason, the most structurally fair of the current systems are based on AGI, not after-tax income.

 

For political reasons, the assessment percentages have been set quite high.  In a nutshell, parents of modest income are very reasonably assessed a high percentage in order to provide proper support, meaning money that will actually be needed to support the child.  Because voters tend to believe that more child support is always better, politicians then extend similar percentages all the way up to about 95th percentile incomes.  Above about the 80th percentile, child support begins to exceed 100% of total cost, allowing the recipient to spend or pocket the excess.

 

Solutions?  I have none that are politically feasible.  We need to realize that for every payer above the 80th percentile there are probably ten recipients who are getting nothing because the father is in jail, unemployed, or otherwise not paying.  So it's like when your mother asked you to clean your plate because people were starving in Africa: Be happy overpaying your child support because others are paying nothing.

 

If there is any common ground to be found on the contentious subject of child support, it is in improving its structural fairness.  I believe that every state should switch to guidelines based on gross income, not after-tax income.  And ideally the upper-income payers should not be overcharged because lower-income payers are underpaying. The problem is that whenever any change to child support laws are considered, a political death match ensues between advocates of higher vs. lower overall support levels.  Politicians hate that, so they leave the current system in place, defective or not.

My Reply:

Thanks for your comments.  I can see that the issue of child support is a complicated mess and is not something I want to spend any more time debating.   We can leave that to the family law specialists.  However, my gut feeling is still that requiring a parent to fork over a certain percentage of his/her AGI in non-deductible child support, regardless of the actual costs of raising the kids, is not fair.  Just as with the tax system, it may be the law to do things that way; but it's still not fair.

The original context of my comments was to contrast the financial effects of S versus C corps.  Your comment that S corp distributions can be controlled is flat out wrong.  You are missing the point and are making a good illustration of how little understanding there is about how S corps function. 

With an  S corp, the shareholders have to recognize their share of the corp's income regardless of whether or not any money is actually taken out of the corp.  That was the real life problem that my client had encountered. With a C corp, there is a lot more control over how much of the corp income ever reaches the shareholders' 1040s, if any.  There is no such ability with an S corp, which is something that many people fail to realize when they sign and submit the S election form to IRS.

Kerry Kerstetter

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 3/14/2007 02:01:00 PM Send this post: