When Divorce Leads to Tax Problems

As if going through a divorce isn’t unpleasant enough, there are times, more often than most people realize, that you find yourself owing money to the tax man as a direct result of your divorce.

It can happen in a number of different ways to BOTH spouses.

Spousal Support Is Taxable Income

First, for the lower income spouse with custody of the children: child support is not taxable in the hands of the spouse that receives it, but spousal support is.  If the terms of the separation or divorce agreement entitle the lower income spouse to spousal support then that spouse needs to make provisions to pay the taxes on that income.  If they don’t, then when they file their taxes they will discover they have taxes payable.  Depending on the amount of spousal support received, the number may be significant.

Child Support is NOT tax deductible

From the paying spouse’s perspective, spousal support is a deduction from the payer’s taxable income, but child support is not.  The fact that child support is no longer tax deductible in Canada comes as a surprise to many.  If they were counting on that deduction to reduce their income, and that deduction isn’t there, now the paying spouse can find themselves owing more in taxes than they expected.

Failing To Make Tax Installments

The single most common way that both spouses can get into trouble after a separation or divorce stems from a failure to recognize that the household living expenses and income have dramatically changed.

Self-employed earners, who are responsible more making their own tax installments, stop paying their income tax installments in order to make ends meet, figuring that eventually they will catch up. For people that are self-employed, the tax man becomes an “involuntary creditor” – that’s the government’s term — and it means the government doesn’t offer people credit. Rather people simply don’t pay their taxes which makes the government their creditor.  Individuals going through separation and divorce often find themselves very short on cash and the government is one of the first bills they stop paying.  It doesn’t take very long for self-employed people to accumulate very large tax debts, and then the government adds interest and penalties.

Cashing Out Investments

Another option that people use to try and reduce or limit the amount of debt they incur is to cash out investments.  The most common investment people have is RRSPs.  If you withdraw the funds in small amounts only a small amount of tax is withheld.  Unfortunately a series of 3 or 4 small withdrawals over the course of a year can add up to a large amount that when added to the person’s other forms of income may create a very large tax burden.   Investments that result in capital gains can trigger the same problem.  The gain is not taxed at all when the investment is sold, but when it is reported on a tax return a significant tax debt may be owed.

Tax Debt Solutions

So, what can you do?

Understand the rules. If you pay or receive child or spousal support, remove funds from registered savings accounts or are required to make installments, keep all of these matters in mind and budget for any expected taxes payable.

File your tax returns on time.  You can try and negotiate interest relief or a reduction of penalties if you find yourself in that situation.  Whether or not you will be successful depends on whether or not you filed your tax returns.  Believe it or not, the government takes a very hard line against people that don’t file their taxes.  Of course they want you to pay your taxes, but it is more important that you file them when required in order for the government to know how much you owe and to try and collect the unpaid amounts.

If you do not have the means to pay your taxes, or if you have also accumulated other debts along with your tax liability, you may want to consider a consumer proposal, or perhaps personal bankruptcy.  Tax debt is a debt just like any other in a bankruptcy or proposal.  Canada Revenue Agency does have the power to place a lien on your home or other assets or seize a bank account, so if you know you have a potential significant tax debt it is important to talk to a professional bankruptcy trustee sooner, as opposed to later, about making an arrangement with your creditors, including CRA, through a consumer proposal.

Separation and divorce are among the most common reasons that Canadians file for bankruptcy or make a proposal to creditors. And tax debts can be one of the debts they are dealing with.

Ted Michalos is a Chartered Professional Accountant (CPA) and a Licensed Bankruptcy Trustee. As a co-founder & President of Hoyes, Michalos & Associates, he speaks regularly at local commerce and professional events about insolvency issues and has testified before the Canadian Senate on issues of bankruptcy legislation. His expertise focuses primarily on helping individuals solve their financial problems.

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