Tax Consequences of Lump Sum vs Monthly Spousal Support: Why the difference matters
Spousal support can be awarded and paid as lump sum or periodic monthly payments. Each method has its own benefits and drawbacks. However, there are tax consequences in opting for one or the other that should be factored into determining an amount.
The Spousal Support Advisory Guidelines do not provide any guidance as to whether lump sum is appropriate for any given case. While a lump sum award is not made to essentially redistribute family assets, it can be used to relieve against hardship if the division of family assets still leaves one of the parties in difficult circumstances.
Advantages of Lump Sum Payments
There are numerous advantages of a lump sum spousal support payment. All of these factors are discussed in an Ontario Court Appeal decision of Davis v. Crawford, 2011 ONCA 294, which has been referred to with approval by our own British Columbia Court of Appeal: see N.K. v. M.H., 2020 BCCA 121.
A lump sum payment avoids the need for future contact between the spouses, it can provide a sum of money up front to allow a spouse to purchase a new residence or alleviate immediate financial problems, the spouse who receives the lump sum payment need not worry about non payment of support in the future and arrears for retroactive spousal support can be paid immediately.
A spouse who receives a lump sum spousal support award to replace future monthly payments gets the benefit of being able to invest and earn income on the lump sum. However the payor loses the opportunity to obtain the same benefit.
There are downsides to a lump sum payment as well. The needs of one spouse may change over time and a lump sum payment means the spouse who receives it will not be able to apply for variation if something changes. Additionally, there is difficulty calculating what the appropriate lump sum should be, especially if it is ordered in the place of indefinite periodic support.
There are distinct tax consequences for the payors and recipients of lump sum spousal support versus periodic spousal support.
Under the Income Tax Act, monthly spousal support is a tax deduction for the payor who can deduct the total spousal support payments made every year. The recipient of the monthly payments must declare the payments as income on their tax return and pay tax on that amount depending on their marginal tax rate. Lump sum payments are not tax deductible for either party.
It is important to carefully consider the tax benefits and disadvantages of each method of payment and bring them to the court’s attention. The BC Court of Appeal in Robinson v. Robinson, 2012 BCCA 497 has affirmed a trial judge is entitled to to take into account tax consequences in awarding lump sum or periodic payments:
While it may appear on the surface that the judge used too high of a marginal tax rate, I would not accede to the cross appeal. Although the judge referred to the 35% marginal tax rate in the context of tax payable by Mrs. Robinson, she was entitled to take into account the tax consequences to Mr. Robinson of an award of a lump sum compared to the tax treatment of periodic payments: see, for example, Patton-Casse v. Casse, 2011 ONSC 6182 at para. 12, 8 R.F.L. (7th) 393. In para. 129 of her reasons, the judge did make reference to the relative tax situations, and it may be that she took the tax consequences to Mr. Robinson into account when she arrived at the 35% rate.
How should the court adjust a lump sum award for tax consequences?
There is no bright line rule, but courts will typically try to strike a balance between the differing tax consequences to the payor and recipient. This can be complicated where the payor and the recipient have different marginal tax rates and the tax effect for one party may be different than for the other.
As an example, consider a spouse earning around $100,000 per year making $20,000 in spousal support payments each year to his spouse who earns $50,000. Being able to deduct $20,000 per year in spousal support from his income of $100,000 will move the payor from a marginal tax rate of 38.3% to 28.2%: a very valuable adjustment. However, for the receiving spouse, an additional $20,000 per year on top of their $50,000 in keeps them in the same marginal tax bracket of 28.2%. The effect of the deduction of periodic payments offers a far greater tax benefit to the payor than the recipient.
Courts have adopted a variety of ways of dealing with this issue. The tax benefit will not necessarily be equalized between the parties. In some decisions, the court has applied a discount to a lump sum award similar to the rate used to for calculating future loss in personal injury claims: see Wilson v. Wilson 1997 CanLII 2777
How should a spouse prepare to address the issue of tax consequences with the court?
Regrettably, not all lawyers or judges are familiar with the implications of the Income Tax Act. Courts will not automatically address the different tax treatments of spousal support. In calculating a lump sum award, some judges have simply multiplied the amount of monthly support under the guidelines by the number of years support would have been payable. The consequence of this is the payor loses the tax deduction flowing from monthly support payments and ends up paying more than they would have if they simply made monthly payments.
Where parties have relatively uncomplicated finances, it may be relatively easy to request the court make an adjustment as information on the parties’ marginal tax rate is easily obtainable. Where the parties have a joint company or have more complicated source of income, this is not as straightforward and spouse making a claim for an adjustment should consider whether to retain an economist or actuary (keeping in mind that under the Supreme Court Family Rule 13-3, an expert on a financial issue such as taxes may be joint). As an example, in B.L.S. v. D.J.S, 2019 BCSC 846, the parties were ordered to retain a further expert to assist the court with external and distributive taxes flowing from a lump sum payment or division of property.
All spouses should be aware that failing to provide the necessary information at the time of trial can be fatal. The Court of Appeal has refused to reopen a trial to request an adjustment for tax consequences of a lump sum payment where a spouse had the opportunity to provide evidence of the tax consequences to the court but failed to (see Fuller v. Mathew, 2007 BCSC 1099).
If you have a family law issue or questions about spousal support, give one of our experienced family lawyers a call.