Factoring Taxes into a Divorce Settlement

In Ontario, when a married couple goes through the divorce process there is normally an equalization payment required from one spouse to the other spouse. In the absence of a valid marriage contract that states otherwise, the spouses would be entitled to 50% of the increase in the total net family property value from the date of marriage up to the date of separation.

When contemplating the equalization payment there are some very important tax consequences to consider.

Simple example:

If it is determined that at the separation date Harold had $400,000 in net property and Susan had $200,000 in net property, then Harold would have to pay Susan $100,000 so that they each end up with $300,000 in value.

You'll notice in the example that Harold would have to provide Susan $100,000 in order to equalize the net family property value. To be clear though, if Harold provides $100,000 in cash to Susan that would NOT be the same as providing her with investment real estate that is appraised at $80,000 + $20,000 in cash. Why is that? Because of taxes. More on this later.

What is the property that is normally dealt with in a divorce? Let's examine the table below, which outlines the property that Harold and Susan each own at the separation date. Let's assume that they do not own a home, that they rent.

 


First issue:
Are the above stated amounts correct? In other words, do they need to been adjusted for any disposition costs, such as embedded income taxes?

As an example, let's examine the investment real estate (but the same principles can apply to most of the assets that Harold owns). The investment real estate is currently appraised at $80,000 and is held in a real estate holding company that is 100% owned by Harold. Harold bought he property for a deal at $40,000 almost 10 years ago. The increase in value in the land portion would be a capital gain and the building portion may have recapture (taxed as income) and a capital gain associated with it. If Harold were to sell the investment real estate today, after he accounted for the taxes on recapture and capital gains, his CBV figures that he would be taxed $30,000 in total and left with only $50,000 and not $80,000. This leads to an interesting question.... what should the amount for the investment real estate be on Harold's financial statement? Is $80,000 correct (this accounts for no disposition costs) ? Should it be $50,000 (account for the full tax impact immediately)? Or should it be some amount in between??

This is a financial question but also a legal question too. The Ontario case of Sengmueller v. Sengmueller sets out some guidance on the treatment of disposition costs and how they are handled in a spouse's financial statement (this is beyond the scope of this blog post).

For the purpose of this blog post let's assume that it was decided that no disposition costs or embedded taxes were taken into account to reduce the amounts on Harold's financial statement (which may or may not be correct in real life). If you or a client are going through a divorce please talk to a qualified lawyer and a chartered business valuator (CBV) to get proper professional advice.

Second issue:
When receiving an equalization, important to ensure that everything is apples to apples


Harold needs to settle the $100,000 equalization payment that he owes Susan. He had a Chartered Business Valuator value his private company shares and neither he (nor Susan) want to be in business together after the divorce so transferring Susan any of the private company shares is off the table.

Harold therefore proposes that he pay Susan $80,000 in cash and also transfer the $20,000 in non-RRSP marketable securities to her. Transferring Susan $80,000 in cash triggers no tax impact. There is no looming capital gain to be dealt with, no recapture. It is clean and easy. However, the $20,000 in non-RRSP securities can pose some financial problems for Susan. The non-RRSP securities are considered capital property and they can be rolled over to Susan without triggering an immediate tax impact. They would be deemed to be rolled over to Susan at Harold's adjusted cost base (ACB). Let's assume that Harold's ACB for the non-RRSP securities is $5,000. If Susan were to sell the non-RRSP securities immediately after the divorce that would trigger a $15,000 capital gain for her ($20,000 less $5,000 Adjusted Cost Base = $15,000 captal gain.  50% of the capital gain, $7,500, would be taxable to Susan at her marginal tax rate). So... in this case, did Harold really provide Susan with $20,000 in value?? After all, when she sells the non-RRSP securities she will be hit with a tax bill from the CRA.  How should this be handled?  Again, same issue as before, should the non-RRSP securities be discounted for their full tax impact, no tax impact, partial impact ??

Avoid Surprises
Arriving at an equitable distribution of a couple’s marital estate can be challenging, especially when emotions are high.  To ensure that you are armed with all of the information you need to make the right decision, engage a chartered business valuator to provide you with the right information you need to know, especially when there is a private business interest at stake.  There is a lot of nuance at play that can translate into significant financial amounts.

The above are but a few of the taxation issues that come into play during the divorce process. If you have any questions about the financial issues involved in a divorce please call us.

Keystone Business Valuations  (located in Burlington, Ontario)
Steve Skrlac, MBA, CFA, CBV
http://www.keystonebv.ca
905-592-1525