Clearing the confusion for small businesses around income sprinkling
Income splitting lets high-income business owners divert their earnings to family members with lower tax rates.
The rules of income sprinkling, or splitting, are cloudy for some business owners. Income splitting has been practiced for over 40 years. “It is a very common tax-planning arrangement that allows for the distribution of income among members and shareholders,” said Janna Collins, senior manager at BDO Canada. Essentially, income splitting lets high-income business owners divert their earnings to family members with lower tax rates.
Income sprinkling works on the principle that “dividend payments are related to a shareholders’ capital or share interest in a corporation and not to contributions provided by that shareholder to the corporation,” said Collins. Recently, the Supreme Court of Canada made changes to limit the principle. Contribution criteria must be met to benefit from income sprinkling. If the criteria are not met, money received will be heavily taxed.
The benefits of income sprinkling
There are obviously quite a few benefits to income sprinkling, especially for small, family-owned businesses. “The benefits of income splitting relate to the application to all family members of graduated tax rates in addition to personal tax credits and deductions such as the lifetime capital gains deduction,” Collins said. Income splitting allows small business owners to pass income onto others, lowering their own income and placing them in a lower tax bracket. “It is more advantageous for two people to pay tax on $80,000 at $40,000 each than one person to pay.”
With the recent changes, if the income received does not meet the criteria, it will be considered Tax on Split Income (TOSI) and will be taxed at the highest marginal tax rate, regardless of income level.
What does income sprinkling and the new criteria mean for small business owners? “When the proposed legislation was first released on July 18, 2017, it was extremely complex and almost incomprehensible,” said Collins. “The recent changes attempt to simplify the legislation, but whether they are simpler or not depends on the circumstances.”
DBO has been helping small businesses understand the new legislations. For example, it has more of an effect on professional corporations. While the new rules do not affect salaries to individuals, it does affect dividends. “Going forward, family members must work more than 20 hours per week for dividends received to not be TOSI,” Collins said. Also, “dividends cannot be paid to family members unless the person directly holds shares having at least 10 per cent of the votes and value of the corporation.”
This affects companies that have been rewarding their children through a family trust. To receive dividends that are not TOSI, the children will have to hold shares and ultimately a portion of ownership. Another point of confusion in the changes to the income splitting legislation is the definition of services. “Private corporations that have 90 per cent or more of their revenue from the provision of services are in a similar situation,” said Collins. “These corporations are more likely to be subject to TOSI rules because they do not qualify for the exemption for shares holding 10 per cent of votes and value.” For example, it is not clear whether plumbing repair is a service or a service and a supply, therefore invoice for both the service and the parts. Invoicing for the parts could be more than 10 per cent of their income, so TOSI may not apply. This is still unclear in the current legislation.
The bright side
While some details are still cloudy, the new rules of income splitting are not all bad. Older couples receive a benefit: business owners who are over 65 can split income with a spouse without meeting the typical requirements. Individuals are also allowed to inherit shares outside of the standard requirements.
All small business owners benefit from one recent change: “The federal small business tax rate decreased from 10.5 to 10 per cent effective January 1, 2018, and will decrease again to nine per cent in 2019,” Collins said. Also, corporations that must restructure to meet the requirement of 10 per cent votes and value have a grace period to do so—until the end of 2018.
With any change comes an adjustment period. We will have to wait to see how businesses adapt to the changes as the legislation is cleaned up and clarified over the coming months.