Self employed

[Rioe]

Does anyone know how income splitting works in a separation / divorce process?

For 3 years of the company ex worked for company (only as an employee) and earned a small salary. She received a t4 annually and filed taxes as such.

Shortly after separating she started working and earns now more than double what she did when working under my company.

How does the income that she earned from the company get taken into calculations?

Also during the time of working for my company she did some other jobs on the side so each year she had at least 2 T4 statements.

Most calculations use CURRENT income, especially if income is steady and predictable. For example, if calculating her CS obligation, use her most recent pay stub.

It's only people whose income fluctuates that you should go back a few years to obtain an average.

[Desperate_Dad]

I found this post and it interested me as I have assessed income for many corporate owners.

I'm not saying what I suggest is what a judge will see but then again my experience in this area dwarfs any lawyer or judge.

Having said that, here is what I would do...

Get a copy of your corporate T2,

Look for two schedules - one is called Schedule 100 - this is your balance sheet - the other is called Schedule 125 - this is your income statement.

Schedule 125 shows your income, expenses and profit for accounting purposes. It could include personal expenses that were paid by your corporation that are not tax deductible. It is exactly the same as a Notice to Reader statement - This means that your income, expenses and profit has been compiled by an accountant.

Next look for Schedule 1. This reconciles Schedule 125 Income for accounting purposes to income for tax purposes. It starts with your after tax profit for accounting purposes and reconciles it to the before tax profit for tax purposes. Some common addbacks to income is this reconciliation for you will be meals and entertainment expenses which are only 50% tax deductible. CRA's theory on this is that the meal for you is a personal expense but the meal for your client is a legitimate business expense.

All of the other expenses you have listed look like legitimate business expenses to me and should not be added back.

Once you see the before tax profit for tax purposes, look for the corporate tax that you actually owed on that income and subtract it from the profit for tax purposes.

You now have your after tax profit for tax purposes. Then you must grossup this amount by 18% and enter it on line 120 and line 180 of the T1. This is an imputed dividend to you of your actual income.

Next look at the salaries and wages on schedule 125. Assuming you and your ex were the only two employees, this figure will represent your salaries plus the employer CPP contribution. Corporate owners owing over 40% of the voting shares of a corporation pay no EI. Carve out the employer CPP and enter the salries for you and your ex on line 101 of your T1. The income split will be imputed to you unless you make the case that since your ex is no longer doing your accounting work that you will have to hire an accountant to do it and thus incur more professional fees expense.

You can then work through the numbers with any electronic tax package to determine what your tax liability will be an what your true after tax income would be. The tax program will calculate the proper tax, CPP contribution, personal exemptions and also work out the dividend tax credit on your imputed dividend income.

An dividends you paid to yourself are irrelevant as you have imputed your dividend payment. The problem in using actual dividend payments received is that you can pay yourself any dividend payment you want. You could pay yourself more or less than you actually make.

That's my two cents worth. If you have any questions about what I have written, I would be hapyy to answer them for you.

[arabian]

Excellent breakdown and explanation Desperate Dad!

This should be a "sticky" for self-employed people as these questions are asked frequently.

I can remember being with my lawyer and my ex and the judge and the lawyers and the judge got into a very detailed discussion and I have to admit that I "zoned" out for a bit. Your post clarifies things nicely. We had alot more things to deal with (personal services contracts; heavy equipment and depreciation - who owned what etc.). I recall in my situation there was much discrepancy over ownership of equipment and who owned ongoing "contracts" etc. It was a nightmare for me.

[Desperate_Dad]

Thanks for the compliment Arabian.

There are obviously more issues with self employed people and a real thorny issue is depreciation. (It may be called capital cost allowance or amortization). I have seen Judges add this expense back to income and their reasoning is that it is a "non cash" expense. I strongly disagree with this assessment by Judges and here is why.

Depreciation refers to a capitalized expense. In layman's terms this means an expense incurred where the asset purchased is expected to last a number of years. A good example would be computers. You are not allowed to deduct the whole expense when the computer is purchased. Instead the computer equipment is shown as an asset on the balance sheet and is gradually written down over the period of its useful life. This is a legitimate expense that should NOT be added back to income.

However, there is the possibility a self employed person could manipulate the depreciation so it is exorbitant. For example, purchasing a new company car used for the business every year. As most people know, cars depreciate faster at the beginning than when they get older. This can allow a self employed person to inflate the depreciation expense unreasonably in order to pay less support. A decent forensic accountant can spot this scam a mile away by analyzing the financial statements over a period of years.

Income assessment is difficult especially for self employed people and in my view most lawyers waste court time and their clients time because they don't understand what they are looking at.

Again if there are any questions regarding self employment assessment of income, I would be pleased to answer.

[momof2teenboys]

I've looked at Canlii for examples of cases that could be similar to my own and see that the judges do tend to be conservative in allowable expenses but there doesn't seem to be a set way to determine the biggest ones - largely, it's still up to a judges discretion.

I know in my case there will be a few issues that stbx will have issue with -

Computer equipment - what would be reasonable way to show this as a necessary business expense? And how much $$ spent would be considered (while married we budgeted for a new system every 5 years)
Car expenses - working 90% from home office, if car is leased? Would you ask for detailed mileage log? gas receipts? What monthly lease $$ is reasonable?
Meals/Ent - Is asking for the receipt with contact details of client reasonable? (stbx eats out every meal and says it was while working??)
Home office expenses - 90% of work is done at home but there is no dedicated office. Room is shared with another home business and doubles again as a bedroom for one of our kids when he visits. What would you ask for and how would you determine what is allowable? home is a rental so no mortgage.

I think the biggest challenge will be asking for the needed documentation and getting it. I'd like to have as much knowledge as possible before providing our own assessment of income as I know he will also be putting together his own version.

Thanks - this is all really helpful!

[arabian]

momof2teenboys - I was very aggressive in not agreeing to manyof my ex's items when determining income. Judge agreed that ex's legitimate operating expenses had to specified and corroborated by original receipt annually (written in divorce Order). Home use of business was not allowed, nor was any use of personal vehicles or meals. Ex was in trucking business. He very well was able to claim many expenses on his taxes but my position was, and always has been, that how he files his income tax is of no concern to me as long as he is self-employed.

If you say 90% of your work is out of home then why do you think you should be able to claim vehicle expense? I'd disallow that. Meals - if 90% of your work is done at home then why do you think meals are a business operating expense? I'd disallow that.

I think a good rule-of-thumb is to consider what expenses are necessary for carrying out your business. Is the anticipated expense NECESSARY to make income....

Desperate Dad will have a much better way to explain this I'm sure. I'm certainly no accountant, rather an ex-wife of a very devious individual who embraces litigation and who likes to try to claim anything and everything... if he could claim his television cable bill he would.

Desperate Date - we fixed his bacon with equipment depreciation by simply letting him say that the equipment he took was his asset and disallowed finance payments as equipment was solely his at end of finance contract. This totally threw him for a loop, particularly as equipment was 100% paid for and he attempted to submit phony sale contracts for equipment from family members. He was able to get away with this with CRA though as he was never audited as far as I know. He also predictably submitted false receipts (gathered from friends) for repairs and maintenance. Fortunately when we were in business together we had vendor accounts set up (invoices/statements). His dishonesty showed through and only hurt him in the end as the wording of the divorce Order gave me ability to simply discard receipts not corroborated. He soon learned to use established vendor accounts. I also caught him having fellow truckers putting work through his vendor accounts to try to claim expense.... he neglected to examine the invoices carefully and note that equipment serial/VIN numbers are recorded as well as mileage. LOL.

[Desperate_Dad]

There are so many issues here that I will have to deal with them one at a time. Lets start with computer equipment and software which is CCA Class 50.


The depreciation rate has gradually increased from 30% to 55% in the last few years with the exception of a period between 2009 and 2011 when CRA allowed a 100% writeoff.


Most depreciable is calculated on a declining balance to more accurately reflect its value at any given time.


Imagine you purchased 10,000 of computer equipment. This would be capitalized and shown as an asset on the balance sheet. The CCA allowed would be calculated as follows and show as an expense called depreciation, amortization or CCA on the income statement.


Year 1 CCA 5,500 (10,000 * 55%)
Year 2 CCA 2,475 (4,500 * 55%) 4,500 is the 10,000 less 5,500
Year 3 CCA 1,113 ((2,025 * 55%) 2,025 is 10,000 - 5,500 - 2,475)


Now for purposes of income, if you and your spouse determine that 5 years is a reasonable length of time for computer equipment (and I think that is reasonable), you may propose employing a straight line method of depreciation - in other words 2,000 per year.

If that's the case, in year one, you add 3,500 back to income. 5,500 was allowed by CRA but 2,000 was acceptable by you and your ex.


My personal opinion is that the writeoff CRA allows should be allowed each year as long as the computer equipment lasts over the expected lifetime (you and ex agreed on 5 years)


As mentioned in my other post, there is the risk of someone attempting to keep the depreciation high - in other words, selling the old computer hardware and software after a year or two and purchasing new equipment when it wasn't needed.


What you need to look for is an expense called "gain or loss on disposal of asset" on the income statement.


Using our example above, say the computer equipment was sold after the first year. The book value of the computer equipment is 4,500 (10,000 cost less 5,500 CCA). Lets say it is sold for 3,000. What would happen is this...

The asset on the balance sheet would disappear and an expense of 1,500 (4,500 - 3,000) called "loss on disposal of asset" would appear on the income statement.


This is a flag that a capitalized asset has been sold and you can request the CRA form which describes additions and disposals of capital assets to determine what was bought and what was sold and whether it was reasonable to do so. Once you get the right documentation any accountant can tell you what has happened.


At this point, you probably understand more than any judge or lawyer does. They are simply not qualified to deal with complex financial information.

[momof2teenboys]

Desperate_Dad - Thank you! That actually does make sense.
I couldn't wrap my head around how to allow for the purchase of an asset, ie. computer, CCA and adding back what would be reasonable to determine income.

Arabian - I'm going to need to be very aggressive with many items I am sure. But having the knowledge before going in (and I agree most lawyers really don't get this) will save a lot of time and keep my expectations in check.

Would either of you recommend hiring an accountant to work on this? I don't want to get into letters back and forth between lawyers and negotiating what he thinks vs what I think and ultimately having to go to court to have a judge determine things. If I had an accountant go through tax returns and the books right away I would know what the actual income is? Is this something an accountant would offer as a service?

[ross_toronto]

Desperate_Dad - Thank you! That actually does make sense.
I couldn't wrap my head around how to allow for the purchase of an asset, ie. computer, CCA and adding back what would be reasonable to determine income.

Arabian - I'm going to need to be very aggressive with many items I am sure. But having the knowledge before going in (and I agree most lawyers really don't get this) will save a lot of time and keep my expectations in check.

Would either of you recommend hiring an accountant to work on this? I don't want to get into letters back and forth between lawyers and negotiating what he thinks vs what I think and ultimately having to go to court to have a judge determine things. If I had an accountant go through tax returns and the books right away I would know what the actual income is? Is this something an accountant would offer as a service?

I used a CRA who was also a forensic account to assist me in determining income. My case was fairly simple (a small business with just one person working but claims for almost everything). Once I finally got enough disclosure to work with (which was my main stumbling block) the accountant spent a few weeks with the data and came up with a income estimate in a very easy to read report. The expenses were reviewed one by one and he indicated if each should be used to determine income or not. It cost me about 3K. In my case it was not as beneficial as I had hoped (there was no gold found in those hills despite certain appearances) but it did give me the facts I needed to settle outside of trial. The report was written assuming it would eventually be put in front of a judge but in the end we never needed to have a judge review it as it was close to what my Ex was willing to self inpute to.

[momof2teenboys]

Our court order has all the documentation listed that I am to receive in July - but, just judging by behaviour over the past two years, it is very likely we'll be back in court for a motion to compel him to actually provide everything. I don't want to spend more wasted money on a "war of letters" between the lawyers - would rather spend that preparing for trial that's already scheduled for the fall.

Even with a simple single-shareholder/employee business it can get complicated and expensive if that person is expensing everything (who is ridiculous enough to put an airbnb charge on their corporate credit card and swears under oath that he and a girlfriend needed to go away for a weekend for business?) and is determined to spend more and more time dragging their arguments out through the family court system. He is still digging in his heals with the mantra "you can't tell me what to do!"

For me, I find having a clear understanding of what an accountant would be detailing in a report is important. I also find it really helpful to have a reality check so my emotions are no longer leading me through all of this.

It's interesting that what seems to be allowable through CRA is not even close to what family law allows for determining income.

Desperate_Dad - what would you look at to determine what's reasonable for vehicle and home office expenses? Both are leased/rental so no CCA correct?

[Desperate_Dad]

First of all Ross_Toronto...

A few weeks to put together a report? Trust me, it doesn't take that long. The most time I ever spent assessing an individuals income was 5 hours but that was a construction owner who had ownership or part ownership in 34 corporations. To assess most corporate owner's income, I would have an answer within an hour assuming I have all the information I needed in front of me.

momoftwoteenboys

Home office expenses can be tricky. Clearly CRA allows a writeoff based on the percentage square footage of the office compared to the home but a Judge might not see it that way.

The big question to ask is this...

"If the home office was not there, how would expenses be affected?"

Lets take two examples...

1. Mortgage Interest - Would someone really move to a smaller home that didn't have a home office if one was not needed? Likely not. They would use the extra space for personal use. Therefore I would support an addback of mortgage interest or rental income as the case may be.

2. Utilities - Since you are actually using the utilities more since you have a home office, these expenses would be affected by the lack of a home office. I would not support an addback in this case.

So for any home office expense you see that is being claimed, ask yourself the above question and that should help you determine whether it should be an addback or not.

[momof2teenboys]

Thank you!

[Desperate_Dad]

There actually seems to be alot of interest in this topic. I got this question from someone. Essentially it said "You talk about imputing the after tax profit and grossing it up but the child support guidelines talk about pre-tax profit and if I do what you say the court will never accept it"

This is a legitimate question and it deserves to be answered. So what I will do is copy the child support guidelines relevant sections and comment on each one.

16 Subject to sections 17 to 20, a spouse’s annual income is determined using the sources of income set out under the heading "Total income" in the T1 General form issued by the Canada Revenue Agency and is adjusted in accordance with Schedule III.

My comment - Income is not Line 150 of your T1 tax return especially for a self employed person. We already know that.

17 (1) If the court is of the opinion that the determination of a spouse’s annual income under section 16 would not be the fairest determination of that income, the court may have regard to the spouse’s income over the last three years and determine an amount that is fair and reasonable in light of any pattern of income, fluctuation in income or receipt of a non-recurring amount during those years.

My comment - I'd be ok with this. Self employed income can fluctuate year to year and a three year average could be more representative of actual income.

18 (1) Where a spouse is a shareholder, director or officer of a corporation and the court is of the opinion that the amount of the spouse’s annual income as determined under section 16 does not fairly reflect all the money available to the spouse for the payment of child support, the court may consider the situations described in section 17 and determine the spouse’s annual income to include

(a) all or part of the pre-tax income of the corporation, and of any corporation that is related to that corporation, for the most recent taxation year;

My comment - You could use the pre-tax income of the corporation which would be located on Line 300 of the T2 however this amount would NOT be grossed up. I've seen this done before and then the income was grossed up which is completely wrong. Lawyers and Judges do not seem to understand the purpose of the grossup. Lets take a simple example to illustrate.

118,000 Before Tax profit of the corporation
18,000 Income Tax
100,000 After Tax Profit of the corporation

The purpose of the grossup is to bring the after tax profit back to the before tax profit on the T1. So if you work with the before tax profit of the corporation, no grossup. If you work with the after tax profit of the corporation, it needs to be grossed up 18%.

or

(b) an amount commensurate with the services that the spouse provides to the corporation, provided that the amount does not exceed the corporation’s pre-tax income.

My comment - This really makes no sense. I assume they mean voting shares of the corporation. For example if someone only owns 33 1/3% of the voting shares of the corporation then you would work with 1/3rd of the before tax profit.

(2) In determining the pre-tax income of a corporation for the purposes of subsection (1), all amounts paid by the corporation as salaries, wages or management fees, or other payments or benefits, to or on behalf of persons with whom the corporation does not deal at arm’s length must be added to the pre-tax income, unless the spouse establishes that the payments were reasonable in the circumstances.

My comment - I discussed this in a previous post. These payments would be imputed to the owner of the corporation and included on Line 101 of the T1 unless they actually did some work for the corporation and the owner can claim that he/she would have to hire someone to do that work now or have them continue that work at a reasonable salary.

(2) For the purpose of paragraph (1)(g), the reasonableness of an expense deduction is not solely governed by whether the deduction is permitted under the Income Tax Act.

My comment - I'm ok with this. In previous posts, I discussed home office expenses and depreciation where an addback may be warranted.

21 (d) where the spouse is self-employed, for the three most recent taxation years
(i) the financial statements of the spouse’s business or professional practice, other than a partnership,

My comment - I assume they are talking about self employed unincorporated. Just ask for the T2125 for the past 3 years. Note that if the business has a non calendar year end the T1 Line 135 or Line 137 will have a different amount than the T2125. In that case, the T2125 should be used not the T1.

and

(ii) a statement showing a breakdown of all salaries, wages, management fees or other payments or benefits paid to, or on behalf of, persons or corporations with whom the spouse does not deal at arm’s length;

My comment - This is important information to know to be able to impute a salary to the owner.

(e) where the spouse is a partner in a partnership, confirmation of the spouse’s income and draw from, and capital in, the partnership for its three most recent taxation years;

My comment - The draw is irrelevant. You can draw more or less than you actually make in income. Partnership income allocation is shown on form T5013 and either flows to the T1 Line 135/137 or to a corporation so those are the relevant documents you need. See my comments under self employed unincorporated or corporation for the documents you need.

(f) where the spouse controls a corporation, for its three most recent taxation years
(i) the financial statements of the corporation and its subsidiaries,

Financial statements means the T2 schedule 1 reconciliation of income/loss for tax purposes. schedule 100 balance sheet and schedule 125 income statement plus the individuals percentage ownership of the voting shares of each corporation. Schedule 50 shows the ownership of both voting and non voting shares and may not reflect the true ownership.

and

(ii) a statement showing a breakdown of all salaries, wages, management fees or other payments or benefits paid to, or on behalf of, persons or corporations with whom the corporation, and every related corporation, does not deal at arm’s length;

My comment - This is important information to know to impute a salary to the owner.

Ok that's enough for one night. I'll answer other questions I have received regarding self employment in subsequent posts.

[Desperate_Dad]

We all know lawyers are basically the most hated profession on the planet. They don't seem to understand why they are hated but there are many reasons. How about this one. Pretending to know something you know nothing about and charging people an astronomical fee to spout nonsense.

Check out this...

Why is my income for support purposes so much higher than my total self-employment income? | John P. Schuman C.S., Child and Family Law | John P. Schuman

This is what this lawyer thinks about self employed business owners income.

The law requires that an additional adjustment be made to take into account the tax savings that business owners can enjoy but salaried employees cannot. To accomplish this, the law does not just add back the amount of personal expenses or other amounts that do not appear on the business owner’s tax return, but also adds back the tax savings as well. This is called “grossing up” the support payers income for tax. For higher income individuals, this additional amount can be significant. The highest tax bracket is around 43%. This means that the law requires that for every dollar of income that the business owner is able to take off his or her tax return, $1.43 is added back to that reported income for support purposes. This is fair because the adjustments looks at how much money the business owner gets to put in his or her pocket and then bases support on how much a salaried employee would have to earn to have that same amount of money in his or her pocket.

My comment - He thinks the purpose of the grossup is to account for the tax savings business owners enjoy. What?!?!?!?

As you know from my previous posts, the purpose of the grossup is to convert the after tax profit to the before tax profit. Dividends are paid out of after tax earnings so you have to gross the dividends up by 18% (changing to 17% in 2016) to bring it back to the before tax profit which is called a taxable dividend on Line 120 and Line 180 on the T1. There is actually a second level of grossup which is 38% but this only affects business owners making more than 500,000. You may ask yourself...Isn't this double taxation? That is where the dividend tax credit comes in. The purpose of the dividend tax credit is to reduce your tax payable by the approximate amount that your corporation paid in tax. The only real tax advantages that business owners have over salaried employees are:

1. Ability to write off expenses
2. Tax deferral. In other words you can keep money in the corporation and don't pay the full amount of tax on it until you pay it out as a dividend.

So just imagine what this lawyer would do with a corporate owner earning 118,000 before tax or 100,000 after tax. He'd either grossup the 118,000 by 43% which would be 168,740 which is over 50,000 more than the real income or grossup the 100,000 by 43% which iwould be 143,000 or 25,000 more than the real income.

This would completely destroy a self employed payor. Unfortunately this lawyer seems to be the rule instead of the exception. You would be better off going into court completely naked with no documentation at all rather than having this guy as your lawyer.