What Are Split Income Rules? How They Affect Business Owners?

Abstract

Split Income Rules are the rules passed in 2018 to prevent business owners from unreasonably moving business profit to their spouse or adult children, for the purpose of reducing their tax bills. In this article, we will explain what they are, how they affect the taxation on business owners and what strategy we can adopt to mitigate the issue.

What Are Split Income Rules?

When Were They Introduced?

It’s been about 6 years since those rules came into force. In 2017 & 2018, these rules were what all accountants and bookkeepers had been talking about. Six years later, Canada Revenue Agency (CRA) hasn’t announced any taxpayer punished by these rules yet. It’s been so quiet that I almost forgot about them, until one potential client asked me about it.

That being said, these rules are still in force. We don’t know whether the Canadian government has backed down from enforcing the rules or not. We have advised our clients to adopt different profit distribution strategies. That could be why nothing happened so far. Maybe other clients have adopted the same strategies so very few cases have been caught by CRA. In our opinion, it never hurts to be prudent and avoid the risks from the very beginning.

The Root of Income Splitting

The root of income splitting is the concept of progressive income tax rate, also associated with the concepts of a marginal tax rate or a tax bracket.

Most countries, including Canada, adopt a progressive income tax rate system, meaning the tax rate increases while your income increases. In BC, the lowest tax bracket is 20.06%, when taxpayer’s income is under $45,654 (2023). The highest tax bracket is 53.50%, for the portion of income which is over $240,716.

Imagine you were a doctor who makes $500,000 a year in BC, so half of your income was taxed at 53.50%, you probably wouldn’t be too happy about it, right? Since your tax rate is based on your personal income, it would be much better if you could split that $500,000 between you and your spouse so that each of your only have to report $250,000. Or even better, split the income between you, your spouse and two children so that each person only needs to report $125,000. By doing so, nobody would pay the top tax bracket; the highest tax bracket tax rate in this case is only 38.29%.

That’s a lot of tax savings!

(By the way, the Government never said these rules were for doctors. However, most tax professionals believed that doctors and lawyers are the prime targets of the new split income rules.)

Income Splitting Through Holding the Shares

Before the birth of these new rules, the easiest way split income was through share ownership.

Most small corporations in Canada only have a symbolic share capital, such as $1. But still, corporations distribution dividends by the percentage of share ownership. As a result, you could let spouse and children purchase 25% of the company shares, for a total of $0.25 each person. Now you could issue $500,000 in dividends and each family member will get $125,000 cash dividend.

Obviously, this is not fair, because nobody can reasonably expect to invest only 25 cents in shares and receive $125,000 a year in terms of a dividend. This is only possible because: 1. A medical professional corporation needs very little initial capitals. 2. Family members acquired the shares from the family connections, not by competitive bidding. Therefore, the Government decided to create the split income rules in order to counter this tax strategy.

The Punitive Rate From Split Income Rules

If the dividends received by family members are deemed to be split income, the family members need to pay taxes equal to the highest tax rate. Using our previous example, each family member need to pay 53.5% x $125,000 = $66,815.

Apparently, the family would pay a lot more taxes under the split income rules; the doctor in the example would have paid less taxes if he had reported all $500,000 just to himself.

There are exemptions where the family members can avoid paying the punitive tax rate if their situations apply. That’s what we are going to discuss in the next section.

Strategies to Avoid Split Income Rules

Issue Salaries Instead of Dividends

Split income rules only apply to dividend and interest income; it doesn’t apply to employment income. In other words, if you split the income by hiring your spouse and adult children, the CRA cannot push their tax rate to the top tax bracket — even if the CRA considers the employment income unreasonable.

However, the family member needs to be actually working for your company and the pay rate needs to be reasonable. Interestingly, the CRA didn’t specify how they will determine whether the pay rate is reasonable. Therefore, we should probably rely on common sense to decide.

Keep A Timesheet

A major exemption offered in the split income rules is the active participation in business’s operations. If your spouse or adult children actively engage in your business, they can exercise the Excluded Business exemption and none of their dividend or interest income shall fall under the split income rules. Active engagement means “works in the business at least an average of 20 hours per week during the portion of the taxation year of the individual that the business operates or meets that requirement for any five prior years.”

The exemption applies to the current or past 5 years. In other words, working a year for the corporation can give your spouse 6 years’ exemption. The law doesn’t say what position your spouse needs to hold. A position of administrative staff or a receptionist should be good enough. The required hours are set at 20 hours per week so the spouse can still have another part-time job outside your company, or even a full-time job.

Although the CRA doesn’t explicitly say that you need to have a timesheet, most provinces require an employer to keep that as a records. A set of well-organized timesheet is also a supporting document for the salaries paid. We recommend setting up the payroll modules in your accounting software and running the payroll as if your spouse was a regular employee.

Create More Share Types

Your corporation should issue different types (called “classes” in the accounting terms) of shares. Then you can assign different classes to different family members. This allows you to control the dividends paid to each family member. You could withhold family member’s dividends until he or she becomes exempt from the income splitting rule.

Income splitting rules don’t apply if a family member holds less than 10% of your company’s shares. If you have many adult children, you many be able to split half of your business profit by letting them own 9.9% of the shares each.

Pay Yourself More

We setting up the pay rate, we suggest that the owner pay more salaries to himself (or herself) than to the spouse, even though this may result in the owner falling in a higher tax bracket.

Again, this is to make the salaries received by the spouse more reasonable under the common sense. You can offset higher tax bracket by making more RRSP contributions, if you have enough contribution room.

Not All Corporations Are Subject to Split Income Rules

Product-Based Companies

If the major business activity of your business is selling or manufacturing physical products, your are NOT subject to the new income splitting rules. Typically, these companies need a lot of capitals for their daily operations. The shareholders cannot possibly contribute 25 cents and get a dividend of $125,000 a year.

In other words, the Canadian government considers the profit earned by these companies are the generated from the contributed capitals and doesn’t deserve special treatments.

However, if some of the shareholders are between the age of 18 and 24, they are generally still subject to the new split income rules. The law doesn’t believe they are truly independent and probably still under your control.

Service-Based Companies

If over 90% of your business activities are providing services, your business is subject to the new split income rules. For example, if you are a prestigious business consultant and making $500,000 a year, you need to pay attention on how the new rules restrict your profit distribution.

If you provide a mixture of services and products, the rules will be the same as a product-based company.

Regulated Professions

A regulated profession includes a doctor, a lawyer, an accountant or a real estate agent. If your business is in this category, the new split income rules DO affect your business.

As mentioned before, most tax professionals believe that the doctors and lawyers are the real targets of the new rules. The high profits of these companies usually depend on the founder’s professional knowledge. In addition, these companies require very little monetary capitals to generate huge profits. That’s why the composition of share ownership doesn’t represent the value contributed by the shareholders.

For other regulated professions, even though they don’t usually make so much money as doctors, they are still affected as doctors and lawyers are. If the law had specifically targeted only doctors & lawyers; it would have been a discrimination. As a result, the law needs to define a broader scope covering all regulated professions.

If your business unfortunately falls into this category, I would suggest you spend more time making sure your profit distribution doesn’t trigger the split income rules by an accident.