Facts: Mother and Father are the parents of two children. When they divorced, Father’s child-support obligation was set at $3200 per month, the maximum presumptive amount of support for two children.

During some postdivorce litigation, Father, a wealthy real estate developer, sought to reduce his child support after selling several properties for $4.87 million, which resulted in capital gains of $1,085,239., Father invested the sales proceeds, including the capital gain, in a tax-deferred investment called a Qualified Opportunity Zone (“QOZ”).

The capital gains were not reported on Father’s income tax return, which showed a loss of $252,430 for 2020. Father planned to keep the money in the QOZ for seven years, after which the gains would be reported as income on his 2026 tax return.

If the capital gains were included, Father’s income for 2020 would be $768,931.

The trial court included the tax-deferred capital gains in Father’s income, noting that Father suffered only a “paper loss” because he made an intentional decision to invest his profits from the sale of $4.87 million worth of real estate in a tax-deferred investment, i.e., the QOZ. The trial court noted that Father had total control over the income he reports and, therefore, over what child support he pays or does not pay. Because of his investment strategy, he eliminates his income for child-support purposes and his child-support obligation. Specifically, the trial court found:

It was not the intention of the State Child Support Guidelines to allow the obligor to manipulate his income in the guise of investments, thereby reducing or eliminating his child-support obligation while his multimillion-dollar net worth and his upper-income lifestyle remain untouched.

Finding that the definition of income under the Child Support Guidelines differs from the definition under the IRS Code, the trial court denied Father’s request to change child support.

Father appealed.

On Appeal: The Court of Appeals affirmed the trial court.

While a federal income tax return is a valuable data source when calculating a child-support obligor’s income, the object of a tax return differs from that of the Child Support Guidelines. A tax return is designed to determine “taxable income” under the federal tax code. The Guidelines are intended to determine an obligor’s “gross income,” which differs from the federal tax code’s concept of “adjusted gross income.”

Tennessee courts are governed by the income definitions in the Child Support Guidelines, not the federal tax code.

Father argued his investment in the QOZ is comparable to a 1031 exchange, where a property owner can sell a property held for investment purposes and swap it for a new one purchased for the same purpose, thereby letting the owner defer capital gains tax on the sale.

The Court was not persuaded, noting Father sold seven properties in the regular course of his business and then invested the proceeds from the sale into a QOZ fund. He did not sell a property and replace it with a similar property.

The Court found the trial court’s judgment to be sound:

Here, Father is engaged in the real estate business. Thus, the sale of real estate was Father’s primary source of income, and Father controlled whether to use the income from the real estate transactions for paying monthly expenses or whether to place the sales proceeds into a QOZ investment to defer recognizing the net sales proceeds as income for federal income tax purposes. We are also persuaded by the reasoning in Tennessee cases, which recognize the fallacies of a parent controlling or manipulating his or her income for child-support purposes while maintaining a comfortable lifestyle.

Both the trial court’s findings and the record established that Father has substantial assets, which he uses to maintain his elevated lifestyle, and “the goal of the statutes and regulations governing child support is to assure that children receive support reasonably consistent with their parent or parents’ financial resources.” Moreover, one of the major goals in the development of the Guidelines was “to ensure to the extent that either parent enjoys a higher standard of living, the children share in that higher standard.”

For these reasons, and the fact that a tax return is designed to determine “taxable income” under the federal tax code while the Child Support Guidelines are designed to determine “gross income” as that concept is defined in the Guidelines, we find no error with the trial court’s decision to distinguish the effect of federal income tax law upon Father’s 2020 income in determining Father’s income for child-support purposes. As the trial court found, Father had the ability to control how his income will be reported, and by utilizing this control, he made the calculated decision to place the net proceeds from the sale of seven properties into a QOZ fund while maintaining a lavish lifestyle. Thus, to be consistent with the goal of the statutes and regulations governing child support, which are to assure that children receive support reasonably consistent with their parents’ financial resources, we affirm the trial court’s decision to include the capital gains as income for child-support purposes.

The Court affirmed the trial court’s judgment.

Source: Smallman v. Smallman (Tennessee Court of Appeals, Middle Section, November 13, 2023).

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