Income Splitting and TOSI Rules for Lawyers in Canada

By distributing corporate earnings to family members in lower tax brackets, legal professionals could optimize their after-tax wealth. However, the expansion of the Tax on Split Income (TOSI) rules in 2018 fundamentally altered this landscape.

Today, the TOSI rules apply the highest marginal tax rate to "split income" received by family members of a business owner, unless specific, stringent conditions are met. This means that simply issuing non-voting shares to a spouse or adult child and paying them dividends is no longer a viable strategy without genuine, documented involvement in the law practice. Navigating these rules requires a deep understanding of the statutory exclusions and meticulous documentation to ensure compliance and protect your wealth from aggressive Canada Revenue Agency (CRA) reassessments.

Prior to 2018, traditional attribution rules were often insufficient to address dividend sprinkling through private corporations, as highlighted in landmark cases like Neuman v. The Queen and Ferrel v.

The Queen. Parliament responded by creating a mechanical regime that does not require a tax-avoidance motive to apply. If the statutory conditions are met, the tax applies automatically.

For lawyers, the analysis revolves around three core concepts: the specified individual (the family member receiving the income), the source individual (the lawyer whose practice generates the income), and the related business (the legal professional corporation).

When TOSI applies, dividends, shareholder benefits, family trust income allocations, and certain capital gains connected to the law practice are taxed at the highest personal marginal tax rate, effectively eliminating any tax benefit of the distribution. The critical challenge for legal professionals is determining whether a family member qualifies for an "excluded amount" under the legislation.

It primarily affects dividends and some capital gains received by the spouse, adult children, or other family members of a business owner. The rule operates on the presumption that the income is derived from the efforts or capital of the related business owner, rather than the recipient's own contributions.

To avoid this punitive tax rate, the income must qualify as an "excluded amount." The legislation provides several specific exclusions based on the recipient's age, their level of active engagement in the business, the nature of the shares they hold, and the reasonableness of the return on their investment or labour. For legal professional corporations, relying on these exclusions requires careful structuring and robust, contemporaneous documentation.

Salary and ordinary employment remuneration are explicitly excluded from the TOSI regime. However, they remain subject to the general rule under section 67 of the Income Tax Act, which dictates that deductible expenses must be reasonable in the circumstances.

For a lawyer's spouse, legitimate roles might include bookkeeping, office management, marketing, or administrative support. To withstand CRA scrutiny, the law firm must maintain rigorous documentation. This includes formal employment contracts, detailed job descriptions, regular timesheets, and proof of payment through standard payroll channels with appropriate statutory deductions (such as CPP and EI).

Paying an inflated salary for minimal work will not only invite a reassessment denying the corporate deduction but could also trigger shareholder benefit rules.

Any split income received by a minor from a related business is automatically taxed at the highest marginal rate.

There are very narrow exceptions, such as income derived from property inherited from a parent, but for the vast majority of legal professionals, attempting to distribute law firm profits to minor children via dividends or trust allocations is entirely ineffective for tax planning purposes.

e Return" exception, and the age 65+ exception. The "Excluded Shares" exception, which allows dividends to be paid to adults aged 25 or older who own at least 10% of the votes and value of the corporation, generally does not apply to legal professional corporations. This is because the exclusion explicitly disqualifies professional corporations and any corporation where 90% or more of the income is derived from the provision of services.

Therefore, lawyers must rely on other avenues to legally distribute dividends to family members.

The CRA provides a bright- line test: if the individual works an average of at least 20 hours per week during the portion of the taxation year that the business operates, they are deemed to be actively engaged.

Furthermore, if the family member met this 20-hour threshold in any five prior taxation years (which do not need to be consecutive), they qualify for the exclusion indefinitely. This is particularly useful for spouses who may have helped build the law practice in its early years but have since reduced their hours. As with salaries, meticulous documentation is paramount.

The law firm must retain timesheets, emails, project logs, and other evidence proving the family member's active involvement.

The CRA assesses reasonableness based on the labour contributed, the capital invested, the risks assumed, and historical payments made to the individual. In the context of a legal professional corporation, justifying a reasonable return based solely on capital investment can be challenging, as law firms are typically service-driven rather than capital-intensive.

If a spouse personally guaranteed a significant practice loan or contributed substantial seed capital to launch the firm, a commensurate dividend might be justified. However, the return must align with what an arm's-length investor would demand under similar circumstances.

Some law firms utilize management companies (often owned by family members or a family trust) to provide administrative, staffing, or facility services to the legal professional corporation.

Once the source individual (the lawyer) reaches the age of 65, any dividends paid to their spouse are exempt from TOSI, provided the amounts would have been excluded if paid directly to the lawyer. This rule aligns the treatment of private corporation dividends with the pension income splitting rules available to all Canadians.

For retiring law firm partners, this exception provides a powerful mechanism for tax-efficient tax-efficient investing in a law corporation lawyer can investing corporate surplus for lawyers within their professional corporation throughout their career and, upon turning 65, begin paying dividends to a lower- income spouse without requiring the spouse to meet any active engagement or capital contribution tests.

The law firm pays a management fee to the management company, which then distributes the profits to family members. While this structure can facilitate income splitting, it is highly scrutinized by the CRA.

The management fees must be commercially reasonable and reflect the actual value of the services provided. If the fees are inflated, they will be denied as a deduction in the law firm and may still be subject to TOSI in the hands of the family members. Furthermore, the family members receiving dividends from the management company must still navigate the TOSI rules relative to the management company's business.

Lawyers often fall into several common traps that trigger TOSI reassessments. Paying dividends to non-active family members under the mistaken belief that the "Excluded Shares" exception applies to professional corporations is a frequent error.

Another common mistake is failing to maintain written employment agreements or timesheets for spouses claiming the "Excluded Business" exception.

Additionally, using shareholder loans as disguised distributions to family members can trigger both TOSI and subsection 15 (2) shareholder loan inclusions. The penalties for non-compliance are severe. The CRA can reassess the income at the top marginal rate retroactively, apply gross negligence penalties up to 50% of the understated tax, and charge daily compounded interest.

Engaging specialized tax counsel and accounting professionals is essential to ensure that your corporate structure and compensation strategies remain fully compliant with the evolving TOSI landscape.

What is the main planning takeaway from this article? The core message is that income splitting and tosi rules for lawyers in canada requires integrated tax, investment, and risk planning rather than isolated decisions.

Who should review this strategy first? Canadian professionals working with a wealth advisor familiar with the rules outlined above should review their situation before year-end.

How often should I revisit this plan? Most professionals benefit from an annual review, with deeper modelling whenever income, corporate structure, or family circumstances change materially.

Where can I get tailored advice? Book a consultation with SG Wealth Management to translate these concepts into a documented plan for your practice.