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Protecting your business interests upon separation and divorce

Many accountants will likely tell you that there are several tax advantages to incorporating your business, including the opportunity to income split with a spouse and the ability to maximize capital gains exemptions among family members upon a company’s dissolution or sale. To take advantage of these types of tax benefits, business owners may be advised to transfer shares in their companies to their spouses during their relationship, which makes sense at the time. If revenue earned through a corporation can flow into the hands of two members in the same household at lower tax rates while remaining on-side with the Canada Revenue Agency, why not? In taking this advice to transfer shares to their spouses, however, business owners rarely consider what will happen if their relationships break down.

In Ontario, married spouses who separate are expected to equally share the wealth that they accumulated throughout the marriage – both individually and through joint assets. The Family Law Act governs this division process, known as “equalization”. While married spouses can opt-out of equalization at any point during their relationship or upon separation, it otherwise automatically applies to the division of property upon separation of married spouses. “Property” in this context is very broadly defined to ensure that separated spouses leave their marriage with an equal share of the combined fruits of their labour.

As part of the equalization process, spouses must determine the net value of the property they each brought into the marriage as well as the net value of their respective property at the date of separation, including the value of any business interests. Although the value of business interests is shared equally, property equalization does not affect the legal ownership of the business itself.

Where a business owner-operator transfers corporate shares to their spouse during a marriage, the practical issue of removing the non-operator spouse from the business often arises after separation. Although the property equalization regime in Ontario provides for an equal sharing of the wealth accumulated during the marriage, entitlement to any ongoing growth or acquisition of wealth after separation is based on ownership. As a result, so long as a non-operator spouse retains ownership in the corporation, they are presumptively entitled to share in the ongoing growth or loss of the business regardless of their contributions or complete lack thereof to its ongoing operations.

Further, depending on the nature of the shares transferred to the non-operator spouse during the marriage, the value of their shares may outstrip those of the business owner-operator at the date of separation. It can then become exceedingly expensive – if not unaffordable – for the business owner-operator to repurchase the non-operator spouse’s shares or for the business itself to redeem these shares while maintaining its ongoing operations. The reacquisition of shares by the business owner-operator or the business itself may be governed by a shareholders’ agreement signed at the time the non-operator spouse is granted shares or by the corporation’s articles. Again, however, the nature of the shares granted to the non-operator spouse may dictate that the share buyout occurs at fair market value or else the corporation and/or its director(s) may be exposed to liability.

Importantly, property equalization applies to married spouses upon separation. Common law spouses are not subject to the same regime and, instead, must rely on equitable (or “fairness-based”) arguments if they want to share in the value or physical property of their spouses after separation. These equitable arguments typically flow from one spouse’s contributions to the other spouse’s property during the relationship. Ownership otherwise governs the division of property between common law spouses after a relationship’s breakdown, and there is no guarantee that they will share in the value of each other’s property upon separation.

In addition to the above considerations in the family law and corporate law contexts, issues in the realm of employment law may arise upon separation – regardless of whether a non-operator spouse owns shares in the business owner-operator’s company. Whether to facilitate income splitting through a corporation or simply assist in day-to-day operations, spouses often participate in each other’s businesses through, for example, bookkeeping and other administrative duties or in the form of manual labour. These contributions may not be compensated through direct payment or documented in any form of employment contract.

However, the absence of reimbursement for services rendered and/or a signed contract setting out the terms of this working relationship does not mean that no employment relationship exists. And where an employment relationship can be established based on the specific circumstances of the case, the Employment Standards Act as well as the common law and equitable arguments afford protection to the “employee” spouse.

For example, if an employment relationship is found to have existed between the non-operator (or “employee”) spouse and the business, the employee spouse may be entitled to unpaid wages if they did not receive appropriate compensation from the business both before and after a separation. Further, if the business owner-operator unilaterally decides to terminate the employment relationship following a separation, the employee spouse would be entitled to a period of notice or pay in lieu thereof and if the employee spouse is not an owner of the business, they may also have an equity-based claim for reimbursement depending on the extent and nature of their contributions to the company’s growth.

It is therefore important that business owners address the involvement and/or co-ownership of their spouses swiftly upon marriage breakdown, after having received legal advice on their rights and obligations as both business owners and, possibly, employers. Ideally, however, business owners will seek legal advice before restructuring a privately controlled corporation to include a spouse in the ownership of their businesses, to ensure they understand the possible legal implications of doing so in the family law, corporate law, and employment law contexts.

In the family law context, a business operator spouse may want help putting in place a domestic contract that specifically addresses ongoing ownership of their corporation in the event of separation, including how the non-operator spouse’s shares will be reacquired as well as how a potential employment relationship will be addressed to provide a clean break and ensure both spouses are treated fairly. Additionally, business owners may want to work with corporate counsel to ensure that any shareholders’ agreement and corporate articles governing the transfer of shares address a possible separation and ensure the rights of the operator spouse are protected.

By: Jenna Preston, Lawyer of Nelligan Law