Family Law / Divorce Library

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Self-employment Income

When someone is self-employed or has a business, their income for support purposes (their Guideline Income) might be quite different than their income as reported in their tax return. This is the case whether they have a sole proprietorship (conducing a business on their own without it being incorporated), a partnership, or shares in a corporation.

Below, we'll discuss three very common categories of adjustments:

  1. Personal benefits
  2. Undistributed profit
  3. Compensation to friends and family

In the page about Guideline Income we talked about how fluctuating income and changes in circumstances might mean using different figures. Those adjustments are fairly common when we look at self-employment income.

The Imputing Income page sets out some scenarios where we might set someone's income higher. In the self-employment context, income might be imputed if someone is receiving cash payments but not declaring them as revenue, where someone has unreasonably deducted expenses, or where someone has diverted income. For example, income might be imputed if a parent claims that their business now belongs to someone else, but they still have practical control over it.

When someone's income includes dividend income, we have to replace the grossed-up dividend (what's reported in their Income Tax Return) with the dividend that they actually received. That's because the dividend in their tax return is inflated, so that it gets taxed at a different rate.

We don't increase someone's income just because the business has a lot of cash or their retained earnings or equity grew. That's not the proper test. Instead, we're looking at how much income was available for support purposes.

This is only a very brief overview, there may be many more adjustments depending on the circumstances.


Contents

Compensation to non-arm's length persons

Some businesses hire the owner's spouse, new partner, children, or other friends or family members. If the payment isn't reasonable, it can be added-back to the owner's guideline income.

For example, if the owner hires their new partner after the separation and pays them $50,000 per year but they only help out a couple of hours per week, that pay might be unreasonable.

The person who owns the business has to justify that the payments, and any other benefits, were reasonable. This will usually mean providing information about their hours worked, and comparing it to market rates.

To see how compensation compares, you can search for wage data by occupation at the Alberta Government's OCCinfo webpage: https://alis.alberta.ca/occinfo/ or look up job profiles in the Canada Job Bank: https://www.jobbank.gc.ca/career-planning/search-job-profile

Personal benefits

When you own a business, many of your personal and business expenses might overlap. For example you might use your vehicle, cell phone, and home for both purposes.

In relation to support, courts try to figure out how much of the amount deducted as a business expense benefitted the owner personally. That way a business owner isn't paying less support than someone with equivalent income who's only an employee but can't deduct the same expenses.

For example, let's say a person uses the same cell phone just as much for work as they do personally. If they deducted the entire expense, then we should add part of that expense back to their guideline income.

In family law, when we refer to personal benefits we're talking about something different than what an accountant would consider personal benefits. Accountant sees personal benefits as additional compensation that an employer reports. What family courts are essentially looking for though, is the portion of an expense that a person can claim because they're self-employed, which they wouldn't be able to deduct had they only been an employee.

Just because the Income Tax Act or the CRA allows an expense, doesn't mean that the family courts can't add part of that expense back.

The person who owns or controls the business has to prove that each of their expenses are reasonable. This is sometimes referred to as Cunningham or Sweezey disclosure, or a Business Expense Statement. This could mean explaining each category of expense, whether there was any personal benefit, an estimate of how much, and how the personal portion was calculated. It's not enough to just provide a letter from an accountant saying that all expenses were properly deducted.

While the law isn't quite settled, it may also be that we have to gross-up (increase) the personal benefit by the amount of tax that they didn't have to pay. This is because support is calculated based on pre-tax income, and we typically add tax to tax-free payments so that we can properly compare their spending power to that of a normal employee's.

Undistributed profit

After expenses are deducted from revenues, a corporation may have leftover profit. Some of that profit will usually pay taxes, and the remainder is often paid out as wages or dividends to the owner. But sometimes not all of the profit is paid out, and we refer to that remainder as the undistributed profit.

Courts can add all or part of that undistributed income to a person's guideline income when calculating support. The amount that's added back is the pre-tax net income, less dividends. That means that it's the amount before taxes, because child support is calculated based on gross or before tax incomes.

When determining whether to add-back any of that undistributed profit, courts may consider the Kowalewich factors (as cited in Chekowski v Howland, 2013 ABCA 299 at para 12):

  1. The nature of the company’s business
  2. Any evidence of legitimate business
  3. The fact that funds need to maintain the value of the business as a viable going concern are not available for support purposes
  4. The expansion of the business
  5. Depreciation
  6. Possible economic downturns
  7. Return on invested capital

Courts may also consider (Koester, as cited in Chekowski v Howland, 2013 ABCA 299 at para 13):

  1. Because of the separate legal entity of the corporation, should there be a general reluctance by the court to automatically attribute corporate income to the shareholder?
  2. Is there a business reason for retaining earnings in the company?
  3. Is there one principal shareholder or are there other bona fide arm's length shareholders involved?
  4. What is the historical practice of the corporation for retaining earnings?
  5. What degree of control is exercised by the spouse over the corporation?

There are many other courts decisions setting out potential factors to consider. It usually comes down to whether the owner can actually withdraw the funds (for example, were the funds used up for a legitimate business purpose such as meeting debt payments or expenses), and whether there's a strong reason for leaving funds in the company. In practice, many judges default to including the entire amount, unless they can be convinced that there's an extraordinary reason against doing so. Pressures faced by all businesses such as uncertainty usually won't be a sufficient reason.

When it comes to spousal support, it may not be appropriate to add back any compensation beyond a reasonable salary if a spouse has already been paid out for their share of property, because otherwise it would be double-counting. Double-counting usually isn't a concern when it comes to child support though, although when income significantly exceeds $150,000 courts don't necessary need to award the full amount of child support, where the amount would exceed even a wealthy child's reasonable needs.




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Content by Ken Proudman (Edmonton)

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