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Ask a Divorce Lawyer: What Are Retained Earnings?

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Brahm Siegel is a Toronto family law and divorce lawyer, mediator and arbitrator. He is here to answer your questions on all aspects of family law. Write to him at bsiegel@nathenssiegel.com

Q: What are retained earnings?

In accounting, retained earnings refers to the portion of net income which is retained by the corporation and not paid out as dividends to the shareholders.

Q: Why are retained earnings relevant in family law?

Their relevance relates to calculating a spouse's income for purposes of child or spousal support. Section 18(1) of the Federal Child Support Guidelines provides that where a spouse is a shareholder, director or officer of a corporation and the court is of the opinion that the amount of the spouse's annual income as determined by their line 150 of their income tax return does not fairly reflect all the money available to the spouse for the payment of child support, the court may determine the spouse's annual income to be all or part of the pre-tax income of the corporation.

Q: What does that mean?

It means that the courts can treat a payor has having more income than declared on his/her tax return, where, in the judge's view, the spouse has failed to take into income monies which have been set aside as retained earnings.

Q: When will judges do this?

Case law shows that courts will impute income to the payor in these situations where:

- The payor has failed to demonstrate that the retained earnings are required to replenish or replace essential corporate assets or otherwise maintain the value of the corporation as a viable going concern (Kowalewich v. Kowalewich, 2001)

- Where it is necessary to "lift" the "corporate veil" to ensure that the money received as income by the paying parent fairly reflects all money available for payment of child support. This is especially important in cases of sole shareholders who have the ability to control the income of their corporation (Baum v. Baum, 1999)

In the leading case of Brophy v. Brophy (2002), the judge said the following considerations and questions should be examined in deciding to what extent the court should use its discretionary power to look to retained earnings as a means of imputing income to a payor:

1. Because of the separate legal entity of the corporation, should there be a general reluctance by the court to automatically attribute corporate income to the shareholder?

2. Is there a business reason for retaining earnings in the company?

3. Is there one principle shareholder or are there other bona fides arm's length shareholders involved?

4. What is the historical practice of the corporation for retaining earnings?

5. What degree of control is exercised by the spouse over the corporation?

Q: What's your experience been with this issue?

In recent years I have had many cases dealing with this issue. First, I find that judges do not automatically attribute pre-tax corporate income to a shareholder/payor in every case. They tend to be very interested in the facts, want to know about the particular business and its history in terms of paying out previous retained earnings and will assess each case on its particular facts before providing guidance to counsel about what should happen.

Having said that, I also find that if there is no valid business reason for keeping retained earnings in the company, if there is only one shareholder or the shareholder/payor in question has control over the business, if the company has no previous practice of retaining earnings prior to separation, then courts will generally agree that some pre-tax corporate income should be attributed back to the shareholder/payor. Depending on the facts of the case, I have seen figures ranging from 25 per cent to 100 per cent.

Dealing with pre-tax corporate income cases is not easy and usually requires the assistance of a lawyer and often a chartered business valuator. We will discuss the use of CBVs more in a future column, but for now, happy lawyering!

Have a question about family law? Ask Brahm at bsiegel@nathenssiegel.com.

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