Clients who own small businesses and are looking for ways to split income with one or more family members still have several options available – even after the federal government’s recent changes to the taxation of private corporations reduced the available options significantly.
Any tax-planning strategy your small-business owner clients may elect to undertake in light of new “tax on split income” (TOSI) rules will depend on each client’s unique circumstances, including the ages of the family members with whom a client wishes to split income and those family members’ involvement in the business, says Debbie Pearl-Weinberg, executive director, tax and estate planning in Canadian Imperial Bank of Commerce’s financial planning and advice group in Toronto.
“These are the things that clients should discuss with their tax advisor,” Pearl-Weinberg says. “The [TOSI] rules are so specific, and falling offside is so easy.”
The federal government introduced the TOSI regime last year as part of a review of the rules governing small-business taxation. The new rules eliminate many of the ways in which small-business owners had been able to split dividend income. Paying dividends to lower-income family members who might otherwise pay little or no taxes can result in overall tax savings for the family.
Although the practice of income splitting by paying dividends to minor children was covered under the existing “kiddie tax” rules, the new TOSI rules target adult children and spouses in an attempt to eliminate certain types of tax planning, says Aurèle Courcelles, assistant vice president, tax and estate planning, in Investors Group Inc.’s advanced financial planning division in Winnipeg.
However, TOSI rules provide for exceptions that would permit income splitting under certain circumstances – including “excluded business,” “excluded shares” and “reasonable return” exemptions. In addition, a retired business owner who is 65 years of age or older can split dividend income with his or her spouse (or common-law partner), regardless of the recipient spouse’s age.
You should remind your business-owner clients that a salary paid to a family member, regardless of age, continues to be a valid way to split income and is not caught under TOSI rules so long as the salary is “reasonable.”
“You have to be able to prove that the family member is working in the business,” says Courcelles, who suggests business owners keep documentation, such as time sheets, as proof.
Under the excluded business exemption, TOSI rules will not apply if the family member is at least 18 years old and “actively engaged on a regular, continuous and substantial basis” in the business in any given year or in any five previous years, which need not be consecutive. A family member who works an average of 20 hours a week in the business would meet the “actively engaged” test. Family members who don’t meet this test still could qualify for the exemption, depending on the circumstances.
Since the introduction of TOSI rules, some business-owner clients have been considering whether to have family members work more hours to ensure those people meet the “average hours worked” test, says Tarsem Basraon, vice president wealth advisory services, and a high net-worth planner with Toronto-Dominion Bank in Toronto: “I’m seeing a lot of that.” Although qualifying for the excluded business exception without meeting the test is possible, he adds, “that’s less certain. This 20-hours-a-week [guideline] gives you an objective test.”
Under the “excluded shares” exemption, TOSI rules would not apply to a family member who is 25 years of age or older and owns shares in the business representing at least 10% of the votes in and value of that business. For the 2018 taxation year only, a family member has until Dec. 31 to be deemed to qualify for the entire taxation year. In addition, professional corporations and businesses in which at least 90% of the business income is from the provisions of services won’t qualify for this exemption.
A business owner client could consider undertaking a reorganization of the share structure of the business so that a family member qualifies for the excluded share exemption. However, such a step should be taken only after receiving expert tax advice, Pearl-Weinberg says.
A third exclusion is the “reasonable return” exemption, which allows for income splitting if the value of the dividends the family member receives is considered to be “reasonable,” a criterion that is determined by several factors. Those factors are more restrictive for family members between the ages of 18 and 24 than for those 25 years of age and older. A business owner may elect to wait until a family member reaches the age of 25 before paying out dividends to him or her, Courcelles suggests.
However, because the reasonable return rules are new and subjective, uncertainty regarding how the Canada Revenue Agency will administer them still exists, Courcelles says: “What [will] qualify is hard to define.”