With tax season approaching, I thought I might share some of the tax issues that can arise up during separations and divorce. Most tax issues arise in family law as a result of the division of family property. Your family lawyer should advise you that there may be a tax issue that will arise from your separation, at which point you should consult a tax expert.
Registered vs. Non-Registered Assets: When dividing the assets that have accumulated over the course of a relationship, couples are confronted with decisions about who will keep which assets. If a couple owns a house and some RRSPs, it will often make sense for one party to remain in the house and buy out the other party’s interest as well as letting the other party keep the RRSPs (this assumes the value of one-half of the house is greater than the value of the RRSPs).
When making decisions like this, care should be taken to consider whether the RRSPs will be used in retirement, or used prior to that by the party who keeps them. If it is likely they will be used beforehand (to purchase a new house, for instance) consider the tax consequences of withdrawing the funds from the plan and advise the lawyer preparing the separation agreement accordingly – a different division of assets could make more sense.
Note that funds from RRSPs can be transferred from one spouse to another by way of a tax-free rollover, so if one party has an RRSP worth more than the other party, the RRSPs can be equalized as part of the terms of the divorce
Corporations: Shares in corporations owned by a spouse will usually be considered family property and will thus be subject to division upon separation. Valuing the shares or portion of the shares which will be considered family property is best done by a business valuation professional.
The simplest way to deal with shares in a corporation which one party owns or operates is to transfer all the shares to the party who will continue to own or operate the corporation and have that party compensate the other party out of the remaining family assets. A tax expert should again be consulted here, as the parties should consider the impact of a capital gain (or loss) realization as part of this transfer. If there are not enough remaining family assets to accomplish this, then matters can become more complicated.
Spouses are related parties as defined by the Income Tax Act, so in cases like these they are permitted to divide the corporation into two corporations by way of what is called a “butterfly” reorganization. After this procedure is performed, each spouse should own one corporation and the assets of the original corporation will have been divided between them.
Sometimes spouses will opt to hold onto the shares in a corporation owned or operated by their former spouse. I do not recommend this approach, as continuing to be involved in a business of one’s former spouse can involve unpleasant and expensive supervision of the activities of the business.
Support Payments: While child support payments are not deductible for the payor or taxable for the recipient, periodic spousal support payments are.
While spouses are separating, certain expenses usually need to continue being paid and interim support arrangements are often put into place. There is often a temptation to agree that the payor spouse pay some expenses in lieu of making actual spousal support payments to the recipient. Such arrangements can have negative tax consequences, as the CRA will likely not interpret these arrangements as meeting their definition of tax-deductible spousal support payments, even if the separating parties agree to treat them as such.
In short: the greater the amount and variety of assets that two spouses have when separating, the greater the need for tax advice when considering the terms of separation. While most family lawyers are familiar enough with tax law to know when there is an issue, family lawyers are not tax experts. It is important to have a tax professional available to provide advice to both you and your lawyer when separating.