In this article, we will explore ways to share the wealth generated by the corporation with family members without running afoul of the Tax on Split Income (TOSI) tax penalties and other income-splitting restrictions that are set out in the Income Tax Act (ITA).
The benefit of income splitting
Income splitting is the process of redirecting income within a family group to take advantage of the lower tax brackets, deductions, and credits available to each family member. Income is split by transferring income-earning assets from high-income to lower-income family members. Generally speaking, the total tax on family income will be lowest when each member earns approximately the same amount of income.
People are often surprised at the magnitude of tax savings that can be achieved through simple income splitting. Assume an individual earns income that places them well into the top marginal tax bracket, by transferring enough income to another family member, they can bring that person's income up to the cut-off for the top marginal bracket. Income that was previously taxed at the top rates will now be taxed in the lower brackets, with more after-tax cash remaining within the family unit.
The chart below, using 2023 personal tax rates, shows the top personal tax rates on various types of income, as well as the lowest tax rate on such income. It also quantifies the tax difference in earning $100,000 taxed at the top rate in 2023 in Newfoundland (the province with the highest tax rates in 2023) on income over $1,000,000 to earning $100,000 of income where there are no other sources of income. For simplicity, the tax estimates include the dividend tax credit but do not include any other tax credits that may be available or the alternative minimum tax.
Personal tax rates based on income
| ||Employment/interest/ foreign investment income||Ineligible dividends||Eligible dividends||Capital gains|
|Top personal tax rates 1||54.8%||48.96%||46.2%||27.4%|
|Tax rate in the lowest income bracket 2||23.70%||13.19%||3.31%||11.85%|
|Tax on $100,000 taxed at top rate 3||$54,800||$48,960/td>||$46,200||$27,400|
|Tax on $100,000 of taxable income, lowest tax brackets 4||$29,883||$21,719||$16,498||$12,346|
|Difference is an estimate of tax savings from income splitting||$24,917||$27,241||$29,702||$15,055|
|Savings as a percentage of income||24.92%||27.24%||29.70%||15.06%|
Detailed information about personal income tax rates at differing taxable income brackets can be found in our Tax Facts publication.
How to split income
Very simply, income is split by transferring income-earning assets from high-income to lower-income family members. Besides the TOSI rules, which generally target income splitting through the payment of dividends on shares of private companies, there are several income attribution rules in the ITA. These attribution rules work to ensure that a transfer of income-earning property by gift or certain other transfers between spouses and to minor children will result in the attribution of income from such transferred assets back to the transferor. It is generally easier to transfer income-earning assets to adult children by gift, but remember that when property is transferred by gift, it legally belongs to the recipient, and it is therefore beyond the legal control of the transferor.
In tax years prior to 2018, income splitting by using dividend-paying shares of a private corporation was an effective income-splitting technique. However, in 2018, broader TOSI rules were put in place which target this planning. Due to the complexity of these TOSI rules, this article will not provide an analysis of these rules.
Dividends after age 65
A notable exception to the TOSI rules occurs when an owner-manager or their spouse or common-law has reached age 65 by the end of the taxation year. Where that owner-manager has made a sufficient contribution to the family business to qualify for an exclusion under the TOSI rules, dividends their spouse or common-law partner may receive on shares of the corporation will be exempt from TOSI. In such a situation, where a spouse or common-law partner has shares in the corporation of a different class from the owner, the spouse or common-law partner can generally receive dividends that will not attribute back to the owner-manager. Note that for this to happen, the appropriate planning must have been carried out when the spouse or common-law partner shares were issued. To determine if such planning would be appropriate in your circumstance, please contact your BDO advisor.
Prescribed rate loans
Arranging a prescribed rate loan between spouses can be a good way to create an income-splitting opportunity. If a business owner makes an investment loan to a spouse, adult family member, minor child, or family trust and charges interest on the loan at the prescribed interest rate, then any income they earn on the funds will be taxable to the recipient family member and not to the business owner. These plans work effectively when the investment rate of return earned is higher than the prescribed rate of interest charged on the loan. In such situations, a net benefit will be realized because the income earned on the rate differential will be taxed at the lower marginal tax rate of the family member.
Our tax alert article, Using prescribed rate loans to lower your family's income tax bill, describes this planning in more detail.
The recent rapid increase in interest rates has made creating a new prescribed rate loan more difficult since the interest rate on the loan to a family member must be at least equal to the government-prescribed rate at the time the loan is made. Currently, in September 2023, the prescribed rate is 5%, up from a low of 1% which was in effect from July 2020 to June 30, 2022.
Second generation income
The general income attribution rules in the ITA apply only to the first income that is generated on gifted or transferred assets. For example, consider a business owner who pays tax on $2,000, 000 of income withdrawn from their company, and gifts the after-tax amount, say $1,000,000, to their spouse. Assume the spouse invests these funds in marketable securities and earns investment income of $75,000 in the first year.
This $75,000 will be taxed as income earned by the transferor spouse, but the recipient spouse now has $75,000 to invest independently. Any income earned on this $75,000 is not subject to the general income attribution rules. Over time, the recipient spouse can build up a pool of investment funds on which there is no income attribution. However, income attribution will continue on the original $1,000,000 gift, for as long as the marriage or common-law relationship lasts. This approach will take some time to build significant assets that are not subject to attribution, but it has the advantage of being relatively easy to implement. Keeping the initial investment capital in a separate account from the reinvested second-generation earnings is important to not co-mingle funds on which income is attributed back to the transferor with funds not subject to attribution. These rules also apply to certain transfers or gifts between common-law partners.
The TOSI rules do not restrict the ability of a business owner to pay their family members reasonable wages for work that they have done. The key element here is the amount of wages must be reasonable compared to what an arm's length person, with the same level of experience, would be paid for the same work.
How BDO can help
Planning to transfer income-producing assets within a family group can result in a lower overall family tax bill. However, it is not without risks, and it can be complicated to put an effective plan in place as it very much depends on your circumstances.