How do Personal Expenses Impact Income Available for Support?
Section 19(1) of the Family Law Act Ontario Regulation 391/97 Child Support Guidelines (the “Guidelines”) indicates that “the court may impute such amount of income to a parent or spouse as it considers appropriate in the circumstances”.
The section then lists a variety on circumstances for which it may be appropriate to impute income. One such circumstance is section 19(1)(g) which states “the parent or spouse unreasonably deducts expenses from income.” As such, in completing income analyses related to child or spousal support requirements for our clients, where the client or the former spouse is a business owner, we are required to examine the expenses of the business for potential personal expenses.
Any such personal expenses, including an allocation of the personal portion of expenses that may have both personal and business components (such as such as cell phones, sporting event tickets and vehicle expenses), are added to an income conclusion for any given year when determining income available for support.
Not only are the identified personal expenses added to the individual’s income, personal expenses are subject to an income tax gross up which further increases the income. This “gross-up” adjustment is made to reflect the fact that the Guidelines are based on the concept of an employment income equivalency (employees do not own a business which they can use to charge personal expenses). As such, in grossing up personal expenses, the total amount added to income available for support is intended to reflect the employment income required to provide an after-tax equivalent amount of the expense that is paid and expensed through the business.
As a simplified illustration, if a personal item of $1,000 is expensed and the applicable income tax rate is 50%, then the person would need employment income of $2,000 to be left with sufficient after-tax funds to pay the expense personally instead of through a business. Income for support reports will typically add back the actual expense (i.e., $1,000 paid for the personal item) and then also add the tax gross up of $1,000 to reflect the employment income equivalent of $2,000 in income for support.
Depending on the extent, these personal expenses may have a significant impact on the determination of income for support. A common example is legal and other professional fees related to the matrimonial matter. While there is an understandable desire to include these costs as business expenses to reduce income taxes, doing so may result in the expense and the related income tax gross up adjustment being added to income for support regardless of the treatment of the expense permitted by Canada Revenue Agency for income tax reporting purposes.
It should be noted that personal expense adjustments relate to items that are actually expensed in the business’ financial statements. In many small owner-managed businesses, it is common to have a mixture of personal and business items paid from a business bank account. From an accounting/income determination perspective, this usually does not create an issue if the cost is recorded to either a shareholder loan (for an incorporated business) or capital draw account (for an unincorporated business), as applicable. The issue of personal expenses arises when these costs are deducted as business expenses. This point is important since we often have clients who claim that their former business-owning spouses are writing off a significant portion of their household or other personal expenses through the business. However, just because the expenses are being paid by a business credit card or through the business bank account, it does not necessarily mean that these expenses are being deducted by the business.