After a separation, changes in a couple’s finances often result in a change in their tax situation.
Since 1999, a parent paying child support can no longer deduct child support paid in that year from his or her income. Nor does the recipient of child support have to include child support payments in her or his income.
Spousal support, however, which is usually paid monthly, most often changes the tax status of the payor and the support recipient. The amount is deductible from the payor’s income in calculating tax for the calendar year the support is paid, and includable in the recipient’s income for the same year, provided the following conditions are met: the couple has separated, the support is paid periodically, there is a written agreement or court order setting out the spousal support and the recipient has the discretion to use the amount received as she or he likes.
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The rationale for the tax treatment is simple: after separation, two households are more expensive to maintain than one. If spousal support is being paid to the recipient, it is highly likely that the recipient’s marginal tax rate will be lower than the payor’s rate. This tax treatment frees up more money after tax from the payor’s income to support the second household.
For a payor living in Ontario earning $200,000 per year with a separated spouse who earns $10,000 from part-time employment, this can lead to a considerable tax savings. If the payor is required by a court order to pay spousal support of $6,500 per month, the payor pays tax of $34,000 for the year, rather than the usual tax on his $200,000 income of over $70,000.
Instead of the recipient paying tax on only her part-time income of $10,000 (which is zero), the recipient pays tax on her total income which includes her part-time income and her spousal support of $78,000 per year. While the recipient’s taxes increase to $20,200 per year, the tax savings for the couple is significant. The net tax savings is nearly $16,000, leaving that as available net income to help support the two households.
Where a payor has moved out of the home after separation, but continues to pay the expenses for the house, and the recipient remains in the home, provided certain criteria are met, these continuing “third-party payments” may also be deductible to the payor and includable in the recipient’s income. This option is less frequently used, as the recipient will not usually have other discretionary income to pay the tax attracted by the inclusion in income of the payments made to third parties.
As is often the case where the Income Tax Act is involved, a simple concept can quickly become complicated. A common question asked of family lawyers is whether their legal and accounting fees paid relating to the separation are deductible.
Legal fees paid to address custody and access issues are not deductible by either parent, nor are legal fees relating to the parties’ property issues. However, legal and accounting fees paid by the support claimant to address spousal or child support issues are deductible from the claimant’s income in the year those fees are paid, but legal fees paid by the support payor to resolve support related issues are not.
The fees incurred by the recipient are considered to be legal fees incurred for the purposes of earning income: those fees are a ‘cost of doing business’. As a result, professional fees incurred by the support recipient to collect support arrears, establish future child and spousal support, or defend a reduction in child or spousal support are all deductible from the recipient’s income.
By contrast, however, the payor’s fees in defending a claim for support are never deductible, even if the fees are incurred when there has been a loss or reduction in the payor’s income and the payor’s legal and accounting fees relate to attempts to reduce a support obligation or support arrears due to the reduced or lost income.
In short, no matter what, a support payor pays 100 cents on the dollar of the professional fees incurred, and a support recipient with income against which professional fees can be deducted will effectively pay a reduced amount, given the ability to deduct fees from income earned. Predictably, payor spouses are rarely sanguine when they are advised about this interpretation of the Income Tax Act.
Successful litigants who receive court-ordered costs from the opposing spouse, however, must remember to include those costs when received in their income for that year.
If a payor’s family lawyer is well-versed in the nuances of family law, she/he will remind the judge ordering costs of a support-related court attendance to take into account the tax advantage that the support recipient receives, and adjust the costs amount accordingly. Unfortunately for most payors, this calculation is not without its complexity. It is rarely raised in court and taken into account by the judge.
As April 30 approaches, family lawyers often hear from support payors and recipients about their tax woes. Many support recipients have not set aside money from the spousal support they have received for their pending tax bill, but they are usually relieved to receive a letter from their lawyer to file with their taxes which allows them to deduct their support-related professional fees. Payors of spousal support — rarely pleased about paying this support at the best of times — at least have a tax refund to look forward to, but are inevitably vexed by the news that their legal fees are not deductible.
In the world of family law, April is just one more month where separated spouses feel the financial pain of separation.
Laurie H. Pawlitza is a senior partner in the family law group at Torkin Manes LLP in Toronto.