Income Splitting Ideas For Business Owners

Income splitting is a strategic way for business owners to reduce their overall tax liability while providing financial support to their family members. By distributing income among family members in lower tax brackets, high earners can potentially lower their taxable income and make the most of Canada’s progressive tax system.

Beyond the tax savings, income splitting can also be a meaningful way to help loved ones meet their financial goals. In this article, we’ll explore eight practical income-splitting strategies that business owners can consider to optimize their tax planning and support their family members.

Who is Eligible for Income Splitting in Canada?

Income splitting in Canada is governed by specific rules and is generally most beneficial to families where one individual earns significantly more income than others, and owns their own business. Eligible recipients of the income typically include immediate family members, such as a spouse or common-law partner, adult children, or in some cases, minor children, depending on the method used.

However, it’s important to be aware of the rules that govern income splitting, also known as Tax on Split Income (TOSI). The TOSI rules limit the ability to split income with family members, particularly minors. Generally, TOSI rules apply to taxable dividends, taxable capital gains, and income from partnerships or trusts. In the cases where TOSI rules do apply, the individual receiving the income will be taxed the highest rate (53.53% as of 2024), thereby essentially making the income split redundant.

Exceptions exist for family members actively involved in a business or those meeting certain conditions, such as significant investments in the business or receiving reasonable salaries for their contributions. Understanding these rules is essential to ensure compliance while maximizing potential benefits.

1: Dividend Payments to Family

One of the most direct ways to split income to family members is to pay them a dividend. This can be done for any family member that is 18+ years old – whether immediate or extended – but typically works better for families living in the same household.

For this to work the family member must:

• Be at least 18 years old,
• Work at least 20 hours per week on average (and keep timesheets), and
• Receive a dividend amount appropriate for their job description.

Dividends received by family members are not subject to TOSI if the CRA’s conditions are met regarding age, hours worked and payment of a fair and reasonable amount. Otherwise, TOSI dividends are subject to tax at a rate of 53.53%!

2: Income Splitting for Excluded Businesses

The second way for business owners in Canada to engage in income splitting, is to pay dividends to family memberships who are shareholders of an excluded business. Common examples of excluded businesses are manufacturing, retail, distribution, restaurants, or businesses that sell and install products.

Excluded businesses paying their family members dividends must meet 4 criteria to avoid the TOSI rules:

1. Less than 90% of the company’s revenue comes from services,
2. The family member owns at least 10% of the company in both votes and value,
3. The individual receiving the dividend is at least 25 years old, AND,
4. The business is not a professional corporation incorporated by a doctor, lawyer, engineer, and so on.

Paying a dividend to a family member of an excluded business who is in a low tax bracket will reduce the family’s overall tax burden. For example, a family member who receives an ineligible dividend of $50,000 from a family business will only pay $2,575 of personal income tax providing he has no other source of income.

3: Salary Payments to Family

The third strategy is paying a salary to a family member who works in the business and is in a low tax bracket. This strategy requires that a fair wage must be paid based on the job description and hours worked for the salary to be a tax deductible business expense. Furthermore, an employment agreement should be prepared that clearly states the family member’s responsibilities and duties.

There is a slight caveat here, which is that you can pay above the fair wage to reduce your overall tax burden. Just make sure the tax savings for your family outweigh any company tax losses on the ‘excess wage.’

Here’s an example to show how that would work.

VS.

Let’s say Alfonso pays his daughter Tia $40 per hour for administrative tasks, while the fair wage is $18 per hour.

In this case Alfonso’s company would lose $2,640, which is 12% (the corporate tax rate) on the non-deductible wage of $22,000. However, $2,640 is significantly less than what Alfonso would pay if he were to take the $40,000 income for himself, assuming he is in the highest tax bracket (53.53%):

In this scenario, Tia could potentially pay $0 in taxes if she uses the basic personal tax credit of $15,705, with the remaining amount being covered by tuition credits. Additionally, Tia can contribute that income to her RRSP and TFSA.

4: Income Splitting for Retirement-Aged Entrepreneurs

For retirement-aged entrepreneurs in Canada, income splitting becomes a particularly valuable strategy to optimize tax efficiency and support household finances. If the business owner has reached the legal retirement age in their province or territory (typically 65 years old), they can pay dividends to their spouse without Tax on Split Income (TOSI) rules applying. Unlike younger business owners, this group is granted more flexibility, enabling the principal owner to allocate dividends of any amount to their spouse, regardless of the spouse’s involvement in the business.

5: Income Splitting Through RESP Contributions

Income splitting through a Registered Education Savings Plan (RESP) allows business owners to indirectly transfer income to their children. By contributing their own personal income to their child’s RESP account, the business owner can help fund their child’s education. When funds are withdrawn from the RESP for education expenses, the income earned in the account is taxed in the child’s name. Since children are typically in a lower tax bracket, this often results in minimal taxes being paid on the withdrawals.

It’s important to note that RESP contributions are not tax-deductible. However, the government provides an incentive through the Canada Education Savings Grant (CESG), which matches 20% of contributions, up to $500 annually, with a lifetime maximum grant of $7,200 per child. This makes RESP contributions a smart strategy for income splitting while securing a child’s future education.

6: Income Splitting via Lifetime Capital Gains Exemption

Income splitting can also be achieved through the Lifetime Capital Gains Exemption (LCGE) during the sale of a business. By setting up a family trust that owns shares of the business, the beneficiaries of the trust – such as a spouse, parents, and children – can each claim their LCGE when the business shares are sold. If structured properly, each beneficiary is eligible for up to $1,250,000 in tax-free capital gains (as of 2024 limits) from the sale of qualifying small business shares.

For a family of four, this strategy could allow up to $5 million in tax-free gains for the entire family on the sale of a $5 million business. However, several conditions must be met, including ensuring that the shares meet the criteria for the LCGE. Proper structuring and compliance are key to successfully multiplying the LCGE across beneficiaries, so consulting with a tax professional is essential.

7: Income Splitting Through Investment Income

Investment income, particularly from real estate holdings, offers another opportunity for income splitting among family members in Canada This strategy involves setting up a corporation where each family member – such as a spouse and two adult children – owns an equal share of the company. If the corporation generates $10,000 in annual profit, each family member receives $2,500 in dividends – assuming each family member owns 25% of the company.

Provided that all family members are at least 25 years old and each person owns at least 10% of the company shares, the Tax on Split Income (TOSI) rules do not apply. As such, the income is taxed at their respective personal income tax rates. For family members with little or no other taxable income, the dividends may fall within lower tax brackets, resulting in significant tax savings for the family as a whole.

8: Income Splitting Through Gifted Assets

Another effective income-splitting strategy involves gifting personal assets, such as gold, land, or property, to a child. This tax on income split strategy is applicable to personal assets and not corporate assets. Unlike income earned through corporate structures, gifted assets can appreciate over time, and any resulting capital gains are taxed in the hands of the child when they eventually sell the asset. This approach can result in significant tax savings if the child is in a lower income tax bracket than the parent, as capital gains will be calculated based on their income.

Conclusion

Income splitting is a powerful tool that Canadian business owners can use to reduce their overall tax burden while providing financial support to their families. However, navigating the Tax on Split Income (TOSI) rules and other regulatory requirements can be complex. By understanding and implementing the right income-splitting strategies for your situation, you can minimize your tax obligations, support your family financially, and retain more of your hard-earned wealth.