Income splitting is an effective way for families to reduce their overall family income tax burden. Income splitting is the process of distributing income amongst a family group to take advantage of the lower income tax brackets available to each family member. Although income splitting can be achieved in many families, the families who are owners of privately owned corporations and professional corporations can have the largest benefits. As a business owner, you may be earning a substantial income and being taxed at the highest personal tax rates.
With income splitting, you have the ability to hire your spouse and/or children as employees resulting in a shift of some of your income into their hands where it’s taxed at much lower income tax rates. It is, however, important to note that there are strict rules for income splitting and the government looks very closely at these arrangements. Salaries paid must be for actual work performed. Job descriptions and employment records also need to be in place. In addition, the amount of salary paid must be commensurate with what you would pay any other employee who is performing the same job. For example, you cannot pay your spouse $80,000 to do basic office tasks, such as filing and reception duties. If your spouse is working for you as a general office assistant, you should pay him or her a rate equal to the salary of other general office assistants.
There are some additional minor income tax savings benefits to this planning. Since your spouse now has an income, he or she will be contributing to the CPP and will also able to contribute to their own RRSP, which will help you both build a more secure retirement.
This salary planning works well for spouses, however, with adult children it is not always practical for them to work for your company. They may be too young, away at school or the nature of the business may not be suitable for you to substantiate a position for them, in which case, you would not be able to pay them a salary. There is a planning option available for children who are 18 or older which also works for spouses in addition to the above salary option. It entails the child or spouse owning shares in the business either, directly or through a family trust. Owners of certain share’s can be paid dividends allowing the business owner to distribute income to lower tax rate family members. This type of planning is complicated to structure and has other outcomes that need to be considered before determining whether it is the right solution for your family. You should consult with your professional accountant and lawyer to review the options and to implement this structure.
I have listed some other income-splitting strategies you might consider if your spouse is in a lower income bracket. Some of these strategies also work for non-business owners:
- Spousal RRSP – The higher income spouse contributes to an RRSP for the benefit of the lower income spouse. When the income is withdrawn (subject to certain rules) it is income to the spouse with the lower income and therefore taxed at the lower tax rates. However, you must ensure that you follow the rules with respect to the timelines for withdrawal or the withdrawal is taxed to the spouse with the higher income.
- The higher income spouse should pay all household expenses so the lower-income spouse can use his or her earnings for investments. In this case, since the lower income spouse is using their money to make investments the income will be taxed at the lower-income spouse’s tax rate.
- The higher income spouse can make the annual contributions to the lower income spouse’s Tax-Free Savings Account (TFSA). As long as the money remains in the TFSA it earnings are tax free. However, if the lower-income spouse subsequently takes out the TFSA money and invests it, the income from the investments will be attributed to the higher income spouse and therefore taxed at the higher rates.
When dealing with tax planning including income splitting it is important to ensure you understand all the rules and pitfalls.