Gord Krofchick, a forensic accountant, fraud investigator, and business valuator in Toronto, answers:
One of our most common assignments in a family law context is the calculation of income for support purposes. This is often referred to as an income valuation, support calculation or income determination. Because self- employment allows for numerous deductions that reduce taxable income, spouses that own their own businesses will often report earnings on their income tax returns that may not accurately reflect their lifestyles. This can pose problems when couples go through a divorce because one of the objectives of support payments, which are based on the Federal Child Support Guidelines, is to establish a fair standard of support.
There are typically two ways that income is under reported: overstating expenses and undeclared revenue.
The Guidelines provide a number of examples of expenses that should be added back or adjusted in order to give a truer representation of the income a spouse has available for support payments. For example, spouses that employ friends or family members and pay them wages over and above market rates for the same work will have to restate these wages when calculating their income for support purposes; we’ve also encountered spouses that deducted rental expenses for storing files or supplies in their own homes, and these expenses would also need to be added back. Any personal expenses that a spouse has been paying through their business are also included in their income, as well as an additional amount that reflects the benefits they received in doing so by paying lower taxes.
Unfortunately, the Guidelines make no mention of any provision for undeclared income. Some spouses conduct some or all of their business activities in cash and there may not be a paper trail recording these transactions. Income Tax Authorities will assess a taxpayer on unreported income using a net worth assessment to show that the income they reported could not account for their lifestyle or the increase in their personal equity (their assets, less their liabilities). The challenge with unreported revenues lies in presenting a convincing enough argument that this additional income exists; if you can make the case compellingly enough the Courts will often impute some additional income. Making this case often relies on evidence that demonstrates your spouse’s lifestyle, including reviewing their bank and credit card statements, mortgage payments, and credit applications to see if their stated income supports their obligations and their standard of living. Attention has to be directed to the assets and liabilities at an opening and closing period and the resulting changes therein.
Finally, if after all of the above, the Courts find that your spouse’s income as calculated using the adjustments set out above doesn’t fairly represent the income available to them for the purpose of child support, and if they are a shareholder or director of a corporation, the Courts can impute some or all of the Corporation’s net earnings to their income. This is a helpful provision even in cases when income hasn’t been historically under reported; sometimes, spouses will continue to pay themselves a management salary but leave additional earnings in a business to try and reduce the income available for support. However, unless they can demonstrate that their business needs these funds perhaps for a future expansion or the purchase of new equipment – the Courts may reject these attempts to shelter funds when they could easily be withdrawn by the shareholder and available for support.
Gordon Krofchick, CA, CBV is President of Krofchick Valuation Partners and is a forensic accountant with over 30 years’ experience in working with issues that impact a matrimonial separation, divorce, or other complex financial and litigation issues.