If you own a small business, you may be able to reduce your taxable income through a process known as income splitting. One of the most effective strategies involves the distribution of dividend income to your family members. The Canada Revenue Agency (CRA) doesn’t allow taxpayers to split income with other relatives, but there are exceptions to this rule as well as alternative income splitting strategies you may wish to explore.
How Does Income Splitting Work?
Splitting income is the practice through which your business income is rerouted to various designated persons, usually within your family, with the aim of reducing your aggregate tax liability. This is possible because of the combination of Canada’s progressive tax system and the tax-free basic exemption amount.
In other words, when you’re a business owner who winds up in a high marginal tax bracket, you can divert some of your income to a family member. The first part of the diverted income isn’t taxed because of the basic exemption every taxpayer receives. Any additional income beyond the exemption limit gets a lower rate because the family member doesn’t earn enough to qualify for a higher marginal tax rate, and this saves you money on the family’s overall tax bill.
Paying Wages vs. Paying Dividends to Family Members
There are two primary ways to split business income with family members. The first is through wages. In this scenario, the business lists the family member as an employee and pays the person a salary. The second method is to issue ownership shares from your company to your family members and then pay dividends to those family members. A relatively common third method, the “prescribed rate loan strategy,” is more complicated and only applies to low-income spouses.
The CRA has various restrictions in place to prevent abuse of wage-based income splitting in Canada. For example, all salaries must pass the reasonability test, which says the share of income you pay a family member must be congruent with the amount of work or capital put into the business by the family member. If your wife comes in and answers the phone for two hours per day, then you can pay her a reasonable rate for that work. One of your children might hand out sales fliers on the weekend, and you can provide appropriate pay for that job. As a general rule of thumb, the CRA recommends that business owners pay their spouses or children the same approximate wage that a third party would earn for the same work.
In most cases, splitting income is more effective when performed through dividends than wages, especially in larger amounts. This is because there are usually no restrictions on the number of dividends that your business can pay family members, thereby avoiding the reasonability test associated with direct wages.
For example, you issue 10 shares to your wife, 10 shares to one child and 10 shares to another child. It’s up to you how much you pay in dividends per share. You can pay $100 or $1,000.
There are some hurdles associated with dividend-based family income splitting. A special tax is applied to dividends paid to children under the age of 18, or the so-called “kiddie tax.” If your company isn’t considered a small business corporation and you want to issue shares to designated family members, you should keep an eye on corporate attribution rules.
Distributing Dividends to Family Shareholders
Dividend distributions to your family members are made either to shares issued directly to your family members or a discretionary family trust. Direct issues of shares typically differ depending on which family member receives them. Spouses usually receive fully participating shares. Your children often receive restricted shares that never increase in value and can only receive discretionary dividends.
In a family trust, the beneficiaries might include all family members, but distributions of stock and dividends can be made to any individual or group among the beneficiaries, even to the exclusion of your some members.
For example, you can decide to pay dividends to your wife in the amount of $1,000 per share, while your children only receive $50 per share. This allows you to pay dividends in a way that keeps your tax bill as low as possible and still within legal limits. You might also opt to pay a dividend of $1,000 per share to your wife and nothing to your children.
Pension Income Splitting
If you have pension income, you can split up to 50% of that income with your spouse. For example, if you have $50,000 in qualifying pension income, you can shift up to $25,000 to your spouse. You want to do this only when it lowers the family’s overall tax bill.
Regardless of your age, you can split the taxable portion of life annuity payments from a superannuation or pension fund. If you’re over the age of 65, you can split payments from registered retirement income funds, registered retirement savings plans, and qualifying amounts from retirement compensation arrangements. If you receive those types of payments due to being a widow, you can split them with your new spouse or common-law partner even if you aren’t 65 years old yet.
If you earn more than your spouse, you may want to make all of the family’s retirement contributions. That reduces your income and the amount of tax you owe, compared to your tax liability if you and your lower-earning spouse make the same retirement contributions. When you contribute to your spouse’s RRSP, the income is in your spouse’s name upon retirement, which is another form of income splitting.
For example, you pay $500 per year into your spouse’s retirement fund for 10 years. At the end of those 10 years, your spouse has $5,000 in their retirement in their name and not yours.
Self-Employed Individuals and Business Owners
If you’re a freelancer, a self-employed person or a business owner, you can pay your spouse or children income from your business. You can’t pay your family members if they don’t do any work for you. But if they do, you’re required to pay family members a salary similar to what you would pay a non-relative.
For example, if you’re a freelance writer, you can pay your spouse or child for researching a particular topic or typing a handwritten document. The pay needs to be equal to what you’d earn for doing the research yourself or what you’d pay another individual for completing the same work. QuickBooks Online can help you manage payroll with ease and accuracy.
Family Loans for Investments
You can also loan money to a relative to buy investments. If the investments grow, you can split the earnings. You must charge at least 1% interest, and you can give your relative the loan directly or through a trust. Write a contract for the loan that details all the terms, and make sure your family member keeps up with each of the loan payments or payout of any profits as outlined in the contract.
Spousal Income Splitting via Partnership
If you’re married or in a common-law partnership and have more income than your spouse, your spouse may end up paying a relatively low income tax rate while you face a relatively high rate. Splitting your income between the two of you can help even out your tax rates and lower your family’s overall tax burden. If you and your spouse or common-law partner run a business together, you should register the business as a partnership and report your earnings accordingly.
For example, if you own 60% and your spouse owns 40%, you report 60% of the earnings, while your spouse reports 40% of the earnings. If only one of you reports all the earnings, your tax burden is unnecessarily high.
If you’re self-employed, you can effectively split your income by making your spouse a partner. Members of partnerships report their income separately. For example, you could each report 50% of the earnings or choose another arrangement, such as you report 60% while your spouse reports 40%. When you split the income, make sure that it’s equal to the amount of work that each spouse provides to the business.
For this technique to work, you must both provide work on behalf of the business even if it isn’t the same type of work. You may not split your self-employment income unless you’re actually working as partners. This can include things such as your spouse making phone calls for the business, handling the bookkeeping or talking to customers while you tackle other parts of the company’s work.
Filing taxes each year is a requirement for your small business, and you always want to pay your fair share. That doesn’t mean, however, that you need to pay more than absolutely necessary. It’s essential that you explore all the possible tax deductions available to you and your company. Income splitting ensures that your company pays taxes while spreading the expense to other family members who have a lower tax obligation so your family keeps more money in its pocket at tax time. QuickBooks Online can help you maximize your tax deductions. Keep more of what you earn today.