I’ve talked about income splitting through a corporation before in this series, but things have changed! Last December, the Federal Minister of Finance, Bill Morneau, revealed some new rules and in this video, I want to discuss if and how the new changes could affect you, your family, your business and of course, your taxes.
If you recall from my previous videos, income sprinkling is used by small business owners or incorporated professionals to redirect their business income to family members who are in lower tax brackets, usually by issuing dividends.
These dividends are often discretionary, so the owner can direct any amount in a particular tax year to a given family member, so long as they are shareholders of the company. This only worked for lower-taxed family members who were 18 years old and older because of what is known as the Tax on Split Income (TOSI) or more commonly known as the ‘kiddie tax.’ Family members who were under 18 have the highest marginal tax rate applied to such dividends, so that was never an option.
The government has changed these rules specifically to target incorporated professionals (Doctors, lawyers and others) who are benefiting from lower tax rates on what would otherwise have been fully taxable income at the highest marginal rates, if not for the corporation.
In other words, the government is essentially making the argument that these incorporated professionals aren’t adding any economic value to society by their decision to incorporate, and should therefore not benefit from many of the tax advantages of doing so.
Now, I’m not going to wade into the debate over whether this reasoning is right or wrong. What I will say is that all kinds of small businesses are getting caught up in these changes, which is causing an uproar among entrepreneurs and their accountants!
So what are the changes?
The TOSI rules have been extended to cover adult shareholders of private corporations, as well as the minor children that it already applied to.
The question then becomes: If you are a private corporation owner and would like to pay dividends to relatives who are shareholders, when can you do so without being caught by the new rules? Essentially, to escape the new rules, you have to be able to show a significant involvement in the business. The Federal government is putting what they’re calling ‘clear, bright-line tests’ or ‘off-ramps’ to exclude some family members from the TOSI.
Let’s look at these exclusions. One for is the business owner’s spouse, providing they are over 65 years old. Another is for adults over 18 years old who have made a significant labour contribution, which the CRA is measuring at an average of 20 hours a week, to the business during the year or during any of the five previous years.
Here’s another: if you’re age 25 or over, you can be exempt from the TOSI rules if you hold over 10% of the share value and the company earns less than 90% of its income from the provision of services. This exemption doesn’t apply to professional corporations though.
And finally, if you receive capital gains from qualified small business corporation shares and they are not subject to the highest marginal tax rate on the gains under existing rules, the new exception rules will apply.
So what happens if you don’t fall into one of these categories?
Well, anyone who is 25 or older, who does not meet any of the exclusions described above would be subject to a reasonableness test to determine how much of any dividend received, if any, should be taxed at the highest marginal tax rate. In certain cases, adults aged 18 to 24 who have contributed to a family business with their own capital will be able to use the reasonableness test on that related income.
One of my pet peeves is that this has only made the tax code more complex, which adds more potential for unintended consequences. There’s no doubt that these rules are messy and will have accountants working lots of overtime to figure out to whom and how they should apply.
As always, I’ll put some links below if you want to read more about the new changes. In my next post, we’re going to look at Socially Responsible Investing so don’t forget to subscribe to get the notification when that video goes up.
Source: Backgrounder on Simplified Measures to Address Income Sprinkling