What is income splitting?
Income splitting, in a nutshell, is a tax term that describes splitting a person’s income on a tax return to reduce taxes owing. Income splitting is a strategy that can be used by high-income owners of private corporations to divert their income to family members with lower personal tax rates.
If you do a simple internet search, there are two broad definitions of income splitting that produces results. Income splitting on pensions relates to retirement planning and how to best optimize income splitting on retirement pensions between spouses (or common-law partners). The income splitting that will be discussed in this blog post, however, is not for retirement planning, but to lower taxes paid on income earned in a private corporation.
When a private corporation makes a profit, there is a corporate tax on the net profit. When the net profits are disbursed as dividends to shareholders, the individual shareholders are then taxed at a personal level. Personal tax in Canada is taxed in a tiered system, and so the more income earned the higher the overall tax. The idea behind income splitting is to disburse the dividend income among multiple family members so as to reduce the personal tax paid on this income.
Who is eligible for income splitting in Canada?
The strategy for income splitting is typically used for high-income owners of private corporations to divert income to family members with lower personal tax rates.
What needs to be considered?
There are a lot of considerations to be made when taking on this tax reduction strategy. Generally speaking, there are rules that would prevent simply transferring income from a corporation to various family members. There are rules in place that require family members receiving dividends from a corporation to be at least 17 years of age and be significantly involved in the corporation.
The rules are called tax on split income (TOSI) and if these rules are not followed then the income transferred to the receiving family member may be taxed at the highest income bracket, which then defeats the entire purpose of splitting income.
It is highly advisable to talk to an accountant when splitting income to avoid this exact case of being taxed at the highest income bracket. Furthermore, there are other tax strategies that should also be considered in these types of situations.
A few articles for reference: