Income Splitting Strategies

Keep More Wealth Within Your Family

In Canada's progressive tax system, the more you earn, the higher your marginal tax rate becomes. For a family with a single high-income earner, this can result in a significantly higher overall tax bill than a family where two spouses earn a moderate income. This is where income splitting comes in.

Income splitting is a set of strategies designed to shift income from a high-income family member to a lower-income family member, taking advantage of their lower marginal tax rates. For an incorporated professional, these strategies can lead to substantial tax savings for the family unit as a whole. However, the Canadian tax landscape for income splitting is complex, particularly with the Tax on Split Income (TOSI) rules.

Strategy: Paying a Salary to a Spouse or Adult Child

One of the most straightforward income splitting strategies is to pay a reasonable salary to a spouse or adult child for legitimate work they perform for your professional corporation. This could include administrative tasks, bookkeeping, marketing, or any other role that contributes to the business.

Key Requirements:

The work must be legitimate: The family member must actually perform the duties for which they are being paid.
The salary must be reasonable: The compensation must be in line with what you would pay a third party for the same work.

By paying a salary, you create a tax-deductible expense for your corporation, and the income is taxed in the hands of the family member at their lower rate. This also allows them to build their own RRSP contribution room and CPP benefits.

Strategy: The Prescribed Rate Loan

A prescribed rate loan is a powerful tool that allows you to split investment income with a spouse or family member. This strategy is particularly effective when the CRA's prescribed interest rate is low.

How It Works:

The high-income spouse loans money to the low-income spouse.
The loan must charge interest at the CRA's prescribed rate at the time the loan is made. This rate is then locked in for the life of the loan.
The low-income spouse invests the borrowed funds. All investment income (dividends, capital gains, interest) generated from the invested funds is taxed in the hands of the low-income spouse.

This effectively transfers the future tax liability on investment growth to the lower-income spouse, reducing the family's overall tax bill. The interest on the loan must be paid by January 31st of the following year for the strategy to remain valid.

Strategy: The Family Trust

A family trust is a more complex legal structure, but it offers significant flexibility for income splitting and asset protection. Assets are transferred to a trust, managed by a trustee for the benefit of a group of beneficiaries (your family members).

Key Benefits:

Income Sprinkling: The trustee has the discretion to distribute income generated within the trust to one or more beneficiaries each year, minimizing the overall tax paid.
Asset Protection: Assets held within a trust are generally shielded from the claims of creditors of the beneficiaries.
Capital Gains Exemption: A trust can allow multiple family members to access their lifetime capital gains exemption upon the eventual sale of a qualifying small business corporation.

Family trusts are particularly useful for holding shares of a professional corporation or other income-producing assets. They require careful setup and ongoing administration with the help of legal and tax professionals.

Navigating the Tax on Split Income (TOSI) Rules

The TOSI rules were introduced to limit the ability of business owners to split income with family members who are not actively involved in the business. If TOSI applies, the split income is taxed at the highest marginal rate, negating the benefit of the strategy.

However, there are several important exclusions from the TOSI rules, including:

Income paid to a spouse if the business owner is over 65.
Income from a business where the family member works an average of 20 hours per week (the "excluded business" exemption).
Reasonable returns on capital contributed by a family member.

Successfully navigating the TOSI rules is critical to any income splitting strategy. It requires meticulous record-keeping and a clear understanding of the exemptions. Consider integrating these strategies with your estate planning for maximum impact.

A Coordinated Approach to Family Tax Minimization

Income splitting is not a DIY project. It requires a coordinated approach that integrates legal structures, corporate tax planning, and personal finance. When implemented correctly, these strategies can save your family tens of thousands of dollars in tax each year. At SG Wealth, we work with high-income professionals and their legal and accounting teams to identify the most effective income splitting strategies.

Beyond splitting income today, corporate-owned life insurance moves surplus from the corporation to the next generation tax-free through the Capital Dividend Account - a complementary lever for high-income professionals managing wealth across family members.