Income for Support Purposes What is Your Client s Income?

Transcription

1 Income for Support Purposes What is Your Client s Income? Presented by: Matthew Krofchick CPA, CMA, CBV, CMC, CFF Investigative Accounting, Business Valuations, Forensic Economics, & Actuarial Services What is your Client's Income? Determining income of an employed client is straightforward, if income earned is employment income (except for certain adjustments, if required) review T4 Statement of Remuneration Paid But what is the income of a self-employed client? How do Business Valuators figure this out? Discussion on Income Determination only; Business Valuation is a separate exercise involving issues that differ from Income Determination. Issues in Income Determination Is the taxable income of a self-employed client a measure of the actual income they have earned? In many cases, the answer is NO. Self-Employed Individuals attempt to minimize taxable income through means such as: Flowing personal expenses through the business; Paying salaries (income splitting) to non-arm s length individuals; Including expenses incurred for residence through Businessuse-of-home-expenses; Not declaring income earned (cash income), etc.

2 Calculating Annual Income Annual Income for support purposes is calculated pursuant to S. 16 of the Federal Child Support Guidelines, which states that: Subject to sections 17 to 20, a spouse s annual income is determined using the sources of income set out under the heading Total income in the T1 General form issued by the Canada Revenue Agency and is adjusted in accordance with Schedule III. Further, pursuant to S. 17 (1): If the court is of the opinion that the determination of a spouse s annual income under section 16 would not be the fairest determination of that income, the court may have regard to the spouse s income over the last three years and determine an amount that is fair and reasonable in light of any pattern of income, fluctuation in income or receipt of a non-recurring amount during those years. Calculating Annual Income Start with Line 150 of Income Tax Return; Make adjustments (Normalization) in accordance with Schedule III of the Guidelines; Make Other Potential Adjustments, if any; For expenses deemed personal in nature or not required for daily operations of the business, gross up using the following formula to account for tax savings that a spouse is able to generate by deducting these expenses: Amount of Expense / (1-Tax Rate) - Amount of Expense Imputing Income 19 (1) The court may impute such amount of income to a spouse as it considers appropriate in the circumstances, which circumstances include the following: (a) the spouse is intentionally under-employed or unemployed, other than where the under-employment or unemployment is required by the needs of a child of the marriage or any child under the age of majority or by the reasonable educational or health needs of the spouse; (b) the spouse is exempt from paying federal or provincial income tax; (c) the spouse lives in a country that has effective rates of income tax that are significantly lower than those in Canada; (d) it appears that income has been diverted which would affect the level of child support to be determined under these Guidelines; (e) the spouse s property is not reasonably utilized to generate income; (f) the spouse has failed to provide income information when under a legal obligation to do so;

3 Imputing Income 19 (1) (g) the spouse unreasonably deducts expenses from income; (h) the spouse derives a significant portion of income from dividends, capital gains or other sources that are taxed at a lower rate than employment or business income or that are exempt from tax; and (i) the spouse is a beneficiary under a trust and is or will be in receipt of income or other benefits from the trust. 19 (2) For the purpose of paragraph (1)(g), the reasonableness of an expense deduction is not solely governed by whether the deduction is permitted under the Income Tax Act. Example of Income Valuation Income of Ms. Jane Doe, a self-employed individual Pursuant to Federal Child Support Guidelines $ $ $ Total Income for Support Purposes - Line 150 A 15,519 (13,329) (64,852) Add Back: Adjustments to Net Income B 51,377 57,057 51,302 Gross-up of Personal Expenses C=(B/(1-tax rate))-b 10,989 14,509 - Total Adjusted Income D= A+B+C $ 77,886 $ 58,237 $ (13,550) Gross-up was calculated incrementally using tax rates in effect for each income tax bracket up to Ms. Doe s adjusted income for that particular year. Overview of Adjustments Examples of personal expenses that were paid out through the business are shown in the table below; Did not include RRSP Income in 2012 as it appeared to be onetime in nature (separation was in 2014). Adjustments to Net Income Add Back: 100% Business-use-of-home Expense 2, % of Promotional Expenses 2,456 9,069 2,272 50% Insurance Payments for Motor Vehicles 700 1, % Other Discretionary Expenses 45,472 46,939 49,030 Total Adjustments 51,377 57,057 51,302

4 Spouse Owning An Incorporated Business Spouse is Shareholder, Director, or Officer of a Corporation: 18 (1) Where a spouse is a shareholder, director or officer of a corporation and the court is of the opinion that the amount of the spouse s annual income as determined under section 16 does not fairly reflect all the money available to the spouse for the payment of child support, the court may consider the situations described in section 17 and determine the spouse s annual income to include: (a) all or part of the pre-tax income of the corporation, and of any corporation that is related to that corporation, for the most recent taxation year; or (b) an amount commensurate with the services that the spouse provides to the corporation, provided that the amount does not exceed the corporation s pre-tax income. Spouse Owning An Incorporated Business Adjustment to corporation s pre-tax income: 18 (2) In determining the pre-tax income of a corporation for the purposes of subsection (1), all amounts paid by the corporation as salaries, wages or management fees, or other payments or benefits, to or on behalf of persons with whom the corporation does not deal at arm s length must be added to the pre-tax income, unless the spouse establishes that the payments were reasonable in the circumstances. Incorporated Business Mr. John Doe is a 100% shareholder of Doe Construction Company (DCC) a construction and renovation company. Income Statement of Doe Construction Co. For Year Ending November 30, $ $ $ Sales A 201, , ,112 Cost of Sales B 106, , ,621 Gross Profit C = A-B 94, , ,491 Expenses Bank Charges and Interest 5,052 7,655 9,260 Management Fees 60,000 35,000 - Office and General 12,121 9,926 14,766 Telephone 2,124 1, Vehicle 12,498 12,835 9,067 D 91,795 67,168 33,875 Net Income (Loss) before Taxes E = C-D 2,776 47,669 83,616 Provision for Income Taxes ,484 Net Income (Loss) after Taxes $2,776 $47,669 $71,132 Retained Earnings (Deficit), beginning of year (63,734) (60,958) (44,289) Dividends Paid - (31,000) - Retained Earnings (Deficit), end of year ($60,958) ($44,289) $26,843

5 Overview of Adjustments Some of the Adjustments made to determine Mr. Doe s income are: Mr. Doe s tax returns indicate he received $38,750 in taxable dividends from DCC which correspond to an actual dividend payment of $31,000; dividends are subject to a gross-up of 25% for income tax purposes. Accordingly, Mr. Doe s income has been adjusted for this difference; Since Mr. Doe is the 100% shareholder of DCC, the Courts can consider all of DCC s pre-tax income when calculating Mr. Doe s income for support purposes; DCC s losses, however, are excluded in the calculation of Mr. Doe s income; In 2012, DCC paid Mr. Doe $31,000 as dividends therefore, DCC s income attributable to Mr. Doe does not include this amount. Overview of Adjustments DCC's fiscal year ends at November 30. However, we have assumed that the company's pre-tax income in the fiscal year would not be materially different from the income earned during the calendar year ending December 31, as construction / renovation typically slows down in December; The interest payments on Mr. Doe s personal loans were expensed through the company, which were added back; Management fees were payments made to Mr. Doe and were added back as these amounts included self-employment income reported by Mr. Doe on his tax returns and also included income paid to his spouse (INCOME SPLITTING); Tax gross up was added to account for tax savings, using the same formula discussed earlier; and Undeclared cash income was added back to calculate Mr. Doe s income. Adjusted Income Statement Adjusted Personal Income Statement of Mr. John Doe For Year Ending December 31, $ $ $ Total Income - Line 150 A 42,500 53,750 - Adjustment for Grossed-up Dividends B - (7,750) - 100% of Pre-Tax Income C 2,776 16,669 83,616 Total Income D = A+B+C $ 45,276 $ 62,669 $ 83,616 Adjustments Interest on Personal Loans 2,768 4,060 6,906 Management Fees 17,500 20,000 - Professional Fees - - 6,000 E 20,268 24,060 12,906 Gross-up of Personal Expenses F=(E/(1-tax rate))-e 9,170 18,456 9,900 Add: Cash Income G 1,598 1,598 1,598 Total Adjusted Income H= D+E+F+G $ 76,311 $ 106,783 $ 108,020

6 Is there Cash Income? Did the business earn some income in cash? If cash income was not reported, how was it hidden? Was it used to buy assets or fund a high-end lifestyle? Forensic accountants / Business Valuators can impute the actual income of the business. Income from Multiple Sources Mr. Red has multiple businesses and earns employment income from some and dividend income from others. He also receives payments from a family trust. The adjustments to Mr. Red s income from multiple businesses he owns are similar to those discussed earlier (See determination of Mr. Doe s income). The undistributed pre-tax income includes income in those years when the corporations earned pre-tax income, whereas the years in which they incurred losses were not included. In addition, Mr. Red is also eligible to receive dividends from the Red Family Trust. The Red Family Trust was set up as part of a share reorganization of one of the corporations owned by Mr. Red. While the corporation previously paid dividends to the shareholders, it now pays dividends to the trust. Adjusted Income Statement Adjusted Personal Income Statement of Mr. Red $ $ $ $ Total Income - Line 150 A 35,000 23,780 29,000 38,700 Dividends XYZ Limited 90, , ,000 - Colour Incorporated Digital Printing Inc Red Family Trust B 90, , ,000 - Undistributed Pre-Tax Iincome XYZ Limited - 4, Colour Incorporated C - 4, Imputed Dividends from Red Family Trust D ,000 75,000 Total Adjusted Income E = A+B+C+D $ 125,000 $ 128,415 $ 379,850 $ 113,700

7 Pension Income for Support We were asked to calculate Mr. White s income for the purpose of determining the income available for spousal support as at January 1, 2013, when he will be deemed to undergo a material change in circumstances and retire from his job with the RCMP, and at age 65 when his pension is reduced and he begins receiving Old Age Security benefits (OAS). OAS benefits are indexed every quarter; we have used the rates in effect in the most recent quarter (July to September 2012) to estimate the benefit Mr. White will receive when he reaches age 65. Mr. White's monthly pension beginning January 1, 2013 was estimated to be $6,098.16, with $2, of this amount having been equalized through a division of Net Family Property with his wife upon their separation. This leaves $3, per month in pension income that has not been equalized and which we considered income for support purposes. Pension Income for Support Mr. White s pension including the portion meant for equalization between him and his wife, also decreases at age 65. His monthly pension drops to $5,080.73, with $1, of this amount being equalized through a division of Net Family Property with his wife upon their separation. This leaves $3, per month in pension income that has not been equalized and which can be considered income for support purposes. The calculations are shown below: 1-Jan-13 At Age 65 Mr. White's Monthly Pension Mr. White's Monthly Pension Equalized on the Separation Date Portion of Mr. White's Monthly Pension not Equalized Annual Pension Not Equalized A $ 6,098 $ 5,081 B $ 2,330 $ 1,839 C=A-B $ 3,768 $ 3,241 D=C*12 $ 45,221 $ 38,897 Pension Income for Support Mr. White s adjusted personal income is shown below, which includes interest and investment income (which was recurring in nature) as well: Mr. White's Adjusted Personal Income Statement 1-Jan-13 At Age 65 Total Income - Line 150 $ $ Canada Pension Plan Income A 6,698 6,698 Interest and Invesment Income B 1,178 1,178 Old Age Security C - 6,599 Pension Income D 45,221 38,897 Total Income For Support Purposes E = A+B+C+D $ 53,097 $ 53,372

8 Double Dipping In the context of pensions, Double Dipping involves using pension income that has already been equalized in the division of Net Family Property as the basis for determining income for support purposes. While the position that Double Dipping should be avoided is generally supported by the courts, there are judgments wherein, depending upon the circumstances at hand, support payments have been ordered by the courts from the post-retirement pension income. See Boston v. Boston, [2001] 2 SCR 413, 2001 SCC 43 (CanLII) & Roy v. Roy, 2015 ONSC 45 (CanLII) Double Dipping - Other Instances How they are dealt with will depend on the situation. Consider for example the situation where a spouse owns shares of a company that has been factored into an equalization of NFP and at some date post-separation, sells some of those shares. How is the capital gain dealt with? Child Support: - included in income Spousal Support: - not included in income Why the difference? The spouse has been already compensated but the child(ren) would have been beneficiaries of the sale of shares through the parents having more income at their disposal. Sale of Shares Ms. Black is a 90% shareholder of ABC Corp.. In 2013, she received eligible dividends from ABC Corp. and sold some her ABC Corp. shares. In accordance with Schedule III of the Federal Child Support Guidelines (the "Guidelines"), we have replaced the taxable amount of eligible dividends and capital gains received by Ms. Black with their actual amounts and deducted the carrying charges and interest expenses she incurred as stated on Line 221 of her income tax return. Both the eligible dividends and capital gains are taxed at a lower rate than employment income. Therefore, according to s. 19 (1) (h) of the Guidelines, they are grossed-up by a factor of 49.1%, to impute the client s income.

9 Sale of Shares We have imputed Ms. Black's share of ABC Corp.'s corporate pre-tax income in an amount commensurate with her ownership share of the company. We have also presented an alternative calculation of Ms. Black's income for support purposes that does not include the income she received from the sale of ABC Corp. shares during the year. According to her income tax returns, she realized a capital gain of $283, from the sale of 900 ABC Corp. shares The gross-up is calculated in the same manner as before, by a factor of 49.1%. Overview of Adjustments Ms. Black's Adjusted Income for Spousal Support 2013 Total Income (Line 150) Adjustments: Less: Taxable Eligible Dividends Add: Eligible Cash Dividends Less: Taxable Capital Gains Add: Gross Capital Gains Less: Carrying Charges and Interest Expenses Gross-up for Tax on Eligible Dividends Gross-up for Tax on Capital Gains Adjusted Income Before Attribution of Pre-Tax Corporate Income Pre-Tax Corporate Income Rockport Inc. (90% shareholding) Adjusted Income for Support Purposes Capital Gains on Sale of Rockport's shares Gross-up for Tax on Capital Gains Adjusted Income for Support Purposes Excluding Capital Gains on Rockport 2,903,256 (84,751) 61,414 (153,621) 307,241 (7,580) 19, ,759 3,195, ,293 $ 3,613,091 (283,462) (139,091) $ 3,190,539 Spousal Support Advisory Guidelines The Spousal Support Advisory Guidelines suggest appropriate ranges of support in a variety of situations for spouses entitled to support. The guidelines do not provide advice on whether a spouse is entitled to support. In each case, entitlement to support depends on how the law applies to their situation. The Spousal Support Advisory Guidelines are not law. However, judges often base their decisions about spousal support on the guidelines. Many family lawyers also use the guidelines when helping clients to make decisions and set up spousal support agreements out of court.

10 Income Using Spousal Support Advisory Guidelines The accurate determination of spousal incomes is critical to the proper application of the Advisory Guidelines. The starting point for the determination of income under the Spousal Support Advisory Guidelines is the definition of income under the Federal Child Support Guidelines. For the most part, the income issues are the same as those for child support purposes, i.e. interpreting the provisions of sections 15 to 20 of the Child Support Guidelines and Schedule III. Differences in Application of Guidelines The income-imputing provisions of section 19 described earlier, are even more important in spousal support than in child support. In every spousal support case, two incomes are at issue. Income may need to be imputed to a payor spouse, but in addition, a spousal support case may also require that an income be imputed to the recipient spouse, because of self-sufficiency issues. There are a few distinctive income issues that do arise in the spousal support context which are addressed further below. Differences in Application of Guidelines Social Assistance is Not Income Under s. 4 of Schedule III to the Federal Child Support Guidelines, social assistance is treated as income for child support, but only "the amount attributable to the spouse". This adjustment is required as social assistance is included in line 150 income. For spousal support purposes, any social assistance received by the recipient spouse has traditionally not been viewed as income, so that a recipient relying entirely on social assistance would be treated as person with zero income. Conversely, a payor who receives social assistance, has no income, and thus has no ability to pay spousal support.

11 Differences in Application of Guidelines Child Tax Benefit and Other Child Benefits In the with child support formula, these and other similar benefits are treated as income for spousal support, unlike for child support. Benefits for Children Other Than Children of Marriage Spouses may be receiving child-related benefits for children other than "children of the marriage", children of prior or subsequent relationships. Under the Federal Child Support Guidelines, these benefits are generally not treated as part of income for child support or spousal support purposes. Differences in Application of Guidelines Non Taxable Incomes Some disability payments, worker s compensation, and income of aboriginal persons earned on a reserve are non-taxable to the recipient. For child support purposes, this has to be grossed up to approximate equivalent taxable income, under s. 19 (1) (b). For spousal support purposes, the same grossing-up is required by the without child support formula, while the net or non-taxable amount can be used for the basic with child support formula. Disclosure for Income Determination The quantum of information that is required to determine a specific income determination varies on a case-by-case basis; The amount of disclosure required should be proportionate to the size of the business and the nature of its operations; and The disclosure is also affected by the different sources of income (multi-corporation, dividends, trusts etc.).

12 The Business Valuator The Business Valuator should understand the dynamics of an owner-managed business; The parties often look to the Valuator not only as a facilitator, but an active participant in generating options; and Most importantly, the Valuator should be seen as impartial and practical, to resolve the various issues that the partners have been dealing with in their separation without judging them. Services The Business Valuator / Accountant can: Provide an estimate of the Fair Market Value of the business; Provide an estimate of the Income that was earned by the Spouse; Investigate allegations of fraudulent business practices; and If required, impute income if the business earns some or all revenue in cash. Conclusion Determination of Support Payments in a fair and impartial manner is critical towards timely and costefficient settlement of matrimonial proceedings; The Spousal Support Advisory Guidelines and the Federal Child Support Guidelines provide a framework to determine support payments, reducing conflict and tension between spouses; and The process also helps improve the efficiency of the legal process and helps ensure consistent treatment of spouses.

13 Matthew Krofchick, CPA, CMA, CBV, CMC, CFF Toronto Ottawa London Toll Free: Fax: Website: