Income Splitting for Canadian Businesses
The Rules for Income Splitting in Canada
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 in Canada your income is taxed at a higher rate the higher your income is (see Federal tax rates), 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 the Family Tax Cut that allowed individuals to split their income with a spouse for a tax credit up to $2000 is gone, 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:
1) by paying some of it to family members as salary or wages
2) 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 and/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 him 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, he or she will be contributing to the CPP and able to contribute to an RRSP, helping you both build a more comfortable retirement.
The Rules on Income Splitting in Canada by Hiring Family
1) Your spouse has to actually work for the business. That means he or she has to have designated duties that he or she carries out, 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.
2) As the employer, you have to pay your spouse a salary or wage commensurate with the salary or wage you would pay anyone else to do the same job. You can't pay him or her $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 him or her 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 he or she could do for your business.
If your business is incorporated (see Choosing a Form of Business Ownership), 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 the recipients of them 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 share owners 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 non-voting share classes for family members. This is especially useful for children, as non-voting shareholders can receive dividends but do not have the right to participate in decisions relating to company policy. For more information on structuring share ownership see How Do I Set Up Share Classes for My New Corporation? and Articles of Incorporation.
The Rules on Income Spitting in Canada by Paying Dividends to Family
The rules on split income received through dividends are changing as of the 2018 tax year.
Simply put, the current Tax on Split Income, which applies the highest marginal tax rate (currently 33 per cent federally plus provincial tax at time of writing) to split income received by certain family members under the age of 18, is being expanded to cover some family member over age 18 too - thus eliminating the advantage of having the split income taxed at a lower marginal rate.
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 by paying attention to the exclusions and ensuring 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",
"a Related Business where the individual was actively engaged on a regular, continuous and substantial basis ("Actively Engaged") 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" (Guidance on the application of the split income rules for adults, Canada Revenue Agency).
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.
The other exceptions are:
- "The business owner's spouse, provided that the owner meaningfully contributed to the business and is aged 65 or over. In recognition of the special challenges associated with planning for retirement and managing retirement income, the new approach to income sprinkling will be better aligned with the existing pension income splitting rules. This also reflects the fact that a business can play an important part in supporting its owner in retirement.
- Adults aged 25 or over who own 10 per cent or more of a corporation that earns less than 90 per cent of its income from the provision of services and is not a professional corporation.
- Individuals who receive capital gains from qualified small business corporation shares and qualified farm or fishing property, if they would not be subject to the highest marginal tax rate on the gains under existing rules" (Canada Revenue Agency)
You can find out more about how to put the power of income splitting to work for you by talking to your accountant.