Many professionals choose to incorporate a professional corporation to take advantage of the various tax benefits of doing so. Professionals, such as physicians and dentists, who are permitted to include family members1 as shareholders, have historically been able to benefit from income splitting. Essentially, income splitting is a process whereby high-earning individuals can shift income to lower earning family members as a way of reducing their personal tax burden. Typically, in the professional corporation context, income splitting was achieved by issuing non-voting shares to family members and paying dividends on those shares. The dividends were then taxed in the hands of lower income family members, which worked well for family members who were 18 years of age or older. Dividends paid to family members who were under the age of 18 would be subject to "kiddie tax" and were taxed at the highest individual tax rates.
However, in January 2018, the federal government expanded the tax on split income (TOSI) rules to include adult family members. Essentially, "kiddie tax" was expanded to include all family members, regardless of their age. These expanded rules directly impact the ability to split income in the manner described above.
The purpose of the expanded TOSI rules is to limit or eliminate the tax benefits of income splitting where the related family member receiving the income has not made significant contributions to the business. Essentially, in the professional corporation context, dividends paid to all family members are taxed at the highest individual tax rate unless the dividend falls within one of the relevant exclusions.
According to the Canada Revenue Agency (CRA) the TOSI rules apply to split income received by a specified individual from a related business. A "specified individual" is generally someone who is a resident in Canada at year-end, and a "related business" is a business in which an immediate family member (spouse, parents, child or sibling) is involved at any time during the year. If the amount falls within a specific exclusion however, the income will be taxed at the recipient's marginal tax rate. Where it does not fall into one of the exclusions, it will be taxed at the highest personal tax rate. The TOSI rules do not apply to salary or wages paid to family members, as long as the salary or wage is reasonable for work performed.
Although income splitting is greatly restricted as a result of the expanded TOSI rules, there are some exceptions which still allow individuals to benefit from income splitting with family members.
The first exception focuses on the contribution of the family member to the business. If the family member receiving the income is over the age of 18 and is engaged in the business on a regular, continuous and substantial basis, the TOSI rules may not apply.
The requirement for being engaged on a "regular, continuous and substantial basis" may be demonstrated by meeting the threshold of having worked in the business for an average of at least 20 hours per week in the current tax year, or in five previous taxation years. The five previous years do not have to be in succession. Essentially, if the family member has worked at least 20 hours a week on average for five years at any time prior to 2018, any dividends received by the family member now or in the future will not be subject to TOSI.
Proving sufficient engagement in the business in past years to satisfy this requirement may be challenging given the difficulty of obtaining supportive historical records; however, all information that can be made available regarding the history of the business and the involvement of family members will be helpful in demonstrating the family member's involvement in the business.
In order for shares held by family members to be excluded from TOSI, the individual must be at least 25 years of age and hold shares that represent at least 10% of the corporation (in votes and value), and 90% of the corporation's income must be earned from the provision of services. However, this exemption requires that the shares held by the individual must not be shares of a professional corporation. Therefore, this exemption is not available to professional corporations.
If a family member is 25 years of age or older, it is possible to pay to that family member a reasonable amount of income in the form of dividends representing a reasonable return on their contribution to the business, which would be excluded from TOSI. However, while CRA does not provide guidance on what it deems reasonable, the reasonable test considers contributions to the business through a combination of the work performed by the individual in the business, the property contributed by the individual to the business, and the risks that the individual has taken with respect to the business. However, given the lack of guidance from CRA with respect to the definition of a reasonable return, it is unclear how CRA will assess any of the above-mentioned contributions, as well as the corresponding income paid, as reasonable.
If the professional owner is over the age of 65 and splits income with a spouse (or common-law partner), regardless of the age of the spouse or common-law partner, the TOSI rules would not apply. This exemption only applies to the professional's spouse or common-law partner and does not apply to other family members.
Despite the expanded TOSI rules, there are still opportunities that exist to minimize tax consequences and maximize income. There are also many benefits to incorporating a professional corporation, which can be found here.
The TOSI rules are very complex and there are many nuances that are not covered in this article. It is important to seek advice from your lawyer or a tax expert about your specific situation to determine how the TOSI rules will impact your business, as well as the best way to structure your business effectively. If you have any questions, we encourage you to reach out to our Professionals Practice Group for advice and direction.
1 Family members are restricted to the spouse, children and parents of the professional.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.