Income Splitting Constraints from a Corporation

Contact Neufeld Legal PC for your incorporation legal work at 403-400-4092 or Chris@NeufeldLegal.com

The ability to split income from a private corporation with family members is heavily constrained by various tax rules, in particular the Tax on Split Income (TOSI) rules. These rules are designed to prevent business owners from shifting income to family members in lower tax brackets who have not made a meaningful contribution to the business. If income is subject to TOSI, it is taxed at the highest marginal tax rate, regardless of the recipient's personal tax bracket. The rules apply to "split income" received by a "specified individual" from a "related business."

Key Constraints and Exceptions under the TOSI Rules

• The "Specified Individual" and "Related Business"

  • Specified Individual: This generally includes an individual who is a Canadian resident and who receives income from a related business. This can be a minor (under 18) or an adult.

  • Related Business: A business is considered "related" if a related person (such as a spouse, parent, or child) is actively engaged in the business or owns a significant interest (at least 10% of the votes and value) in the corporation.

• Key Exceptions to the TOSI Rules The TOSI rules are not absolute, and several "excluded amounts" or exceptions can allow for income splitting without the punitive tax rate. The availability of these exceptions depends on factors like the recipient's age and their involvement in the business.

TOSI Rules applicable for Individuals Aged 18 and Over

• The "Excluded Business" or "Active Engagement" Exception: This is one of the most common ways to avoid TOSI. An individual is exempt if they are "actively engaged on a regular, continuous and substantial basis" in the business.

  • The 20-Hour Rule: The Canada Revenue Agency (CRA) deems an individual to have met this requirement if they have worked an average of at least 20 hours per week in the business during the year. This can be met for the current year or in any five previous taxation years. This is particularly useful for adult children who worked in the family business part-time while they were younger.

TOSI Rules applicable for Individuals Aged 25 and Over

• The "Excluded Shares" Exception: This applies to individuals who are 25 or older and own at least 10% of both the votes and the fair market value of the corporation's shares. This exception is generally not available for professional corporations (e.g., medical, legal) or service-based businesses, unless the business has less than 90% of its income derived from a related business.

TOSI Rules for All Ages (with conditions)

• The "Reasonable Return" Exception: This exception can be used for individuals who do not meet the other tests. Income received will be excluded from TOSI if it is a "reasonable return" on their contributions to the business. Contributions can be:

  • Labour: The amount of work performed for the business.

  • Capital: The amount of capital contributed to the business.

  • Risk: The degree of risk assumed in the business. The CRA expects the amount of income to be comparable to what would be paid to an arm's-length employee for similar services. Proper documentation (e.g., job descriptions, time logs) is crucial to support this claim.

• The "Safe Harbour Capital Return": This is a specific type of reasonable return based on a prescribed rate of return on the capital the individual contributed to the business.

• The "Spousal Exception" for Seniors: If the business owner is 65 years of age or older and can receive a TOSI-exempt dividend, their spouse or common-law partner can also receive dividends without the TOSI rules applying.

• Other Excluded Amounts:

  • Taxable capital gains on the disposition of qualified small business corporation shares, with some limitations.

  • Income and gains received as a result of the death of the business owner.

  • Income from property acquired through a court order or written separation agreement.

Practical Considerations related to TOSI Rules

• Salary vs. Dividends: Paying a reasonable salary to a family member for work they perform is often a viable strategy for income splitting, as salary is a deductible expense for the corporation. However, the salary must be reasonable for the services provided.

• Documentation: Due to the complexity of the rules, it is essential to maintain detailed records to justify any income paid to a family member. This includes employment contracts, records of hours worked, and job descriptions.

• Prescribed Rate Loans: Loaning funds to a family member at the CRA's prescribed interest rate can be an effective way to split investment income. The income earned on the funds above the interest paid is taxed in the recipient's hands at their lower tax rate.

• Family Trusts: Using a family trust can offer flexibility in distributing income, but the TOSI rules still apply to dividends allocated from a trust.

The constraints on income splitting are complex and require careful planning. It is highly recommended to consult with a qualified tax advisor to ensure compliance with the law and to explore the best strategies for your specific situation.

Although there are numerous permissible tax strategies and tax advantages arising from a corporation, it is important that those tax strategies are appropriately applied, especially where they have changed over time, and become far more restrictive. For professional legal services related to optmizing your corporate business, including permissible tax strategies to optimize your return from a corporate business, contact our law firm at 403-400-4092 or via email at Chris@NeufeldLegal.com to schedule a confidential consultation.

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