Preliminary Thoughts on Income and Valuation Family Law Issues Arising from COVID-19

How long will the virus and the shut-down of the world last? When will the economy recover? What are the financial implications for family law? Although valuators are great at making assumptions, we don’t have all of the answers.

There are a few key issues that affect many of our mutual clients. We thought it might be helpful to think out loud and share some of our thoughts.

Income for Support – Employees

Many employees and businesses are experiencing a sharp reduction or complete cessation of income. The longer the economy stays in this condition, the more widespread the problem will become. Income earned in 2019 and prior years may no longer be the best indicator in determining current income.

How will we deal with the onslaught of payors who claim they cannot pay existing support obligations based on pre-COVID income? And how do we calculate current income where the past is less relevant, and the future is unknown?

For straight-forward T4 employees, it might be possible to estimate 2020 income based on EI and other wage subsidies, but this too will depend on assumptions about the duration of unemployment/reduced employment.

For employees who usually earn a large part of their income in the form of a bonus, it will be a little more complicated. Many bonuses calculated for 2019 will have been paid in the first quarter of 2020, so for these individuals, the impact on their bonuses may not be felt until 2021.

With so much uncertainty, one solution might be “if & when”. For example, if an employee’s estimated 2020 income is 60% of usual, perhaps calculate support based on this amount but provide for a lump-sum catch-up to the extent that income exceeds this amount. The spousal support portion of the lump-sum catch-up is likely not taxable/deductible (see below) and will have to be adjusted to an after-tax amount. If this method is unacceptable to the recipient, then perhaps the reverse is possible (i.e. pay support based on pre-COVID income but allow for an adjustment to future support amounts if income falls below this amount). This will be tricky from a tax perspective, so advice from professionals will be required. To avoid expensive support calculations you can set floors and ceilings (e.g. if income is 10% higher or lower than the estimate then no catch-up is required).

With respect to support based on a formula, the CRA’s folio on Support Payments states:

“A specified sum of money that is subject to an adjustment in accordance with some reasonable formula or index may qualify as an allowance even though the exact future amounts payable are not specified in the order or agreement. An example of such an adjustment might be one to be made with reference to a percentage of the payer’s income, federal or provincial child support guidelines, or the cost of living index.

Where a separation agreement or court order provides for spousal support payments that are tied to a bonus or incentive payments, the payment could meet the definition of a support amount even though the exact future amounts are not specified in the order or agreement. Providing all other requirements of the definition of support amount are met, a payment that is calculated by reference to bonuses or incentive payments that are calculated at regular intervals (for example, annually, quarterly or monthly), would meet the requirement of being periodic. If the payment is calculated by reference to bonuses or incentive payments that do not occur regularly, then the payment would not meet the requirement of being periodic.”

Income for Support – Corporate Attribution to Business Owners

This will be trickier. Not only will many businesses have reduced income, but cash-flow may also become a problem if receivables cannot be collected and owners need to retain cash to cover overhead. On the other hand, businesses may be able to access subsidies and take advantage of debt holidays.

A case-by-case assessment will be required, but flexibility along the lines of “if & when” might be helpful here as well.

Business Valuations – Hindsight

A basic principle of business valuation is that value is determined at a specific point in time and the use of hindsight is generally inadmissible.  However, hindsight is appropriate to test the validity of assumptions relied upon.

A pre-COVID date of separation value is likely now impaired, at least on a short-term basis. Will Serra[1] be invoked? In Serra the court held that an equalization payment that did not reflect the post-separation decline in the value of the husband’s business was unconscionable.

As indicated in Serra with respect to the post date of separation decline in value of the husband’s textile business: “This was not a case where the owner of the diminishing asset could have sold it in a falling market to preserve at least some of its value. Nor was it a case of a temporary decrease in the value of an asset resulting from a temporary economic recession. An equalization of net family property that required the husband to pay more than his total net worth (and arguably as much as twice his net worth) because of a marked post-separation decline in the value of his major asset, over which he had absolutely no control and in spite of his best efforts to save the business in the face of the wife’s trust claims, the preservation order and the need to comply with his support obligations, was unconscionable.”

For businesses that have completely failed this might be a viable argument.

But in many cases, the impact of the pandemic will be temporary, and the business can expect to recover once the world returns to normal or something close to it. Although valuations are determined at a point in time, they should not be influenced by a transient boom or bust. We don’t know how long the pandemic will last, nor what a recovery will look like nor how long it will take.

Depending on the nature of the business, unless there is a change in the law regarding the valuation date, valuators will have to make assumptions and perhaps consider various scenarios around estimates and timing of future income and asset values.

All of these factors are also relevant for marriage contracts entered into during this time.

We will probably see a lot of hindsight arguments in the future.

Business Valuations – Jointly Owned Businesses

Current date valuations for purposes of buying out a spouse’s interest may be best put on hold.

Even holding companies having no goodwill value will have likely suffered declines in the value of real estate, marketable securities, notes receivable, etc.

Some couples will, however, want to reach a settlement now. In such cases, an earn-out arrangement may work. For example, a valuation can be calculated at a low (with pandemic) and a high (without pandemic). The buyer pays the low price upfront, but the price can be adjusted for certain future events. The balance of the potential purchase price can be put in escrow or otherwise secured.

This concept is easy in theory but is much harder to apply in reality. Being precise might not be possible. What are the conditions to be met and how should the formula work? What about cash flow and the ability to pay? What is the time frame for the formula?

Valuations of Deferred Stock-Based Compensation

Many employees receive compensation in the form of benefits that are tied to the employer company’s stock price. The most common such benefits are RSUs (restricted stock units) and employee stock options.

RSUs are usually awarded on an annual basis and then vest in equal parts on the following three anniversary dates. At each vesting date, the cash equivalent is determined (i.e. the number of RSUs times the stock price at anniversary date) and the cash equivalent is paid to the employee as taxable employment income. The employee does not have control over vesting. The employee benefits or suffers from the increase or decrease in the value of the stock from granting to vesting.

Employee stock options allow an employee to purchase the company’s stock at some future date at a certain exercise price (i.e. the price of the stock at the date the grant was awarded). Employee stock options usually vest over a 3-5 year period, but the employee can exercise the option any time between vesting and expiry (options usually expire 10 years after granting). The employee is not compelled to exercise the option but can choose to do so where the market value of the stock exceeds its exercise price. There is no inclusion in income until the option is exercised.

The market value of the related stock price is a key input in the valuation of such benefits. The sudden and sharp declines in the value of most public company shares will have a significant impact on value.

Example 1: At the July 2019 date of separation your client held RSU’s and the company’s stock price was $100 per share. The 2020 one-third portion of the RSU vested March 2020 and your client realized value based on $60 per share. The remaining two-thirds will vest in March 2021 and March 2022.

Example 2: At the April 2020 date of separation your client held RSU’s and the company’s stock price was $60 per share, well below the pre-pandemic value of $100 per share. The RSUs will vest over the next 3 years.

Example 3: At the March 2020 date of separation all of the employee’s stock options were vested but not exercised and the expiry date is 2025. At the date of separation, the stock price is below the exercise price.

All of the same hindsight, Serra-type arguments may apply to stock-based and deferred compensation.

It’s also possible that companies will somehow reimburse employees for reductions in the value of these types of compensation – but don’t hold your breath.

The most logical method is “if & when”, if the parties can agree to it.

Other Considerations

Stock portfolios have been affected. If jointly owned then half of each underlying investment can be transferred to each individual spouse, where practicable.

Similarly, the parties can “horse-trade” other jointly owned property, such as assets in a real estate portfolio.

But for assets held by an individual spouse, all of the pandemic-induced value reductions will be an issue for pre-pandemic separations not yet equalized, for pandemic era dates of separation, and for pandemic era dates of marriage.

We can probably expect to see an increasing number of personal and business bankruptcies. The legal and financial implications of the fallout will present many challenging issues, some of which cannot be anticipated. We will all have to navigate carefully.

By: Paula G. White, CA, CPA, CBV, CFF, and Brandon A. Lewis, CA, CPA, CBV, CFF

[1] Serra v. Serra 93 O.R. (3d) 161

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