Depreciation Not Always an “Addback” in Child Support Calculations

November 02, 2006 | Income Calculations, Legal Perspective

Icon for author Brian Vertz Brian Vertz

The National Litigation Consultants’ Review this month contains a terrific article about depreciation addbacks in the context of income calculations for child support. Since the goal of a child support calculation is to allocate available cash flow (rather than taxable income) between the child’s parents, business depreciation expenses are usually added back to the net income. Depreciation expense is also added back when normalization is performed on the income statement of a company in a business valuation. In both instances, depreciation is regarded as a non-cash expense.

This article reminds us that depreciation is nothing more than a method of allocating the cost of capital assets over a number of years. Depreciation often reflects an underlying expense that really does affect cash flow, but recurs less frequently than every year. We should not blindly add back depreciation if there is an underlying capital expense that can be expected to recur in the future. At the same time, we must avoid “double counting” by deducting depreciation annually and capital expenses as they are incurred.

Perhaps one of the reasons why this principle is overlooked, the article suggests, is the implementation in 1986 of the MACRS depreciation method under the Internal Revenue Code. This method represented a shift from “estimated useful life” to “cost recovery.” The MACRS depreciation method allowed businesses to write off capital expenditures more rapidly than the useful life of the capital assets.

An even more rapid method of depreciation is the “Section 179” expense, which allows a business to write off a capital expense (up to $108,000 in 2006) immediately if the company does not exceed a limit (currently $430,000) of capital acquisitions in a single year.

Consider the difference between two examples of capital assets: real estate and automobiles. Automobiles wear out over time, usually cannot be resold for their purchase price, and must be replaced eventually. Real estate, on the other hand, does not wear out, usually increases in value over time, and need not be replaced. Depreciation expense related to automobiles probably should not be added back in child support calculations, but depreciation expense related to real estate probably should.

In Pennsylvania, we have the Labar case to guide our courts. In Labar, the Pennsylvania Supreme Court held that depreciation should be added back to the business owner’s income if (1) the income tax savings created by depreciation deductions was distributed to the business owner and not reinvested in the business, or (2) the underlying capital outlays (such as inventory build-ups) were unnecessary or represented an attempt to shelter income from child support obligations. Absent specific evidence of intent to shelter income, it must be presumed that business expenditures were legitimate and necessary.

The National Litigation Consultants Review is available to business valuation experts who subscribe to KeyValueData through the Certified Valuators and Analysts website.

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