Income splitting is the transfer of income from a person in a higher income tax bracket to a family member in a lower income tax bracket. Because of the marginal tax rate in Canada, tax rates increase as your income rises. However, by "transferring" some of your income to a family member whose income is lower than yours, you can pay significantly lower income tax.
And while regulations have tightened in this area in recent years, businesses still have income-splitting strategies available to them that can create considerable tax savings.
There are essentially two ways you can split your business income:
- By paying some of it to family members as salary or wages
- By transferring some of your income to family members through dividends
Income Splitting Through Paying Salary or Wages
As a Canadian business owner, you can decrease your actual income by hiring your spouse or children as employees and passing along some of your business income to them in the form of salary or wages.
Suppose, for instance, your business's net income is $75,000. But your spouse has been working in the business all that year, and you paid them a salary of $30,000. Your net income drops to $45,000, a considerable tax savings for you. And, because your spouse's income of $30,000 is taxed at an even lower income tax rate, you get, in effect, a double tax savings.
And Canadian income tax savings are not the only benefits to this tax strategy. Because your spouse now has an income, they will be contributing to the Canada Pension Plan and able to contribute to a Registered Retirement Savings Plan, helping you both build a more comfortable retirement.
The Rules on Income Splitting by Hiring Family
There are two major rules that govern how Canadian businesses can use this strategy.
- Your spouse or child has to actually work for the business. That means they have to have designated duties in the business, just like any other employee. And as the employer, you have to keep and maintain the requisite employee records. Just saying that your spouse worked for you last year and picking a number you like out of the air is not enough.
- You have to pay them a reasonable salary or wage. In other words, the wage should be commensurate with the salary or wage you would pay anyone else to do the same job. You can't pay them $70,000 to do basic office tasks, such as filing and answering the phones, for example. If your spouse is working for you as an office assistant, you need to pay them a rate equal to what other office assistants make.
Keeping employee records and paying your spouse an appropriate wage or salary is a small price to pay, however, for such powerful Canadian income tax benefits. If your spouse or child isn't already an employee of yours, maybe it's time to think seriously about what they could do for your business.
Income Splitting by Dividends
If your business is incorporated, another method of income splitting is to pay dividends to your spouse and children. The great thing about this tax strategy is its flexibility—the amount of dividends and their recipients can vary from year to year depending on how much income you want to distribute to lower your tax bracket.
To split your income using dividends, you must set up your corporation so that your spouse and children are shareholders; then you can distribute dividends between family members to reduce your tax burden. Note that, since dividends are paid to shareholders, the family members do not have to be employees of the business to receive dividends (although they can also be employees of the business and receive a salary as well as shareholder dividends).
Your corporation can be structured so that there are additional nonvoting share classes for family members. This is especially useful for children, as nonvoting shareholders can receive dividends but do not have the right to participate in decisions relating to company policy.
Rules for Paying Dividends to Family
The rules on split income received through dividends changed as of the 2018 tax year. Simply put, the current tax on split income, which applies the highest marginal tax rate to split income received by certain family members under the age of 18, is being expanded to cover some family members over age 18, thus eliminating the advantage of split income in some cases.
So the key to using this method of income splitting now is to ensure that the dividends are not going to lower-income family members that will be affected by the tax on split income. You'll need to pay extra attention to the exclusions in order to ensure those family members are following the rules.
For instance, if the family member receiving the dividend is 18 years old or older, the dividend will not be affected by the tax on split Income if it comes from an "excluded business," defined by the CRA as:
"...a Related Business where the individual was actively engaged on a regular, continuous, and substantial basis...in the activities of the business in the taxation year or in any five prior taxation years of the individual.
"An individual will be deemed to be Actively Engaged if the individual works in the business at least an average of 20 hours per week during the portion of the taxation year of the individual that the business operates, or meets that requirement for any five prior years. The five taxation years need not be consecutive. In any other case, whether an individual is Actively Engaged will depend on the facts and circumstances of that case."
If your business is seasonal, the family member only needs to have worked 20 hours per week during the part of the year your business operated.
There are a number of other exceptions to the new rules surrounding dividends, with very specific criteria. Before you make any assumptions about what you can or can't do with split income, review the CRA's guidelines and talk to your accountant about how to put the power of income splitting to work for you.