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Sheltering retained earnings

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In the divorce context, issues often arise about retained earnings in a nonmarital closely held subchapter S corporation.

Recent case law provides guidance on how the shareholder spouse can shield retained earnings from the other spouse, and how the nonshareholder spouse can protect himself or herself and make a claim on behalf of the marital estate.

In general, when the corporation is the non-marital property of one spouse, the retained earnings are also deemed nonmarital and not subject to division as marital property. However, the nonshareholder spouse can make a claim for reimbursement to the marital estate if he or she can show that the shareholder spouse made significant personal efforts during the marriage that caused a substantial appreciation in value and was undercompensated for such efforts.

He or she may also have a claim if the retained earnings were not historically retained in the corporation at such a high level and there is no legitimate business reason for doing so.

Courts look more critically at the level of retained earnings held in the corporation when the shareholder spouse is the sole or majority shareholder and has the authority to determine his or her salary, declare dividends and decide what level of earnings to retain in the corporation.

Two recent Illinois decisions demonstrate the application of these factors in the context of divorce.

They also provide guidance on how to shelter retained earnings, as well as how to inject their value as a part of the marital estate.

In In re Marriage of Schmitt, 391 Ill.App.3d 1010 (2d Dist. 2009), the 2nd District Appellate Court reversed the trial court’s determination that the husband’s corporation and all parcels of real estate he purchased during the marriage were his nonmarital property.

Kim Schmitt worked at Colonial, a subchapter S corporation, and acquired 49 percent ownership of Colonial before his marriage. During the marriage, Schmitt purchased several parcels of real estate and other business interests, including Bricks, another subchapter S corporation, using distributions paid out of Colonial’s retained earnings account. The trial court held that because his ownership interest in Colonial was acquired before his marriage, it was nonmarital property; so too was Bricks and all the real estate he purchased during his marriage using funds distributed by Colonial, and later by Bricks.

The appellate court reversed the trial court’s decision and held that because Schmitt purchased the real estate and Bricks with income and distributions attributable to his personal efforts, these newly acquired assets were marital property subject to division between him and his wife.

Quoting the 3rd District opinion of In re Marriage of Joynt, 375 Ill.App.3d 817 (3d Dist. 2007), the Schmitt court explained that retained earnings and profits of a subchapter S corporation are a corporate asset and remain the corporation’s property until severed from the other corporate assets and distributed as dividends. However, once severed and distributed, either as salary, dividends or distributions charged against a spouse’s retained earnings account, they are deemed marital property if generated from personal efforts.

Shortly after Schmitt , the 1st District Appellate Court decided the case of In re Marriage of Lundahl, 396 Ill.App.3d 495 (1st Dist. 2009), which further clarified the rule of law that retained earnings attributable to personal efforts of a spouse are marital property when distributed. The court also extended the rule to provide that retained earnings may be marital property, even when they are retained in a nonmarital business, if there is no legitimate business reason for retaining earnings at such a high level and the retention of earnings is at the sole discretion of the shareholder spouse and designed to deprive the other spouse and marital estate from sharing in the profits.

A key factor in Lundahl was that the husband was the sole shareholder of the premarital subchapter S corporation. Because he had sole discretion over how much he was paid, which was not very much, and how much of the retained earnings should be distributed to him, the retained earnings were deemed marital property.

Lundahl may have been able to shelter the retained earnings if the substantial increase in retained earnings were not attributable to his personal efforts or if he was better compensated for his significant personal efforts during the marriage.

He also might have protected their non-marital character if he was a minority shareholder or had an independent corporate board making decisions on salary, level of retained earnings and distributions made to shareholders. Showing a pattern of historical retained earnings and legitimate business reasons for the high level of retained earnings also would have helped his case.

However, without those protections in place, the court viewed the retained earnings as income derived from personal efforts during the marriage and, thus, marital property subject to division between Lundahl and his wife.

Originally appeared in the July 2010 issue of Chicago Lawyer