Tax Implications of Divorce or Separation for Business Owners

If you are a business owner and you are in the process of a separation or divorce, what are the tax implications of divorce for you and your business? Here’s a quick overview.

Separating or divorcing can take a toll as it tends to involve lengthy paperwork and division of assets. You may also be rightfully concerned about the impact of the situation on your business. As a business owner, you will need to keep your house in order with the Canada Revenue Agency (CRA) now that your marital status will change. According to CRA, you will be considered separated if you live apart from your spouse or common-law partner for 90 days or more due to a relationship breakdown.

For tax purposes, the agency requires you to notify them of your new status as it affects how you file your taxes.

If you are a business owner and you are in the process of a separation or divorce, what are the tax implications for you and your business? Here’s a quick overview.

Spousal rollover

Spousal rollover is the cost of transferring assets between spouses or common-law partners. Here, one of the spouses can transfer assets to the other based on the original adjusted cost base (ACB) and undepreciated capital cost (UCC). The rollover provision only applies if the asset transfer is due to a settlement. This prevents the asset transfer from incurring significant capital gains tax.

Spousal attribution rules

According to the attribution rule, if one of the spouses or common-law partners transfers property below fair market value (FMV), income or capital gains earned from the property will be taxed on the transferor. This rule continues to apply until a divorce or spouses live separately due to a breakdown in the relationship. During separation, capital gains attribution stops if you and your partner make a joint election.

Tax on split income (TOSI) rules

In general, TOSI subjects income to the marginal tax rates at the top tier (now 33%). Those going through a separation should keep this rule in mind to avoid costly asset division. Under the rule, spouses or common-law partners are exempt if they live apart due to a breakdown of their marriage or common-law partnership. Even so, it requires an in-depth evaluation of one’s situation to ensure the exemption is justified.

Capital gains exemption

Under the law, those who are eligible can claim a cumulative lifetime capital gains exemption based on net proceeds from the sale of corporation shares. Spouses are considered to be non-arm’s length, including any corporation they manage, which extends to after they divorce or separate. If a corporation under one spouse buys shares from another corporation controlled by the other spouse, as a form of asset division, there needs to be careful consideration. Otherwise, it could lead to negative tax consequences, including being unable to claim capital gains exemption.

Understanding butterfly transactions

Also known as butterfly splits, they enable the business owner to divide corporate assets. This counts during a separation or divorce, as the corporate assets are split into two corporations, with each partner owning one company on a tax-free basis. There are two common types of butterfly transactions.

The Related-Party Butterfly

This is relevant to non-arm’s length parties, which are usually common-law partners or married couples. It
allows flexibility for the couple deciding how to split the business assets among the two separate companies. It
reduces the friction between which type of assets, whether active or passive, can be transferred to whichever
company.

The Divisive Butterfly

This only applies to arm-length parties. It involves stringent rules that govern how two business partners divide the business, where each company must receive pro rata shares of the business and non-business assets. It’s more complex and rigid in comparison.

As a measure of caution, it’s better to work with an expert such as an accountant to ensure any division of the corporation doesn’t incur significant tax costs.

Protecting your business from tax effects

Any miscalculated move when dividing your assets with your spouse could have long-lasting detrimental impacts on the business. Proper planning and partnering with a trusted tax expert will minimize time and effort spent reaching favorable terms while undergoing a divorce or separation.

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