What is Income Splitting?

What is Income Splitting?

By definition, income splitting involves diverting dividend income (and certain other types of income) from one family member to another member in a lower tax bracket resulting in substantial tax savings.

By way of example, let’s take the assumed owner of a private corporation and call her Mary. Mary has two daughters, Sue and Chelsea, who are currently studying full time and, as such, have hardly any income. If the corporation pays a dividend of $30,000 to each child, there will be little if any tax to pay on those dividends after deducting federal and provincial “dividend tax credits.” However, if Mary currently falls into the top tax bracket, her tax on a dividend of $60,000 would be close to $30 000. As such, with a technical adjustment, Mary saves herself $30 000 in tax annually.

A simple solution to this workaround would have been to extend the existing rules that apply to children under 18. Under the current tax laws, minors are taxed at the highest rate on the entire dividend amount. If the government had extended the existing tax legislation to older children, this would have eliminated the opportunity to take advantage of this ‘income splitting’ loophole in a simple, easy-to-understand manner.

Unfortunately, the government elected to bring this new elaborate and very complicated set of tax rules into play.

“This is where it becomes a minefield for individuals to navigate.”

What does this mean for me?

In essence, these new regulations mean that family members of all ages who receive dividends from a private corporation have to convince the tax authorities that their contributions to the family business are meaningful enough to justify the dividends they receive. Otherwise, they risk tax penalties on the dividend income.

Under these rules, if family members are over age 24 and have not worked an average of 20 hours a week in the business, they may have to prove that their contributions to the business are reasonable in comparison to the similar contributions of their relatives as well as concerning the dividends received.

These ‘contributions that are to be assessed are multi-faceted – work performed, property contributed, and risk assumed all come into play.

This makes defining what % dividend every family member involved in a private corporation can receive without incurring penalties highly complex. The decision is highly dependent upon the perceived value of each family member’s respective contributions.

How valuable are one person’s hours of work in comparison to another? What value should be placed on property contributed to the corporation or loan guarantees undertaken? There are also numerous exemptions to take into account.

For example, these new rules do not apply to certain family members, provided, in part, that less than 90% of the corporation’s income is earned through a service business. This is where income splitting becomes a minefield for individuals to navigate.

Need advice on personalized income-splitting tax strategies? Contact us for more information on how we can help you protect your wealth.

By: Steven R. Kark (CFP, CLU, CHS, EPC, MDRT)

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