Do your clients use income splitting strategies to reduce their tax liability? If so, you should chat with them about the new income sprinkling rules, effective in 2018. The rules aren’t as strict as originally proposed, but you and your clients still need to be ready.
What Is Income Sprinkling?
Income sprinkling is when an individual or business "sprinkles" income to other family members. The goal is to reduce the tax liability of the person or entity who earned the funds, by transferring it to family members in lower tax brackets. In some cases, this strategy reduces the amount of tax the Canada Revenue Agency can collect, and as a result, the government is cracking down on the practice. The exact rules vary based on the age and status of the person receiving the transferred income, but as long as your clients meet the guidelines, they can sprinkle freely.
Income Sprinkling for Children Under 18
The new rules don’t affect taxpayers under the age of 18 because there was already a rule in place for these individuals. To review, if your clients transfer income to their minor children, the children face the Tax on Split Income. Also called the kiddie tax, the TOSI applies the highest marginal tax rate to the sprinkled income, regardless of the child’s other earnings.
Work Requirements for Children Over 18
Under the new rules, family members over the age of 18 also face the TOSI, unless they work for the company. To qualify as an employee, family members must log at least 20 hours per week. For seasonal businesses, family members only need to work during the busy seasons.
Investment Guidelines for Children Over 25
Once your client’s children reach the age of 25, they can avoid the TOSI as explained above, but beyond that, they can also invest in the company instead of working for it. To avoid TOSI in this situation, the child must own at least 10% of the company and have 10% of the votes on the board. The money the child invests must be arms-length money, which essentially means your client can’t just give the child money to invest.
Unfortunately, professional corporations and service businesses don’t qualify. If your clients businesses fall into these categories, make sure they understand their children may face the TOSI on sprinkled income, even if they own part of the company.
Special Rules for Spouses Over Age 65
The good news is that spouses over 65 don’t have to worry about TOSI. Say you have a client who’s spent a career building up a business. When they retire at age 65, the company begins to issue dividends to their spouse. In this situation, because your client meaningfully contributed to the business, their spouse can receive dividends taxed at the usual rate. This rule is designed to help people with their retirement planning.
Types of Income Affected
Income sprinkling rules only apply to dividends from private companies, capital gains, and certain income from trusts and partnerships. These rules don’t apply to salaries. Based on a long standing rule, business owners can only issue salaries to family members who actually work for the company.
If you have clients who are going to be affected by these rules, remind them to track the business contributions made by children or spouses under the age of 65. Timesheets or work logs can show that someone worked the required number of hours, and in terms of financial investments, your clients should have records of the funds as well as details that prove the funds are arms length from the client.
Income sprinkling sounds nice. Who wouldn’t want income sprinkled on them? But, if handled incorrectly, income sprinkling can lead to unexpectedly large tax bills. Make sure your clients are ready for the changes in 2018 and moving forward.