Often, when spouses separate, they may each own shares in a business which has been the main source of income for the family but operated by just one of them. In working out the details of their financial arrangements it will likely be appropriate that all of the shares be transferred into the name of the person who has been operating that business. The purpose of this Comment is to outline the major tax implications of transferring shares in a family owned business between separated or separating spouses. (For information about the tax considerations of transferring other assets between separating spouses, see the Article: Income Tax Implications of Transferring Assets Between Separated Spouses.)
Assume that Mr. X and Mrs. X each own 50 per cent of a family business corporation. The family business has a fair market value of $200,000 at the date of separation. The adjusted cost base (the original amount paid for the shares) of Mrs. X's shares is $1,000. As part of the settlement of matrimonial property rights, the parties agree that Mrs. X will transfer her shares in the business to her husband.
Mr. X could obtain 100 per cent control of the company in any of the following three ways:
Rollover of Mrs. X's shares to Mr. X on a tax-free basis.
Transfer of Mrs. X's shares to Mr. X at fair market value.
Acquisition of Mrs. X's shares by the company.
Tax-free Rollover of Shares
Shares in a private company may be transferred between spouses on a tax-free basis using a rollover provision set out in section 73(1) of the Income Tax Act. This automatic rollover (i.e. no election is required) can be used by spouses, or former spouses, pursuant to the settlement of rights arising from the marriage. Under this mechanism, the transferor (Mrs. X) is deemed to have transferred the property at proceeds exactly equal to her adjusted cost base of the shares. The transferee (Mr. X) is deemed to have acquired the property at the transferor's adjusted cost base. In our example, Mr. X would be deemed to have aquired the shares for $1,000.
Should the rollover provision be used while the spouses are married and living together, any income or capital gains produced by the property after it is transferred will be attributed back to the transferor spouse. The attribution rules are designed to prevent income splitting between spouses. However, attribution of income does not apply to the period in which the parties are living separate and apart by reason of marriage breakdown (no election need be filed). Attribution of capital gains does not apply to the period in which the parties are living separate and apart by reason of marriage breakdown providing both spouses sign a joint election. The joint election is filed with the personal income tax return of the transferor spouse for the taxation year in which the shares are disposed of or for any previous taxation year. No attribution of income or capital gains applies after a divorce is final. As a result, so long as the parties set out what they are doing and file the joint election, Mrs. X can transfer the shares to Mr. X and he will be the one responsible for all of the taxes for income or capital gains attributable to the shares. Parties will generally want to do this so that the person realizing the income or capital gains is also the one paying the taxes on them.
Transfer of Shares at Fair Market Value
It may be beneficial to elect that the transfer take place at fair market value when the transferor spouse has unused capital losses or capital gains exemptions. The transferor spouse may unilaterally elect that the rollover provisions of section 73 (1) not apply and will have a capital gain. The transferee spouse will acquire the shares at an adjusted cost base equal to fair market value. The attribution rules will apply as described above on a tax-free rollover of the shares. However, providing the transfer at fair market value is structured as a sale, the attribution rules may be avoided.
Section 74.5(1) provides that the attribution rules do not apply if all of the following conditions are met:
i) The transferor spouse elects not to take advantage of the section 73(1) rollover;
ii) At the time of the transfer, the fair market value of the transferred property does not exceed the fair market value of the consideration received; and,
iii) Where the consideration received by the transferor includes indebtedness, the debt bears a commercial rate of interest and that interest is actually paid not later than 30 days after the end of each year in which it becomes payable.
Acquisition of Shares by the Company
A corporation may purchase its shares for cancellation or redeem its shares. In our example, a purchase for cancellation or redemption of Mrs. X's shares would take place at the fair market value of $100,000. To the extent that the purchase price exceeds the paid up capital of the shares, the acquisition of shares by the corporation will result in a deemed dividend to Mrs. X. Based on a 36 per cent maximum tax rate for dividends in Ontario, Mrs. X would pay approximately $36,000 in income taxes and retain cash of approximately $64,000. This is slightly less than the tax that would apply to a capital gain on a sale at fair market value if the gain is not sheltered from tax. It also provides for the use of corporate funds to purchase the shares. Mr. X would then own 100 per cent of the issued and outstanding shares, however his adjusted cost base in the shares would not have increased.
This Comment is only a brief outline of some of the various tax considerations to which separating spouses should turn their minds when transferring shares in a family owned business. They should be sure they have a proper idea of the value of the asset being transferred and that they have received the advice of both a lawyer and an accountant to make sure that the deal they sign is the deal they thought they were getting. (Nothing in this Comment has dealt with the fact that there are different ways to value a business of the kind referred to above and that merely accepting a figure from the company's Financial Statements may not be the best thing to do.)
Bruce Roher, C.A., C.B.V., C.F.E., is President of Fuller Jenks Roher Inc., Business Valuators and Litigation Accountants. For further information, he can be reached at (416) 977-8692 or via E-mail at firstname.lastname@example.org