Income Splitting Through Family Dividends

by Craig Anthony

2 min read

If you own a Canadian small business corporation, you may be able to reduce your taxable income through a process known as income splitting. One of the most effective strategies involves the distribution of dividend income to family members.

The Concept and Purpose of Splitting Income

Splitting income is the practice through which business income gets rerouted to various designated persons with the aim of reducing aggregate tax liability. This is possible because of the combination of Canada’s progressive tax system and the tax-free basic exemption amount.

In other words, a business owner who winds up in a high marginal tax bracket might divert income to a family member. The first part of the diverted income is not taxed because of the basic exemption. Any additional income beyond the exemption limit is still taxed at a lower rate because the family member doesn’t earn enough to qualify for a higher marginal tax rate.

Wages vs. Dividends

There are two primary ways to split business income with family members. The first is through wages; the business lists the family member as an employee and pays a salary. The second method is to issue ownership shares to the family members, and then pay dividends to the shareholders.

A relatively common third method, the “prescribed rate loan strategy,” is more complicated and only applies to low-income spouses. See this list for a full breakdown of permitted income-splitting arrangements.

The Canada Revenue Agency has various restrictions in place to prevent wage-based income splitting from being abused. For example, all salaries must pass the reasonability test, which says the share of income must be congruent with the amount of work or capital put into the business by the family member. As a general rule of thumb, the CRA recommends that business owners pay their spouses or children the same approximate wage that a third party would have earned for the same work.

In most cases, splitting income is more effective when performed through dividends than wages, especially in larger amounts. This is because there are normally no restrictions on the amount of dividends that your business can pay family members, thereby avoiding the reasonability test associated with direct wages.

There are some circumstantial hurdles associated with dividend-based income splitting. A special tax is applied to dividends paid to children under the age of 18, or the so-called “kiddie tax.” If your company is not considered a small business corporation and you want to issue shares to designated family members, you should keep an eye on corporate attribution rules.

Distributing Dividends to Shareholding Family Members

Commonly, dividend distributions to family members are either made to shares issued directly to family members or to a discretionary family trust. Direct issues typically differ depending on which family member receives them. Spouses normally receive fully participating shares. Children often receive restricted shares that never increase in value and may only receive discretionary dividends. In a family trust, the beneficiaries might include all family members but distributions can be made to any individual or group among the beneficiaries, even to the exclusion of some members.

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