Considerations for income analyses of business owners during separation or divorce for the purpose of determining support payments.
When a marriage or common-law relationship ends, many factors are ‘at play’ in determining how each individual will fare. From a financial perspective, there are two key aspects to the matrimonial separation with the first being the equalization of property or the splitting of the net assets owned by the separating couple. The second financial item, and topic of this article, is the potential obligation that exists for either child or spousal support.
Spousal support and child support are both established by the Divorce Act and the Family Law Act but are addressed slightly differently. Child support is governed by the Federal Child Support Guidelines (“Guidelines”), which is legislation that must be followed. The standards around spousal support are outlined in Canada’s Divorce Act, and the Spousal Support Advisory Guidelines (SSAG). The SSAG is not legislated and as such does not hold the same weight as the child support guidelines. They are interpreted more as suggestive versus prescriptive in nature. Where there is not enough money to fund both child support and spousal support, child support will take precedence.
Determining spousal support and child support in Canada is subject to an assessment of each of the respective incomes of the separating spouses. The starting point of this assessment is the personal income tax returns of each spouse. Where an individual is an employee, their reported income is clearly stated on their T4 tax slip and is provided by their employer, an independent party. This makes the assessment of income relatively simple. On the other hand, the income reported on a business owner’s personal income tax return is often considered to be discretionary and may be comprised of a number of different components such as dividends and/or salary with respect to remuneration received from the business. Personal expenses could also be run through the business without being included as income of the business owner. This may result in personal tax returns that do not adequately represent an individual’s income. On top of that, there may be income that is being generated within a corporation but not distributed out to the business owner. As such, an income analysis, including certain calculations and income gross ups, is necessary to ensure all of a business owners’ actual available income is considered, and income is not inappropriately shielded from support determination.
What is involved in an income analysis?
There are several factors involved in an income analysis that will be used to determine the amount of income upon which the spousal and/or child support payments will be based. The starting point is the total income included on line 15000 (previously 150 up until 2018) in the individual’s personal tax return, which sums up their total reported income. This total income is comprised of a number of income sources including, but not limited to, salary, commissions, Old Age Security and other pension income, dividends, interest and other investment income, partnership income, taxable capital gains, RRSP income and self-employment income.
After considering line 15000, certain adjustments are required by the Guidelines. These adjustments include, but are not limited to, items such as:
- Taxable vs. actual adjustments. For a variety of reasons, the Income Tax Act treats different source of income differently. Common examples of this are dividends and capital gains.
- Dividends – For income tax purposes, the actual dividend income that is received is grossed up by a specified percentage. This grossed up figure is referred to as a taxable dividend and is the amount included in line 15000.
- Capital gains – Capital gains are reduced by 50% in order to determine taxable capital gains, being the amount included in line 15000.
The Guidelines are based on actual income rather than taxable amounts prescribed for income tax purposes. As a result, taxable dividends are adjusted to remove the gross up and taxable capital gains are adjusted to reflect the actual capital gain realized for purposes of the individual’s income available for support. While these are the primary two types of income that get adjusted, there are also other potential adjustments such as adding in capital dividends, which are not subject to income tax and as such are not reported on an individual’s tax return.
- Personal expenses that are paid and expensed through a business on behalf of a business owner will need to be added to income available for support purposes and grossed up to an employment income equivalent. These can include telephone bills, auto expenses, meals, home office expenses, home renovations, clothing, etc. The gross up to an employment income equivalent is a concept that attempts to adjust income, which may be subject to different tax rates than employment income, or personal expenses to a level that would be comparable to income earned by an employee (who only earns employment income). This adjustment is necessary as the Guidelines for child support are based on a payor’s level of employment income. For example, to have enough money to pay for $1,000 personal expense, employment income of more than $1,000 is required. This is because employment income is subject to income taxes. If an individual’s income tax rate is 50%, they will require employment income of $2,000 to have $1,000 left after income taxes in order to pay that personal expense. As a result, the personal expense of $1,000 would be added back as well as a gross up of $1,000 in order to provide the $2,000 employment income equivalent income for support purposes. These expense items are only adjusted when they are expensed by the business and not if they are just paid for by the business and properly recorded as shareholder loans, reflected in the individual’s income and/or paid back to the company.
- Any related party remuneration that is paid for income splitting purposes (i.e. the amount paid exceeds the fair value of services provided) will have to be added back. Additionally, a gross up for the corresponding income tax benefit from the income splitting should be considered.
- Attribution of pre-tax corporate income that is not distributed to the shareholder must be considered. It is important to determine why these funds were not distributed. Were they purposely being left in the business to reduce the income of the business owner or is there a valid business reason to retain the funds? In general, the onus is on payor to demonstrate why income retained in a corporation should not be attributed. . Valid reasons include creditor agreements, shareholder agreements, capital expenditure requirements, or historical distribution practices. If there is no valid reason for the business to keep the income, it must be attributed to the business owner.
- Unreported income and cash sales (i.e. “under the table transactions”) must be estimated, added, and grossed up to an employment income equivalent. Some examples of occupations that may have unreported income include HVAC, mechanics, salons, and cash jobs. A spouse may be requested to provide cash income statements. Alternatively, a lifestyle and spending analysis is conducted that reviews all available financial information, including credit card and bank statements, in comparison to reported income on tax returns for a period of time to determine if there is unreported income.
In making these adjustments, consideration must also be given to potential “double dipping” issues in which income is generated from assets that have already been equalized with the spouse. It must be determined whether or not this income should be included as income for spousal support purposes. It is worth noting that while the business’s income is open to evaluation, certain other assets, pensions, and stock options are generally excluded from an analysis – see blog on double dipping [BP to insert Link here].
An income analysis ensures an accurate representation of an individual’s income when completing calculations and negotiations of spousal support and/or child support. Engaging a CBV early in the separation process can help you save a lot of time and resources in the long run by hiring an independent expert trained in completing the analysis. CBV’s who specialize in family law have in-depth knowledge of accounting, tax principles, and an understanding of the Federal Child Support Guidelines as it pertains to income that is available for support which enables CBVs to be accepted as experts in the courts.