Small business owners, including incorporated professionals such as doctors, lawyers, accountants and others, will likely face a higher tax bill in the years ahead as a result of Finance Minister Bill Morneau’s announcement this week targeting several common, and until now, perfectly legal, tax strategies used in conjunction with private corporations.
The strategies under attack can be categorized into three main areas: income sprinkling, earning passive investment income in a corporation and converting a corporation’s ordinary income into tax-preferred capital gains.
Among these changes, it’s the first one — income sprinkling — which is perhaps deemed the most offensive of the three and the one that will likely have the broadest financial impact on small business owners and incorporated professionals.
While there are various legal and government-sanctioned forms of income splitting, the most common one being the splitting of pension income or RRIF withdrawals (after age 65) with a spouse or partner, Mr. Morneau chose the term “income sprinkling” rather than income splitting to describe how some families use private corporations to sprinkle income among family members. In a typical example, dividends that would have been received by the primary owner/manager of the private corporation, say, mom or dad, would instead be paid to the spouse, partner or kids of the primary shareholder, who are often in lower tax brackets than the primary owner/manager and thus the family’s total tax bill would be reduced.
This result stems from the fact that Canada taxes us on an individual basis, rather than as a family unit and imposes progressively higher tax rates on each individual, such that the higher your personal income, the higher your rate of tax. Canada also allows each individual a basic personal amount (equal to $11,635 in 2017) which effectively allows every Canadian to receive at least the first $11,635 tax-free.
Private corporations can pay dividends to family members who, if they have no other income, can use their basic personal amounts to shield such income from tax. For example, in Ontario, an individual with no other source of income could receive about $51,000 in eligible dividends without paying a cent of federal or provincial tax. In many corporate structures, it’s typical for the common shares to held by a family trust in which the spouse and the kids of the owner/manager are the beneficiaries and the trustee has discretion as to which beneficiary receives dividends each year and how much each receives.
As the government noted in its discussion document, “The income distributed to the family member may exceed what would have been expected, having regard to the family member’s labour and capital contributions to the business, in arrangements involving arm’s-length investors.”
Of course not all private corporations are engaged in income sprinkling as it typically only provides meaningful benefits when the family member that receives the “sprinkled” income is either in a lower tax bracket than the owner/manager or has tax deductions or credits, including the basic personal amount or tuition carryforwards, which otherwise would go unused.
In addition, the tax savings achieved through an income sprinkling plan must be material enough to justify both the initial and ongoing transaction costs associated with most income sprinkling arrangements, which often involve the set up and maintenance of a discretionary family trust and in some cases, multiple classes of shares.
When it comes to income sprinkling of salary income, the current tax rules are quite strict in that the Income Tax Act only permits “reasonable” amounts to be deducted from the corporation’s income when salary or management fees are paid to employees, including family members. This rule is meant to prevent a parent who owns a corporation from paying his spouse or child an annual salary when he or she doesn’t actually perform any work or provide services to the business.
When it comes to dividends, however, there is no reasonableness test in that anyone who owns share of the corporation may receive dividends. There is, however, a special tax known as the “kiddie tax” which came into place in 1999, to prevent income splitting with minor children (i.e. kids under the age of 18). Prior to this tax, known formally as “tax on split income” (TOSI), it was quite common for private companies to pay tens of thousands of dollars in dividends to toddlers, which would effectively be received tax-free as the kids would use their basic personal amount to shelter this income from tax.
The TOSI regime killed this planning nearly two decades ago by subjecting dividends from private company shares paid to minor kids to top, highest-rate taxation and denying the use of personal tax credits (other than the dividend tax credit) to shelter such amounts.
However, as the government noted, the current TOSI rules do not fully respond to income sprinkling involving adult family members. In its paper, the government took a close look at the age of individuals who reported non-eligible dividends on their tax returns. (Non-eligible dividends are generally dividends paid on private company shares from income eligible for the small business rate.) The government found that in each year reviewed, the amount of non-eligible dividends reported by those aged 18-21 exceeded both the amounts earned by the 22-25 and 26-29 age groups. As the government wrote, “this anomaly in the distribution suggests the presence of dividend sprinkling, because the tax benefits of income sprinkling are higher, on average, when adult children of high-income filers are younger and have lower income.”
As a result, this week the government announced proposed changes, to be effective in 2018, to extend the TOSI to certain adult individuals. Under the proposed new rules, an adult family member will be expected to contribute to the business, either in labour or capital, in order be exempt from the TOSI on income received. In other words, the amount received by such adult family members must be “reasonable.” There is a stricter test for 18-24 year olds. In a nutshell, if the amount isn’t reasonable, then a top rate of tax will apply, putting an end to current strategy of dividend sprinkling among non-involved family members.