Determining Income for Business Owners in an Ontario Divorce

For a salaried employee, determining income for child or spousal support is often relatively straightforward. For a business owner, it can be considerably more complicated.

A business owner might report a salary of $100,000 while controlling a corporation that earns significantly more. Profits may remain inside the company. The corporation may pay certain expenses. The owner may receive dividends, shareholder benefits or income through related companies.

This does not mean all corporate income automatically becomes personal income for family-law purposes. But it does mean that a business owner’s personal tax return may tell only part of the story.

Why a Business Owner’s Tax Return May Not Be Enough

Business owners often have more control over how and when they receive income than employees do. An incorporated business owner may be able to decide how much salary to pay themselves, whether to receive salary or dividends, how much profit remains in the corporation, whether family members are employed by the business, and whether certain expenses are paid personally or through the company. These decisions may be perfectly legitimate from a business or tax-planning perspective. Family law, however, asks a different question: what income fairly reflects the financial resources available to that person for support?

For child support, income generally starts with income reported for tax purposes, subject to adjustments under the Child Support Guidelines. Where a spouse is a shareholder, director or officer of a corporation, section 18 of the Guidelines allows a court, in appropriate circumstances, to consider all or part of the corporation’s pre-tax income. The objective is not simply to take every dollar of corporate profit and call it personal income. The court must determine whether the individual’s reported income fairly reflects the money available for support

What Happens to Retained Earnings?

Retained earnings are profits a corporation keeps rather than distributing to shareholders. There are many legitimate reasons to retain money inside a company, including payroll, taxes, debt payments, equipment purchases, inventory, expansion and working capital. As a result, retained earnings are not automatically treated as income available to the shareholder. But the opposite is also true. Leaving money inside a corporation does not automatically prevent it from being considered when determining support.

The central question is often: Does the business genuinely need to retain the money, or could some of it reasonably have been available to the owner?

Consider two businesses that each earn $500,000 before tax.

One is a consulting company with low overhead and substantial cash reserves. The other is a construction company requiring significant payroll, equipment financing, bonding capacity and working capital.

The accounting profit may be identical, but the amount realistically available for distribution could be very different.

That distinction can become critical in a separation.

Corporate Expenses and Payments to Family Members

Corporate expenses may also need to be examined.

A company might pay for vehicles, travel, meals, cell phones, insurance, home-office costs or other expenses. Some may be entirely legitimate business expenses. Others may provide the shareholder with a personal economic benefit.

The fact that something appears as an expense on a corporate financial statement does not necessarily end the analysis.

Payments to family members can also attract scrutiny.

For example, imagine that a corporation pays the owner’s adult child $80,000 per year. If the child genuinely works in the business and $80,000 is reasonable compensation for the position, the salary may be entirely appropriate.

If the compensation substantially exceeds what the business would normally pay someone else to perform the same work, the analysis may be different.

What If Business Income Changes From Year to Year?

One year may not provide an accurate picture of a business owner’s income.

Businesses can experience significant fluctuations because of seasonality, large contracts, rapid growth, temporary downturns, unusual expenses or one-time events.

The Child Support Guidelines allow courts, in appropriate circumstances, to consider patterns and fluctuations in income over the preceding three years.

This can be particularly important for entrepreneurs, real estate professionals, seasonal businesses and owners whose compensation includes irregular bonuses or dividends.

Similarly, a sudden reduction in salary after separation does not necessarily mean support will immediately be based on the lower number.

Courts can examine historical income, current business performance, changes in salary and dividends, corporate expenses, industry conditions and whether the owner’s financial decisions make commercial sense independent of the separation.

What Financial Information May Be Required?

Determining income properly often requires looking at both personal and corporate records.

Depending on the issues, relevant documents may include personal tax returns and notices of assessment, corporate financial statements and tax returns, shareholder loan accounts, dividend and payroll records, corporate bank statements, year-to-date financial statements, management-fee records and information concerning related companies.

Not every case requires every document listed above. Disclosure should be proportionate to the issues genuinely in dispute.

Where the finances are complex, a forensic accountant or other qualified financial professional may also be involved.

An expert may assist with questions such as whether expenses should be normalized, whether retained earnings are genuinely required for operations, whether payments to related parties are reasonable, and how much corporate income could realistically be available to the shareholder.

KEY TAKEAWAYS

If you own a business and are going through a separation or divorce, keep these points in mind:

• Your personal tax return may be only the starting point.
• Corporate profit is not automatically personal income.
• Keeping money inside the corporation does not automatically prevent it from being considered for support.
• Legitimate working-capital requirements and business expenses matter.
• Personal benefits paid through the corporation may affect the analysis.
• Payments to family members or related parties may need to be justified.
• Several years of financial information may provide a more accurate picture than a single year.
• Complex cases may require assistance from an accountant or other professional.
• Most importantly, the income used for family law purposes can be very different from the income shown on a business owner’s personal tax return.

Getting Advice When a Business Is Involved

Determining income can be one of the most consequential financial issues in a business-owner separation.

An income figure that is too low can distort child or spousal support. A figure that ignores legitimate business expenses, debt or working-capital requirements can create equally serious problems for the business owner and potentially the company itself.

The goal should be a defensible income determination based on the actual financial evidence, the corporate structure and the applicable family law principles.