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R. Eagley v. L. Eagley (2/12/93), 849 P 2d 777
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NOTICE: This opinion is subject to
formal correction before publication in the
Pacific Reporter. Readers are requested to
bring typographical or other formal errors to
the attention of the Clerk of the Appellate
Courts, 303 K Street, Anchorage, Alaska
99501, in order that corrections may be made
prior to permanent publication.
THE SUPREME COURT OF THE STATE OF ALASKA
RONALD EAGLEY, )
) Supreme Court No. S-4498
Appellant, )
)
v. ) Superior Court No.
) 3AN-87-5841
LINDA EAGLEY, )
) O P I N I O N
Appellee. )
______________________________) [No. 3928, February 12, 1993]
Appeal from the Superior Court of the
State of Alaska, Third Judicial District,
Anchorage
Peter A. Michalski, Judge.
Appearances: Kenneth F. Brittain,
Brittain & Pentlarge, Anchorage, for
Appellant. Mary A. Gilson, Assistant
Attorney General, Anchorage, Charles E. Cole,
Attorney General, Juneau for Appellee.
Before: Rabinowitz, Chief Justice,
Burke, Matthews, Compton, and Moore,
Justices.
RABINOWITZ, Chief Justice.
In this appeal, Ronald Eagley challenges the superior
court's determination of his income for the purpose of
calculating child support under Alaska Rule of Civil Procedure
90.3.
FACTS AND PROCEEDINGS
Ronald and Linda Eagley were divorced in August 1987.
In the Child Custody and Property Settlement Agreement approved
by the court, the parties agreed upon joint legal custody of
their minor child, Rae Anne Eagley, born January 8, 1977. Linda
was awarded primary physical custody, with liberal visitation
rights for Ronald. Ronald was obligated under the agreement to
pay $300 per month to Linda in child support. In January 1990,
the Child Support Enforcement Division moved on Linda's behalf
for a modification of child support to comply with Civil Rule
90.3.
Ronald is the self-employed owner of Gwennie's Old
Alaska Restaurant. At the time of the hearing before Master
Ashton, Ronald's 1988 tax return was the most recent one
available. Based on Ronald's 1988 tax return, Ronald's "gross
profit" for 1988 was $456,814.57 with deductions of $459,076.91.
The Master calculated a business loss of $2,262.34. After adding
in Ronald's interest income of $515.71, dividend income of
$18.00, a capital gain of $10.45 and a permanent fund dividend of
$826.93, Ronald's income loss for 1988 was calculated at $891.25.
Master Ashton made the following findings of fact and conclusions
of law:
Most of the deductions claimed by
Mr. Eagley are not in dispute. The following
deductions are in dispute: $54,285.09 in
depreciation, $18,000.00 in accrued but
unpaid interest, $9,000.00 in personal draws,
$12,471.00 in in-kind benefits of housing,
food and utilities.
I find that although the
depreciation and the accrued but unpaid
interest are deductions allowed under the
Internal Revenue Code, these amounts should
not be deducted from income for purposes of
the computation of child support.
Mr. Eagley made payments in the
amount of $33,480.28 in 1988 toward the
principal of his loan for the purchase of the
business and the real property that it is
located on. This amount is not deductible
under the Internal Revenue Code, but is a
reasonable and necessary expense of doing
business under the particular circumstances
of this case.
. . . .
Mr. Eagley's income for purposes of
calculating child support is as follows:
$9,000.00 draws
12,471.00 housing, food and utilities
39,829.00 depreciation
18,000.00 accrued but unpaid interest
515.71 interest income
18.00 dividend income
10.45 capitol [sic] gain
826.93 permanent fund dividend
SUBTOTAL $80,671.09
-33,480.28 principal
TOTAL $47,190.81
On the basis of these findings the Master awarded Linda
child support in the amount of $786.00 per month. Both parties
then filed objections to the Master's findings. The superior
court modified the Master's findings in part, concluding that the
principal payments should not be deducted and that including
draws and housing, food and utilities would be "double counting"
these items. The superior court's altered calculations of income
are as follows:
$39,829.00 depreciation
18,000.00 accrued but unpaid interest
515.00 interest income
18.00 dividend income
10.00 capital gain
826.00 permanent fund dividend
33,480.00 principal payment
$92,678.00 TOTAL
The superior court awarded child support in the amount
of $1,000 per month because Ronald's calculated income exceeded
$60,000. Ronald appeals.1
DISCUSSION
Civil Rule 90.3 governs the calculation of adjusted
annual income for the purposes of determining child support
obligations. Civil Rule 90.3(1) states that "[a]djusted annual
income as used in this rule means the parent's total income from
all sources." The Commentary to Civil Rule 90.3 states the
following in regard to determining income when the parent is self-
employed:
Income from self-employment
. . . includes the gross receipts minus the
ordinary and necessary expenses required to
produce the income. Ordinary and necessary
expenses do not include amounts allowable by
the IRS for the accelerated component of
depreciation expenses, depreciation of real
estate, investment tax credits, or any other
business expenses determined by the court to
be inappropriate. Expense reimbursements and
in-kind payments such as use of a company
car, free housing or reimbursed meals should
be included as income if the amount is
significant and reduces living expenses.
Alaska R. Civ. P. 90.3 Commentary III.B. While this court has
not officially adopted or approved the commentary, we have relied
on it for guidance in determining adjusted annual income for self-
employed parents. Alaska R. Civ. P. 90.3 Commentary I.A; See
Ogard v. Ogard, 808 P.2d 815, 819 (Alaska 1991); Coghill v.
Coghill, 836 P.2d 921, 926 (Alaska 1992).
I. DID THE SUPERIOR COURT ABUSE ITS DISCRETION IN INCLUDING
ACCRUED BUT UNPAID INTEREST AS INCOME UNDER CIVIL RULE 90.3?
The superior court found that "[t]he inclusion [of]
accrued but unpaid interest in 'income' could be unjust unless it
is deducted from income for child support purposes when actually
paid."
Ronald contends that the superior court abused its
discretion in including $18,000 of accrued but unpaid mortgage
interest in Ronald's income for Civil Rule 90.3 purposes. Ronald
argues that for an accrual basis taxpayer, there may be a
discrepancy between the interest deducted and the interest paid,
but that the two would be equal over time. He also asserts that
the inclusion of accrued but unpaid interest in the income
calculation places an unfair burden on the parties to seek
modification yearly because Ronald is an accrual basis taxpayer.
Linda responds that because Ronald's 1988 income was
the basis for determining his child support obligation, the
deduction for accrued but unpaid interest is effectively an
accelerated deduction and should not be allowed under Rule 90.3.
Linda analogizes the deduction for the accrued interest to
accelerated depreciation deductions, which would be excluded from
ordinary and necessary business expenses under the view adopted
in Section III.B of the Commentary to Civil Rule 90.3. According
to Linda, Ronald has not indicated that in the future he will pay
significantly more than the $102,000 in mortgage interest that
was actually paid in 1988.
Civil Rule 90.3(a) defines adjusted annual income as
"the parent's total income from all sources" minus specified
items. We have held that:
Given this broad definition, we believe
that the superior court has discretion
whether to include in income amounts
voluntarily deposited into deferred income
compensation accounts. Under this rule, the
court will be able to prevent a parent from
decreasing his or her child support
obligation by shifting income earned
presently into the future.
Bergstrom v. Lindback, 779 P.2d 1235, 1237 (Alaska 1989).
The superior court had before it evidence that the use
of an accrual interest methodology results in an income
calculation reflective of a smaller amount of cash than was
actually available to Ronald. Ronald's accountant testified that
the only major accrual component of Eagley's business was
mortgage interest, because most of the transactions in the
restaurant business were on a cash basis. This same witness
testified that use of a cash basis accounting system, rather than
the accrual basis, would reflect an increase in Ronald's business
income of $18,000.2
We hold that the superior court did not abuse its
discretion in including $18,000 in accrued but unpaid interest in
its Civil Rule 90.3 calculation of Ronald's income. Ronald is
correct that the discrepancy between interest accrued and
interest paid would be rectified over time. However, because
child support obligations are calculated based on a single year's
income, allowing a deduction for accrued but unpaid interest
leaves the potential for manipulation of income.
We also hold that having decided to disallow a
deduction for accrued but unpaid mortgage interest payments, the
superior court must also reduce the resulting annual income by
income taxes which would have been paid had that portion of the
mortgage interest deduction been disallowed for that year's
income for tax purposes. Bergstrom, 779 P.2d at 1237.
II. WAS THE SUPERIOR COURT'S INCLUSION OF DEDUCTIONS FOR
DEPRECIATION OF REAL ESTATE IN ITS CALCULATION OF RONALD'S
ADJUSTED ANNUAL INCOME ERRONEOUS?
Ronald asserts that the superior court abused its
discretion in including in child support income the $39,829 of
deducted depreciation of real estate. In commenting on the
Master's Recommended Order, the superior court observed:
Inclusion [in income] of 100% of
depreciation fails to take into account the
"use" of the item depreciated and business
expense related to replacement of the item.
But it seems evident that in many cases
depreciation as a tax incentive is more
generous in "protecting" income than
experience might demonstrate necessary to
recognition of the actual "use"of the item.
It is the responsibility of the self-employed
parent to demonstrate what portion of the
depreciation is unaccelerated and a real
measure of asset use.
The court further noted that although deductions for depreciation
are allowable under the Internal Revenue Code, they do not
require "out-of-pocket expenditure." The superior court relied
on the Commentary to Civil Rule 90.3 which states: "Ordinary and
necessary expenses do not include amounts allowable by the IRS
for the accelerated component of depreciation expenses,
depreciation of real estate, investment tax credits, or any other
business expenses determined by the court to be inappropriate."
Civil Rule 90.3 Commentary III.B.
Ronald urges us to reject that part of the commentary
disallowing deductions for real estate depreciation because
"there is no rational reason to treat depreciation of buildings,
fixtures and other improvements to realty differently than
depreciation of other tangible assets." Ronald suggests that we
adopt the approach taken by the Delaware Supreme Court in Turner
v. Turner, 586 A.2d 1182 (Del. 1991), disallowing only the
accelerated portion of such depreciation deductions.3
Linda responds that one goal of Civil Rule 90.3,
assuring that child support awards accurately reflect the
parent's ability to pay, mandates that amounts that do not
reflect the actual costs of doing business should not be
deductible. Cox v. Cox, 776 P.2d 1045, 1047 (Alaska 1989).
Linda points to The Report of the Child Support Enforcement
Commission to the Honorable Governor William J. Sheffield
(Commission Report), dated October 1, 1985, as support for her
argument. The Commission Report noted "[f]or the self-employed,
income net of reasonable costs of business shall be included in
gross income. Depreciation of assets and other tax credits which
shelter current income netted out will not be allowed." Report
at VI-15. The disallowance of real estate depreciation taken in
the Commentary to Rule 90.3 reflects the view that depreciation
of real estate constitutes a greater shelter for income and
reflects less accurately the actual costs of business assets.4
We agree with the Commentary to Civil Rule 90.3 that
ordinary and necessary expenses calculated in determining the
adjusted gross income of a self-employed parent "do not include
amounts allowed by the IRS for the accelerated component of
depreciation expenses."5 On the other hand we are not persuaded
that the Commentary's categorical disallowance of all
"depreciation of real estate"as an "ordinary and necessary
expense" in determining the net disposable income of the self-
employed parent should be adopted. Our rejection of this portion
of the Commentary was foreshadowed in Ogard v. Ogard, 808 P.2d
815, 819 (Alaska 1991) where we said:
Furthermore, while we acknowledge
the court's concerns regarding the accuracy
of an income tax return as a reflection of
true income, the technique the court employed
did not allow sufficient recognition of
appropriate business expenses. Although the
committee commentary to Rule 90.3 states that
there should be no deduction for accelerated
depreciation, see Rule 90.3 Comment III. B.,
there is no similar suggestion with respect
to straightline depreciation of business
equipment. Depreciation is a means of
reflecting on an annual basis the costs of
capital equipment. Such costs are real and
should not be disregarded unless it appears
that equipment was acquired in order to avoid
or reduce the obligor's child support
obligation. Unless that is the case here, on
remand, the court should allow a realistic
deduction for depreciation.
As Ronald persuasively argues, there is no rational
reason for disallowing straightline depreciation of buildings,
fixtures, and other improvements, yet allowing such depreciation
costs for business equipment. We therefore hold that in the
context of a Civil Rule 90.3 adjusted income determination, the
superior court should allow, as ordinary and necessary business
expenses, a deduction for straightline depreciation of the
parent's business' real estate.6 Thus the relevant inquiry on
remand of this case to the superior court will be whether
Ronald's claimed depreciation of $54,285.00 contains any element
of accelerated depreciation.7
III. DID THE SUPERIOR COURT ERR BY INCLUDING PAYMENTS TOWARD
PRINCIPAL OF DEBT IN CALCULATING RONALD'S ADJUSTED ANNUAL
INCOME?
Ronald argues that the superior court erred in
including the payment of $33,480.28 towards the principal on his
debt for acquiring the business in his adjusted annual income.
Instead, he argues, the payment should have been deducted from
his adjusted annual income. Such payments of principal are not
permissible deductions under the Internal Revenue Code. Ronald
argues, nonetheless, that they are reasonable and necessary
business expenses as contemplated by the commentary to Civil Rule
90.3.
Linda agrees that the superior court erred in including
the payment of $33,480.28 towards the principal on Ronald's debt
for acquiring the business in his adjusted annual income.8 She
contends, however, that the payment of principal is not an
"ordinary and necessary business expense"and thus should not be
deducted from his income.
The superior court concluded that "[s]uch deduction of
principal payment is incorrect since it represents distribution
of actual income of the business to the owner in increased equity
in the business." Linda observes that the payment on the
principal is a payment toward the purchase of an asset and should
be considered an investment rather than a necessary business
expense. Linda argues that the amounts of principal payments are
negotiable and can be manipulated to shelter income during the
minority of the child. (Here the parties' child will attain
majority on January 1, 1995.) Additionally, Linda contends that
the questioned principal payment is in effect an investment which
increases Ronald's equity in the business. In this respect, she
argues that it is no different than any other type of investment.
We agree with Linda's position. Here the amounts of
principal required to be paid by Ronald are negotiable and can be
manipulated to shelter income during the minority of the child.
Additionally, principal payments constitute an investment which
increases Ronald's equity in the business. Ogard, 808 P.2d at
819 n.7 (deduction of both depreciation expenses and principal
payments rejected as constituting double deduction).
AFFIRMED in part, REVERSED in part, and REMANDED for
proceedings not inconsistent with this opinion.
_______________________________
1. A child support award will not be overturned absent a
finding of a clear abuse of discretion. Richmond v. Richmond,
779 P.2d 1211, 1216 (Alaska 1989). This court will set aside the
superior court's award only if, on the basis of the entire
record, this court is left with a "definite and firm conviction
that a mistake has been made." Id. (citing Hunt v. Hunt, 698
P.2d 1168, 1172 (Alaska 1985)).
2. As Linda correctly points out, if Ronald's payment of
accrued interest increases in future years and, as a result,
affects his income, he is free to request a modification of his
child support obligation.
3. The court in Turner explains:
The concept of depreciation, as an
expense, is a recognition of the fact that
certain fixed assets, which are used in a
business, wear out gradually and will
eventually need to be replaced.
586 A.2d at 1187. The annual depreciation "expense" is most
simply calculated by dividing the difference between the original
cost of the asset and its scrap value by the estimated useful
life of the asset. This calculation yields the "straight line
depreciation." Id.
4. This is also illustrated by the testimony of Kenneth
Gain, Linda's expert witness, and Donald Stevens, Ronald's
expert. Gain testified that there is often a wide disparity
between the depreciable life of a building for tax purposes and
the actual life of the building. Gain's testimony is confirmed
by that of Stevens, who indicated that Ronald was depreciating
the real estate on his tax return over a 15 year period. Stevens
testified, however, that under the "straight nonaccelerated
method"the period for depreciation would be 40 years. Gain also
explained that the depreciation does not accurately reflect the
loss of value. He explained that the value of buildings rarely
decreases to zero at the end of their economic life. Gain
continued "in reality what you see from a purely economic
standpoint is not a real reduction in income. It is something
that is allowed for tax purposes largely because of the lobbying
of the real estate industry."
5. Some states have specifically excluded accelerated depre
ciation from a parent's income for calculating child support
payments by statute. See Colo. Rev. Stat. 14-10 115 (7) (a)
(II) (B) (1992) ("[o]rdinary and necessary expenses does not
include amounts allowable by the internal revenue service for the
accelerated component of depreciation expenses. . . . "); Wis.
Admin. Code, HSS 80.02(13) (defining gross income adjusted for
child support as excluding accelerated depreciation). Some
states have specifically disallowed such use of accelerated
depreciation through case law. See In re the Marriage of
Mitchell, 746 P.2d 598 (Montana 1987).
Other states have given courts the discretion to either
include or disallow accelerated depreciation in the calculation
of income for child support determinations. See, e.g., Me. Rev.
Stat. Ann. tit. 19, 311 (West 1992) ("[a]t the discretion of
the court, amounts allowable by the United States Internal
Revenue Service for the accelerated component of depreciation
expenses . . . may or may not be treated as ordinary and
necessary expenses.").
6. See In re Marriage of Gaer, 476 N.W.2d 324 (Iowa 1991)
(in case where husband was self-employed truck driver, allowing
deduction for straight line depreciation of husband's truck for
child support determination); Freking v. Freking, 479 N.W.2d 736
(Minn. App. 1992) (allowing "actual," but not accelerated,
depreciation of husband's farm equipment for calculation of
husband's income for child support determination). But see Reid
v. Reid, 822 P.2d 534 (Idaho 1992) (disallowing straight line
depreciation of husband's farm equipment for purposes of
establishing his gross income for child support calculation).
7. In Turner v. Turner, 586 A.2d 1182, 1183, 1189 (Del.
1991), the court disallowed the claimed deduction of depreciation
when the lifetime of the asset for tax depreciation purposes was
shorter than the actual useful life of the asset, resulting in
accelerated depreciation of the asset. Here, as in Turner, the
evidence indicates that the actual useful life of the asset is
greater than the useful life used for depreciation purposes. In
this regard see note 4, supra.
8. It is apparent that the superior court's calculation in
this regard is incorrect.
To determine Ronald's adjusted annual income, the
superior court looked to Ronald's 1988 business tax return and
added income Ronald earned plus the items that the court
determined were not proper deductions under Civil Rule 90.3,
namely depreciation, accrued but unpaid interest and the payments
toward principal.
Ronald claimed the depreciation and accrued but unpaid
interest as deductions on his tax return. He did not claim the
principal payment, however, as a deduction on this tax return.
Thus it was improper for the superior court to include this
amount in its adjusted income determination.
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