Tax considerations for professionals that divorce: Dividing assets

The process of effecting a divorce can be complex and is often costly. Among other matters, it requires dividing assets between the ex-spouses and confirming any childcare or spousal payments.

There are also important income tax considerations when dividing  assets that a professional may own — including Registered Retirement Savings Plans (RRSPs), Tax Free Savings Accounts (TFSAs), a principal residence, and private company shares.

RRSPs and TFSAs

RRSPs may be transferred between spouses before or after a divorce is finalized without any income tax implications. The transfer must be between the RRSP accounts of the ex-spouses — otherwise any withdrawal from a RRSP account would be taxable as income in the year withdrawn. The ability to transfer the RRSP between spouses without triggering an income tax liability usually occurs when:

• spouses are living separate and apart,
• the transfer occurs pursuant to a separation agreement, and
• the transfer is made in settlement of rights arising on the breakdown of a marriage or common-law partnership.

TFSAs can also generally be transferred on the break-down of a marriage from an ex-spouse without affecting either individual’s contribution room, provided the transfers are done directly between TFSAs and not first withdrawn by one spouse.

Real estate assets

The family principal residence is often one of the most valuable assets to consider when dividing assets.  It is therefore important that a separation agreement cover various tax matters relating to the principal residence, including who clan claim the principal residence exemption (PRE) if multiple personal properties are owned during marriage and continue to be owned upon divorce.

Generally, a disposition of a principal residence is shielded from income tax because of the PRE. A married or common-law couple may only claim one PRE amongst themselves for each year of marriage. If a divorcing couple owns multiple properties, the first spouse to file a tax return and claim the PRE on a specific property may negate the other’s ability to claim the PRE for another property during the same period. Given the tax-free nature of selling a principal residence, this could potentially lead to a very unfair result for one spouse.

Also, if a property is transferred on a tax-free rollover basis to an ex-spouse, it is possible the recipient can incur a capital gain in the future which is not shielded by the PRE ­— and that capital gain can be attributed back to the transferor. In this case, “attribution” would create a result where one spouse receives the sale proceeds with the other spouse assuming the income tax liability.

It is possible to avoid this issue by filing an election with the Canada Revenue Agency (CRA). The election prevents the income tax liability from being attributed to the spouse who initially transferred the property. Or, in other words, the spouse that receives the sales proceeds will be liable to pay the income tax liability.

Professional corporation

Often, much of the wealth for a professional is held in their professional corporation due to the ability to accumulate passive investments such as publicly traded securities. Therefore, on a divorce, the equalization of assets includes the value of a professional corporation.

Ideally, equalization will be possible, where the professional keeps their shares and value of their professional corporation and the ex-spouse obtains other assets — this avoids splitting up the value of the professional corporation, which can be complicated and expensive.

There are several options to consider if it is not possible to divide the assets without splitting the value of a professional corporation:

Redemption of shares

If both ex-spouses own the shares with value of the professional corporation (and if allowable under provincial regulatory rules for a particular profession), the simplest option is to redeem the shares held by the non-professional (i.e., the company buys back the shares). However, a redemption will likely result in a taxable dividend being deemed to have been paid to the recipient ex-spouse. 

Purchase shares

Another option is for the professional to purchase shares of the corporation from their ex-spouse. This may be beneficial to the seller if they can claim the capital gains exemption, as it could reduce or eliminate the income tax otherwise payable for the disposition of the shares.

Related party butterfly

The last option is referred to as a “related party butterfly.” Generally, a related party butterfly divides the assets owned by one corporation such that some would be transferred to another corporation owned by the ex-spouse on a tax-deferred basis. Each ex-spouse would then own their own corporation with their own assets on a go forward basis.

This could work in the professional context by, for example, having the professional ex-spouse keep the corporation with the practice assets and the non-professional ex-spouse owning the shares of the other private corporation with the non-business assets, such as publicly traded stocks. It may be possible to undertake a related party butterfly even if both ex-spouses did not initially own shares of the private corporation. Undertaking a related party butterfly requires adherence to many detailed tax rules so it is recommended that this be implemented by a qualified tax advisor.

Contact us

To learn more, contact Michael Saxe, CPA, CA, LLM, Partner, MNP Tax Services at [email protected] or Marty Clement, CPA, CA, Partner, MNP Tax Services at [email protected].