Divorce leads to small business headaches

The situation

Twelve years after a long-awaited City Hall wedding, George and Javier* have decided the spark is gone. The breakup has been amicable, and neither is in a rush to divide assets. They have no children. But George (47) and Javier (59) are not just married; they also co-own a successful consulting business in Vancouver.

Javier is the principal, and he incorporated the company 20 years ago. He wants to retire within the next two years, and has been paring back his hours. His book of business grosses $1 million per year.

George had always worked odd jobs, and started doing bookkeeping and administration for Javier six years ago. As he spent more time in the office, George found he had a knack with clients, and decided to get his management consultant certification. That paid off and, over the last two years, he’s amassed a small book that grosses $250,000 per year.

The pair neglected to amend their shareholder agreement to reflect George’s contributions, so Javier continues to hold 100% of the shares.

As part of Javier’s exit strategy, he’d planned to give his shares to George using the spousal rollover provisions in the Income Tax Act. Those provisions would have allowed Javier to avoid realizing a capital gain on the shares and, in the eyes of CRA, George would have bought the capital property for the same amount that Javier had sold it for.

Now, their impending divorce has thrown a wrench in things. For instance, they don’t know what to do about the shares.

In terms of assets, the couple owns a condo on the waterfront and has modest investments, since they’ve always plowed money back into the business. Javier has a TFSA of $40,000, and George has a $50,000 TFSA and $20,000 RRSP.

Given that they both want the best for each other, what can be done to rewrite their shareholder and succession plans? Should they delay their official separation for the sake of tax efficiency?

A strategy for a tax-deferred exchange of shares

Jennifer Poon, Director, Tax and Estate Planning, Wealth, and Jeffrey Waugh, Director, Wealth & Insurance Tax Solutions, Sun Life Financial, look at the tax implications of transferring Javier’s assets to George. Read More

The experts

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Divorce now or later?

Kassar: The tax rules allow for separating spouses, or spouses that are part of the divorce settlement, to transfer assets between each other at the cost base without triggering taxes, if it is part of an agreement or court order.

The separation agreement, divorce agreement or court order would dictate how they’re going to separate those assets. It would dictate, for example, that they’re going to pass 50% of the shares to George. The Income Tax Act allows this to be completed as a transfer at the cost base. If it’s just a matter of transferring shares from Javier to George, there is no tax implication.

Separation agreement

Glanzberg: If they were given tax advice saying, “You’d better do this before you’re officially separated,” then, absolutely, they could hold off on the divorce. They could take as long as they want for the divorce and just do the separation agreement beforehand. A separation agreement can be done anytime. Now, it doesn’t always work. You could spend a few months negotiating back and forth in the hopes of coming to an agreement and it could totally blow up. Some clients get pissed off because they spend a fair bit of money and time turning their wheels with no results, and they’re left with, “Well, I guess we’re going to court.”

A ton of people get separated and divorced and never see a lawyer because they speak to one another. The truth is they could use an online boilerplate separation agreement, or even write one on a bar napkin if they really wanted to. Ideally, you always want a witness to confirm that you and your partner, or ex, signed an agreement.

Even if you don’t use a lawyer to draw up the agreement, it’s most important to get a certificate of independent legal advice. That’s a certificate at the back of the agreement with a lawyer saying, “I’ve given so-and-so advice and, in my opinion, they understood what I was advising them; they understood the content of the agreement; they did not appear to be under duress, and they signed it willingly.”

Then, the party does a confirmation below the certificate, saying “Yes, I, Javier, do confirm that the lawyer gave me this advice, and I’m signing this.”

You want this so that, five or 10 years down the line, they don’t come back and challenge the agreement, saying, “I had no clue what I was signing; I wasn’t represented; I was forced to do this.”

A signed agreement is a valid contract between two parties, and you’re entitled to get it entered in court. You don’t need to start a court action—it’s the court stamp on it that provides more air of authority on the document.

Split the corporation?

Kassar: Javier would like to retire, but George would probably like to continue working so it makes sense for them to split the corporation. They should speak to a tax lawyer about completing that transaction prior to getting a divorce.

Javier may have accumulated some assets. The consultancy has been generating a million dollars per year recently. They’ve put money back into the business, and the fact that they have very little personally tells me they must have accumulated a substantial amount inside the corporation.

It comes down to how they would like to transition the business. Are they going to continue to operate as business partners? Is George going to buy out Javier over time? They need to decide on a share split. Javier cannot just give all his shares to George, because he would have not enough to retire on. He will want the passive assets and passive income to fund his retirement.

Caulder: Twenty percent of the company might be worth $200,000. As a rule of thumb, consultancies can be sold for 1x revenue, but it depends what kind of consulting they do.

Kassar: One possibility is that George will get the business and the clientele list, and he will continue to operate the active side of the business while Javier takes passive income.

They each get what they want out of it. Otherwise, Javier only has $20,000 in an RRSP and a small TFSA. He wouldn’t be able to retire on that.

If George and Javier decide they do not want to operate as partners in one corporation, they can split it into two. There is a strategy that can be implemented referred to as a butterfly transaction. It’s not called a butterfly in the Income Tax Act, but that’s what the professionals refer to it as.

There are two types of butterfly transactions: one for related parties, what’s called non-arm’s-length parties; and one for non-related parties, or arm’s-length parties. If they do this while they are married, it’s easier to complete and has fewer restrictions.

Float like a butterfly

Caulder: Javier will probably want to keep his 80% or whatever they decide. Assuming that, one imagines doing what’s called a single-wing butterfly. First of all, George is given these shares under the spousal rollover provision, so he’s got 20% of the company.

13.9%

The percentage of the Canadian population aged 15 and over who lived alone in 2016, up from 1.8% in 1951

Source: Statistics Canada

Then George forms a new company. Then we engineer a series of transactions so that you end up with a situation where the new company is both owned by, and has shares in, the other company. After the cross-share ownership happens, you redeem both sides of the transaction, so that there is a break, and Javier goes away with his original company being 20% smaller and George has his new company with his 20%.

In this transaction, you’re depending on what’s called the inter-corporate dividend exemption. Generally, married and divorcing couples can divide up their assets amicably, or at least pursuant to a negotiation, without having to write a bunch of cheques to the Tax Department. Outside of this exemption, the Income Tax Act has an anti-avoidance provision, called Subsection 55(2), that’s very scary.

It’s a provision allowing the tax authorities to say, “I know you guys think you’re having inter-corporate dividends, but we have the right to look into this thing and decide, up to three years after the fact, that we think the transaction was more in the nature of a capital gain than a tax-free dividend.” Kaboom: not tax-free at all.

People go to tremendous lengths to anticipate that. A lot of parties spend money to go to CRA for an advanced ruling. In an arm’s-length deal, if you and I were selling things to each other, it would be a big risk. If this was a brother and sister breaking up a family business, there’d be all kinds of concerns.

But this sounds like a clean deal, because they have that marital relationship.

What Javier and George need to decide

Do they write their own separation agreement?

If so, include their plan for the business and get it approved by lawyers with a certificate of independent legal advice.

What’s the share split on the corporation?

Is it 80-20, 50-50, or another split? They need to include the share split in their separation agreement, the terms under which George will pay for his shares, and/or how many shares he’s entitled to without paying for them.

Do they want to remain as business partners, or create separate companies?

If they do not want to remain as business partners, they could do a butterfly transaction, which is easier while they’re still married.

Dividing the assets

Glanzberg: There would be practical issues as to whether George could actually pay Javier for the shares. George may have only been working the last two years as a consultant, so he might not have a lot of savings or equity to buy out Javier’s shares as part of a separation agreement.

If the parties had the business valued, there would be a presumption that, by giving George X amount of shares, you’re transferring him X amount of dollars.

If it’s a consulting business, most of the goodwill and value of the company comes from the consultants themselves. So, with Javier out of the picture, those shares could perhaps be worth a lot less.

Shareholder agreement

Kassar: There will come a point where George is doing all the work and growing all the value in the company, and 50% (or the other share) of that growth and effort would be going to Javier. There needs to be an understanding that they are comfortable with whatever split they want to do, and those terms need to be defined in a shareholder agreement.

Caulder: Management consultants are creatures who live and die by their client relationships. Typically, these businesses don’t have a lot of tangible assets. Nor is it realistic or possible to contractually assign clients to an individual. The issue of whose client is this, and who owns it, can be very divisive.

That’s why people recommend shareholder agreements. A shareholder agreement needs to contain clauses and language that address the deterioration of the relationship. Agreements have to talk about what if so-and-so fails to show up for work, or what if he becomes abusive, or starts drinking? You have to define conditions of default.

Most shareholder agreements don’t do that because it’s difficult. You’re not inclined to do it while everybody’s enthused about the future. In theory, we can talk about how shareholder agreements should cover all these things, but then you’re getting to 50 to 75 pages in length, and you can figure about $500 per page. So, people just cut it, even though the agreements are worth the trouble.

What about the condo?

Gordon Caulder: Waterfront property is like gold, so there is going to be, possibly, a huge value allocation to the condo. It might even be more than the value of the business. Out here in Vancouver, you get the 58-year-old guy who just lucks out, ends up with a house with a nice desirable address that’s now worth $4 million—and his business is worth nowhere near that much. That’s a tax-free $4 million thanks to the principal residence exemption, assuming he’s lived there all the time.

The big issue is: How do we replicate that lifestyle with two households instead of one? The answer is, you don’t. You can’t. That’s a real shock to a lot of people. People get divorced and think their lifestyle won’t be impacted, but it sure will be.

I see the occasional husband who’s got the expensive house and hangs on to it because he wants it. But, in order to have it, he mortgages the hell out of the place to write his ex a check. That becomes a huge financial strain down the road.

Stephen Glanzberg: [For] any marriage, at least here in B.C. and in Canada generally, the presumption is a 50-50 division of all assets. B.C. is unique with its Family Law Act that defines family property as any property that even one spouse has an interest in.

While the presumption is 50-50, in law you can always rebut a presumption. For instance, if it was a short-term relationship, would it be unfair to divide things 50-50? Another classic one is, “I was the only one contributing to and maintaining the asset, so it would be unfair to split it 50-50.”

The B.C. Family Law Act now recognizes anything that you come into the relationship with, as excluded. The classic family law scenario used to be, “I had this million-dollar home that’s all mine, I get married, and voila, a week later, I’ve lost half my home.” Excluded property is anything you come into the relationship with. That will always be yours.

*This is a fictional scenario. Any resemblance to real persons is purely coincidental.

A tax-efficient strategy for expanding her business

Jennifer Poon, Director, Tax and Estate Planning, Wealth, and Jeffrey Waugh, Director, Wealth & Insurance Tax Solutions, Sun Life Financial, look at the tax implications of transferring Javier’s assets to George.

For this case study, we’re refraining from commenting on family law, specifically concerning the calculation of net family property, in accordance with British Columbia’s Family Law Act. The comments provided relate to the tax implications of transferring assets between divorced spouses, specifically transferring Javier’s shares to George.

Succession plan assumptions

Before moving forward with some ideas about deferring taxes during this exchange of shares, we first need to look back at Javier and George’s divorce situation, make some assumptions and ask a few questions.

We’re assuming that:

• Javier wants to receive fair market value (FMV) for his shares.
• Since the separation is amicable, there will be continued communication (but perhaps not a working business relationship between George and Javier).
• Javier will require capital or cash flow for retirement.
• The couple may require a business valuator to determine the FMV of the shares.

And, we wonder:

• Does George have the cash flow to pay Javier for the purchase price for his shares?
• Is the corporation a qualified small business, and does Javier qualify for the lifetime capital gains exemption on these shares?
• Would Javier’s shares be included in the net family property calculation? This must be considered in their succession plan.

Tax-deferred exchange of shares

Typically, when transferring shares between two non-arm’s-length parties, it’s rare for the purchasing party to have the funds needed to pay for the shares. We can also assume that the seller doesn’t want to trigger any capital gains. In this particular case, we can work with the lawyers to include the shares as part of the equalization payment Javier may need to pay to George.

What can Javier do to facilitate the transfer of his shares to George? He may want to consider an estate freeze using a section 86 reorganization. How would that work? Well, at a very high level, Javier would exchange all his common shares in the corporation for new preferred shares. The new preferred shares would have an adjusted cost base (ACB) equal to the ACB of the old common shares.

They would also have a redemption value equal to the fair market value (FMV) of the old common shares. Since Javier is exchanging his common shares for preferred shares of equal value, there’s no capital gain. And because the preferred shares have a fixed redemption value, Javier’s capital gains liability is also fixed at its current level.

What about future growth in the business? As part of the reorganization, George will receive new common shares in the company. Those shares will be worth nothing at the outset, because the company’s current value will be in Javier’s preferred shares. But if the company grows in value, George’s shares, not Javier’s, will grow in value.

This is a tax-deferred exchange, as long as the following four criteria are met:

• The preferred shares must be redeemable at the option of the shareholder (in this case, Javier).
• The preferred shares should pay dividends at a reasonable rate.
• The corporation would not pay dividends to other classes of shares if doing so would jeopardize the corporation from redeeming preferred shares due to insufficient net assets.
• When the FMV of the net assets of the company becomes less than the redemption value, the preferred shares must become cumulative preferred shares. That means that if the company misses any preferred dividend payments, it can’t pay any common share dividends until it has paid all preferred dividends in arrears.

What’s the result from all this? Javier receives the value of his shares and a passive income stream for retirement, and George would be the only one participating in the future growth of the company. George’s shares may or may not have any voting rights, depending on the agreement between the two parties. And, over time, George can have the corporation redeem the preferred shares – payment for which will be treated as a deemed dividend to Javier.

When taking this route, it’s important to remember that either Javier or George could die at any time. In that case, they will need to have an agreement in place that lays out what happens to any shares they own at that point. A buy-sell agreement, or sometimes a clause that is part of the shareholders’ agreement, accomplishes this by outlining what will happen to each of the owner’s shares if either one dies. It may also cover what happens in other circumstances that could affect the shareholder’s ability to operate the business, like a disability or critical illness. The agreement will often state that the surviving shareholder will purchase the shares from the estate of the deceased. In order to make sure the shareholders have the money to do this, these agreements are typically funded with life insurance – often the lowest cost option.

Division of assets: Settling the condo

Special rules apply for transfer of property as a result of marriage breakdown:

• If the transfer of property is in settlement of property rights arising from a divorce judgment or agreement, there are no immediate tax consequences.
• The Income Tax Act also provides an exception for RRSP and RRIF withdrawals. Amounts in an RRSP or RRIF may be transferred from one spouse’s plan to the other’s, provided there is either a court order or a written separation agreement outlining the division of assets.

For Javier and George, transferring ownership of their waterfront condo (or selling it and allocating the proceeds between the two of them) would be relatively straightforward from a tax perspective, given that the home appears to be their principal residence and therefore exempt from capital gains tax.

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