On July 18, 2017, a new set of rules was introduced by the Federal Government, specifically altering how small business owners were taxed. These changes were in draft form and had wide ranging impact. In October, 2017, the Federal government walked back a number of the proposed changes. There was one group of changes, however, that they have stated that they will be going ahead with as of January 2018.
We are still waiting for revised legislation to give us specific details as to how these changes are going to impact the owners of small businesses. However, if they proceed in any way similar to the draft legislation that was proposed on July 18, 2017, one thing is certain – this will affect how we distribute corporate assets in a divorce situation.
Currently, we can divide up the assets that divorcing spouses are entitled to in a small business in a couple of different ways. Since under matrimonial property law, spouses are generally entitled to 50% of the assets of the marriage and under corporate law, shareholders are entitled to compensation as set out in the articles of the corporation, we can use a combination of gifts, butterflies and dividends to move assets in the most tax efficient way possible to the exiting shareholder spouse.
Under these new rules, however, spouses that are not involved in the business (or who are not as involved as the other spouse) will be subject to penalizing tax rates. When you combine this with a divorce situation, one of two things has to be true. Either there will be a carve out for people that are getting divorced (which could lead to abuse of the divorce system) or spouses getting divorced would be subject to much higher rates than they are currently, significantly increasing the tax cost in getting divorced.
Let’s look at an example.
Husband and Wife own shares equally in a corporation. The corporation is operated by Wife who uses it to run a small consulting business. Husband has never been involved with the corporation. Wife has been putting money aside in the corporation for lean times and, at the time of separation, the corporation is worth approximately $200,000 – half in an investment account and half from the goodwill of the business. Pursuant to a settlement agreement, Husband is entitled to $100,000 of value from the corporation. Husband has been disabled and so has no other employment income.
Currently, we could take $100,000.00 and give Husband a dividend on his shares, spacing the dividends out over a couple of years to ensure he doesn’t pay a significant amount of tax on that dividend. Depending on his personal situation, we may be able to put all $100,000.00 in his hands, tax free. After receiving the dividends, he can gift his shares to his Wife. There is no tax consequence on the gift so long as it is done prior to divorce.
Under what we believe the new system will look like, if we follow the same process, Husband will pay $50,000.00 – literally half of the value – to the government in taxes. It does not matter when he receives the cash or how much income he has from higher sources. Husband receives this income and has to pay the highest rate of tax on it.
There is no doubt that the new tax legislation will have a tremendous impact on how married spouses compensate themselves, but it seems as though the Federal Government may have overlooked how this will impact spouses who are separated/divorcing.
Aim Law Group
tax law specialists