Small Business Owner Planning: Income Splitting – What You Need to Know

For small business owners in Canada, smart tax planning can make a significant difference in managing cash flow, reducing tax liabilities, and building long-term wealth. One powerful – yet often misunderstood – strategy is income splitting.

When used correctly, income splitting allows business owners to distribute income among family members in lower tax brackets. However, recent legislative changes and attribution rules from the Canada Revenue Agency (CRA) mean that this strategy must be approached carefully and with professional guidance.

In this post, we’ll break down what income splitting is, how it can benefit small business owners, the rules to be aware of, and how to determine whether this strategy is right for your situation.

What is Income Splitting?

Income splitting refers to the practice of redistributing income within a family to take advantage of lower marginal tax rates. Instead of one individual being taxed at a high rate, income is shared with a spouse or adult children whose incomes are lower, thereby reducing the family’s overall tax bill.

For small business owners, this typically involves paying family members a salary, dividends, or allocating income from the business to family members who are shareholders.

Why Income Splitting Matters for Small Business Owners

Canada has a progressive tax system—meaning that as your income increases, so does the rate at which you’re taxed. A successful small business owner could easily find themselves in the highest marginal tax bracket, paying over 50% in taxes depending on the province.

By spreading income across family members who are taxed at lower rates, you may:

• Significantly reduce the family’s total tax burden
• Provide compensation to family members who contribute to the business
• Allow family members to accumulate RRSP and TFSA contribution room
• Fund education or living expenses for adult children in a tax-efficient way
• Increase net household cash flow and savings potential

However, income splitting must be approached correctly to avoid penalties, attribution of income back to the primary earner, or triggering the Tax on Split Income (TOSI) rules.

The Tax on Split Income (TOSI) Rules

In 2018, the Canadian government introduced new Tax on Split Income (TOSI) rules to limit income splitting for high-income earners. The TOSI rules apply to most types of income earned by individuals from a private corporation if the individual is a family member of a shareholder.

Under these rules, any split income that doesn’t meet certain exceptions may be taxed at the highest marginal tax rate, even if the recipient is technically in a lower tax bracket.

TOSI Applies To:

• Dividends from private corporations
• Interest on loans made to a related business
• Capital gains on the sale of shares in a private corporation

Who Is Exempt from TOSI?

Fortunately, not all income-splitting arrangements are subject to TOSI. Exemptions include:

1. Excluded Business

If the family member is actively engaged in the business for at least 20 hours per week during the year (or during any five previous years), income they receive is generally not subject to TOSI.

2. Excluded Shares

Dividends received from shares in a corporation that earns less than 90% of its income from services and is not a professional corporation (e.g., medical or legal corporations) may be excluded from TOSI if the recipient is 25 or older and owns at least 10% of the votes and value of the company.

3. Reasonable Return

TOSI may not apply if the income received by the family member is considered a “reasonable return” for their contributions to the business—based on factors such as capital contributed, labour provided, and risk assumed.

4. Spouses of Business Owners Over 65

If the business owner is 65 or older, they can split income with a spouse even if the spouse doesn’t meet the above criteria. This is similar to pension income splitting.

Common Income Splitting Strategies

1. Paying Salaries to Family Members

This is one of the most straightforward strategies. If a spouse or child works in the business, you can pay them a reasonable salary based on the work performed. The salary must be justifiable in terms of hours worked and responsibilities, and appropriate records should be kept.

Pros:

• Deductible business expense
• Creates RRSP and CPP contributions for the family member
• Can be used for children over the age of 18

Cons:

• Must be justifiable to the CRA
• Requires payroll remittances and T4 slips

2. Issuing Dividends to Family Shareholders

If your business is incorporated, you may be able to issue dividends to family members who own shares in the business. To avoid TOSI, the individual must meet one of the exemptions outlined above.

Pros:

• Potentially tax-efficient if TOSI doesn’t apply
• Flexibility in timing and amount of income paid

Cons:

• Complex rules under TOSI
• May require restructuring of share classes

3. Spousal Loans

A spousal loan involves lending money to your lower-income spouse to invest and earn income. The loan must bear interest at the prescribed CRA rate (currently low), and interest must be paid annually.

Pros:

• Effective for investment income splitting
• Can shift future capital gains to the lower-income spouse

Cons:

• Requires strict documentation
• Interest must be paid annually to avoid attribution rules

4. Using a Family Trust

A family trust can hold shares in the corporation on behalf of family members and allow for income or dividends to be distributed in a flexible manner. A trust can also be used for estate planning.

Pros:

• Flexibility in distributing income
• Potential to multiply the lifetime capital gains exemption
• Useful for long-term planning

Cons:

• Complex to set up and administer
• Subject to scrutiny under TOSI rules

Real-World Example

Let’s consider a simplified example:

James owns a profitable incorporated plumbing business in Ontario. His wife, Lisa, works part-time doing administrative tasks for the company. Their adult daughter Emily, age 22, helps with social media and marketing.

James wants to reduce the family’s overall tax bill by splitting income. Here's what he might do:

1. Pay Lisa a salary of $25,000 for her admin work, supported by time sheets and job descriptions.
2. Pay Emily a reasonable salary of $15,000 based on her work hours and tasks.
3. Consider issuing dividends to Lisa if she qualifies under the excluded shares rule.
4. Set up a family trust for long-term planning and possibly include other children in post-secondary education to benefit from trust income in the future.

Working with a financial advisor and tax professional, James can navigate the TOSI rules while ensuring the income splitting is legitimate and optimized.

Avoiding Common Pitfalls

Income splitting can trigger red flags with the CRA if not properly documented or justified. Here are a few things to avoid:

• Paying unreasonable salaries to family members not working in the business
• Failing to keep records (like time logs or job descriptions) for family employees
• Assuming TOSI doesn’t apply without consulting a professional
• Using cookie-cutter strategies that don’t reflect your unique family or business situation

When to Talk to a Financial Planner

A financial planner like Dunbrook Associates with small business experience can:

• Review your current structure for income splitting opportunities
• Help assess whether family members qualify for TOSI exemptions
• Work with your accountant or tax lawyer to restructure your corporation
• Develop a long-term income strategy that includes retirement, estate, and succession planning

Income splitting is just one piece of a comprehensive small business financial plan. It works best when integrated into a larger framework that considers tax efficiency, wealth transfer, and business sustainability.

Income splitting offers small business owners in Canada a powerful tool for reducing taxes and supporting family members. However, with the introduction of the TOSI rules, it’s no longer as simple as issuing dividends or writing a pay cheque to your spouse or kids.

Understanding the rules, keeping detailed records, and seeking expert advice are essential to making this strategy work for your family and your business. With proper planning, income splitting can help you maximize after-tax income, strengthen your family’s financial security, and build a legacy that lasts.

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