Income Splitting with Family Members

Income splitting is a tax-planning technique designed to shift income from a taxpayer paying a high rate of tax to another taxpayer within the family unit paying tax at a lower rate. Unfortunately, there are a number of legislative provisions—“attribution rules” and other anti-avoidance measures—designed to prevent saving taxes by shifting income between taxpayers.

Permitted arrangements

There are still a number of legitimate tax-planning arrangements that can be used to effectively redistribute income in a family unit:

  • Make contributions to a spousal RRSP. Setting up a spousal RRSP is a good idea if you expect your spouse or common-law partner to be in a lower tax bracket than you on retirement. When funds are withdrawn from the spousal RRSP, they are taxed in your spouse’s or common-law partner’s hands at his or her lower tax rate (this arrangement is subject to special rules to prevent abuse). This reduces your family’s total tax bill. This strategy also means that benefits such as the pension credit can be made available to both of you, and you may reduce your exposure to the Old Age Security (OAS) clawback
  • Share CPP payments – The Canada Pension Plan Act permits you to assign a portion of your retirement pension to your spouse or common-law partner. If your spouse or common-law partner is in a lower tax bracket than you, shifting this income to his or her hands helps lower the total family tax bill. The number of months you have lived together is a factor in determining how the benefits are split.
  • Pension income splitting. If both spouses are in the same tax bracket, income splitting will not provide the benefit of a reduction in the marginal tax rate.  However, pension splitting may still be useful if it creates or increases a pension tax credit for the spouse.
  • Loan to spouse or partner at prescribed rate 1% to invest. The net tax savings to the couple would be having the dividends taxed in spouse or partner’s hands at the lowest rate.
  • Transfer or sell assets to family members for FMV consideration, any subsequent capital gain or loss realized on a sale to a third party can be taxed in your spouse or common-law partner’s hands (rather than in your hands).
  • Gift to minor children capital assets that are appreciating in value so they can earn capital gains not subject to attribution.
  • Give cash or other assets to your adult children. Gifts of cash could enable them to maximize their deductible RRSP contributions.
  • Take advantage of the fact that income earned on income is not subject to the attribution rules. Although the initial income earned on property loaned to a non-arm’s-length person may be attributed back to the person making the transfer, income earned on that income will not be attributed.
  • Invest child tax benefit payments in your child’s name.
  • Contribute to an RESP.

If you are small business owners, the ability to sprinkle income among family members was greatly curtailed. However, there still are some limited exceptions to the new rule that will be discussed in our next newsletter.

It’s crucial that you confer with your tax adviser, who can review your personal situation and give you advice about which income-splitting strategies best fit your circumstances.

Maximize Your Business Income Tax Deductions

Tax Deductions and Business Expenses

The first rule for maximizing your business income tax deductions is to have all your business-related receipts. The CRA (Canada Revenue Agency) insists that all of your business expenses need to be backed up with receipts, so you have to collect them (and keep them for six years, as the CRA may want to look at them sometime).

Income Tax Deductions and the Cost of Doing Business

Have you deducted all of your business taxes, and business-related dues, memberships and subscriptions?

If you’ve borrowed money to run your business, have you deducted all the interest and all the related fees?

Have you deducted all your insurance business expenses?

Have you deducted all your management and administration business expenses?

Have you deducted all your relevant maintenance and repair business expenses?

Have you deducted the full cost of all your office business expenses and supplies?

Home Business Tax Deductions

Have you deducted an appropriate portion of all of your home maintenance costs?

If you own your home, have you deducted expenses related to home ownership?

Automobile Income Tax Deductions

If you use a vehicle in the course of your business, have you deducted all of your business expenses related to your automobile(s)?

Travel-Related Income Tax Deductions

If you’ve traveled to conduct business over the past year, have you deducted all related travel expenses when calculating your small business tax deductions?

Income Tax Deductions Related To Employing Your Spouse or Child

If you’re going to deduct your family employee as a business expense, you must:

  • pay the spouse or child a salary,
  • pay the same amount of salary that you would pay someone else to do the job,
  • pay a salary that is reasonable for the child’s age,
  • and the spouse or child must be doing work that is necessary for earning business or professional income.

All of these conditions must be met before your child or spouse is considered a legitimate employee for income tax purposes.

Income Tax Deductions Related To Advertising, Legal Fees & Other

Dumping the Landlord & Buying Your Own Business Space

Congratulations! Your business has grown to the point where you no longer want to pay someone else’s mortgage and you have decided to buy your own property. You have a lot of issues to deal with; one of the chief ones being “How should I acquire the property?”

If your business is an unincorporated proprietorship and you buy the property personally, one of the key concerns is going to be paying down the debt used to acquire the property. Assuming that you are in the top tax bracket in Ontario, for every dollar of profit earned you will pay 46.41 cents in income tax and have 53.59 cents left to pay down the principal on the mortgage.

This might be a good time, therefore, to consider incorporating your business and acquiring the real estate in a corporation. The first $500,000 annually of “active business income”, or ABI, is taxed at 15.5% in Ontario. That would mean that for every dollar of profit earned you would have 84.5 cents left to pay towards the principal and so this will help speed up the debt repayment process.

But should you buy the property in the same corporation as the one in which you carry on your business (which I’ll call Operating Company)? What if you want to sell your business down the road but want to keep the real estate and be someone else’s landlord to finance your retirement? Having the operations and the real estate in the same company like this may prevent you from accessing your $750,000 lifetime capital gains exemption (CGE) because you may be stuck with selling the business assets of Operating Company (which would be taxable) as opposed to the shares of Operating Company (a portion of which may be non-taxable). It can be very difficult to separate out the business from the real estate in the future if a sale is already in the works. What if your business runs into trouble? Having the real estate in the same company as the operations may expose the real estate to claims of creditors.

So assuming you decide to set up a holding company to buy the property, then your next question may be “How do I pay off the debt in Holding Company?” Operating Company and Holding Company would enter into a lease agreement whereby Holding Company would lease the property to Operating Company. The rental income earned by Holding Company would be taxed at the 15.5% rate (because it would also be considered ABI) and so Holding Company would use the after-tax profit to pay down the debt.

Another good question concerns the ownership of Holding Company. With proper planning, family members could own an interest in Holding Company. This could allow for additional CGE claims on the sale of the shares of Holding Company, thus reducing the income tax bill on the eventual sale of the real estate even more (consideration could be given to bringing the family members into ownership of Operating Company now as well).

What if instead of buying an existing building you decide to build your own? In Holding Company, the entire cost of the building would be written off for income tax purposes on a very slow basis (it would take almost 40 years to write off 90% of the cost). With some planning, Holding Company could bear the cost of the main structure of the building and Operating Company could bear the cost of the interior “fit-up”. Operating Company would treat this cost as a leasehold improvement and could write it off over 6 years, thereby significantly increasing the tax write-off and the resulting tax savings.

As indicated above, only the first $500,000 of annual ABI is eligible for the 15.5% tax rate and in Ontario, this rate goes to 25% for income above $500,000. Operating Company and Holding Company would have to share this $500,000, so if their combined income exceeds $500,000, the higher rate applies on the excess.