October 1, 2022
by TMFD Financial
It is a common complaint that we pay too much tax in Canada, so it’s no surprise there is great interest in using techniques that ease the tax burden for our families. We recognize that CRA’s primary objective is to collect as much tax as possible, but as individuals, we are permitted to structure our affairs to pay as little tax as possible within legitimate means.
Income splitting is the technique of transferring income from a family member subject to a high tax rate to a family member at a low tax rate. The end result is less tax payable overall.
The Canadian tax system is based on graduated tax rates, which means we pay a higher rate of tax as income rises. In most provinces, the top personal tax rate exceeds 50%. And since tax returns are based on individual income, not family income, the system creates imbalances in many situations. For example, a household with one spouse earning $200k and the other spouse no income will pay substantially more tax than a household in which both spouses earn $100k (in this example, a difference of approximately $20k)1. This happens because the graduated tax rates have a disproportionate effect at higher tax brackets. The corollary to reducing tax is to employ income splitting with as many family members as possible. However, there are limitations to these techniques which is why there are certain ‘attribution’ rules in place to curb the indiscriminate use of income splitting.
Let’s take a closer look at common income splitting opportunities and some of the pitfalls to avoid.
Can I pay a salary to my spouse or other family members?
Salary is paid to employees for their work and contributions to the business. CRA takes the position that paying salary should be commensurate with their duties. We often encounter dentists who pay their spouses (or children) for an administrative position, which is legitimate for tangible contributions to the practice, such as coordinating appointments for patients, handling receivables and payables, managing staff, or office cleaning. But in many cases, the spouse does not contribute greatly, if at all. CRA would ask the dentist if they would pay the same salary to an unrelated individual for the same contribution to the practice; if the answer is no, then it might be deemed aggressive tax planning. For an associate dentist, it is even more difficult to justify since there isn’t an office to run and staff to manage. The key is to use discretion in determining an appropriate salary to pay family members which is commensurate with their contributions and abilities.
Can I pay a dividend to my spouse or other family members?
Yes, in many cases it is possible to pay a dividend to family, but a great deal of caution is required. Only shareholders of the Professional Corporation are eligible to receive dividends. The Articles of Incorporation specifies the traits and restrictions regarding which class of shares can receive dividends and the maximum amounts, if applicable. Furthermore, CRA introduced a broad set of new guidelines and restrictions in 2018, often called ‘Tax on Split income’ (TOSI) rules, which greatly limits payment of dividends and other forms of income to family members. The new guidelines deter dividends to family members under a variety of conditions, including those that work in the practice less than 20 hours per week, and for adult children under the age of 25; in these situations, family members automatically pay tax at the top personal rates on these dividend distributions.
Can I add my spouse or other family members as shareholders of my Professional Corporation?
Yes, spouses, children and parents of the dentist may be shareholders of a Professional Corporation. This is often done for two reasons—to allocate dividends to family (subject to the guidelines above) or to benefit from the eventual sale of the dental practice. Family members may be assigned ‘growth’ shares (aka ‘participating’ shares) to benefit from the Lifetime Capital Gains Exemption (LCGE), which could save taxes up to $244k per person1. It is best to include family members as shareholders from inception of the company to avoid potential problems with corporate attribution. This can occur when the corporation is restructured to add family members as shareholders after the practice is well established and profitable. Corporate attribution effectively reduces or eliminates income splitting by assigning a deemed interest rate to the value of shares received on the transfer, thereby requiring the dentist to include into income a deemed taxable benefit. Efforts to restructure a corporation need to be carefully designed to avoid these negative consequences.
Income splitting is a powerful and legitimate strategy for minimizing taxes for the family. There are many other forms of income splitting that may be available, such as transfers or loans to spouses, adult children, minor children, or family trusts. For retirees, they may also utilize Spousal RRSP’s, pension splitting (including RRIF income) and the sharing of CPP retirement benefits. However, the rules for determining attribution are intricate, so it is advisable to seek professional guidance before restructuring your affairs.
At TMFD Financial, we specialize in the business of dentistry – which means our group of professionals understand your industry and how income splitting will affect you, and your business.
Let us help you look at the “big picture” to ensure that the most suitable choices and strategies are chosen for you, your practice, and your family.
*TMFD Financial offers accounting, financial planning, and consulting services for dentists through one convenient point of contact. Their integrated team of proficient financial professionals work together to synchronize all the moving parts of a dentist’s personal and professional finances. All tax and accounting services are provided by TMFD Professional Corporation, Chartered Professional Accountants.
1 Ontario tax rates, 2022