Income Splitting Through a Corporation

The Path to Business Ownership – An Accountant’s Viewpoint – Part 6

Income Splitting Through a Corporation

In March’s article, I covered the tax benefits for corporations with income qualifying for the small business deduction.  This month I will explore and outline the benefits of income splitting through a corporation.

One of the greatest benefits of setting up a business as a corporation is the ability to distribute profits to individuals in lower tax brackets.  This is accomplished by setting up family members as shareholders in the company.  Additionally, it provides a structure through which you can multiply the capital gains deduction if your company meets the definition of a qualified small business corporation.

An incorporated business has several means to split income with family members, including:

  • Paying a reasonable salary for work performed in the business (reasonable is the key);
  • Paying a guarantee fee if your spouse pledged assets, or otherwise guaranteed a business loan or other debts for the company;
  • Paying director fees for services performed in the capacity of a director, and;
  • Paying dividends to lower tax-rate family members.

Perhaps the most advantageous income splitting approach is to pay dividends to adult family members who own shares in the company.  The tax savings can be quite a substantial amount if one shareholder is at the highest tax bracket while the other/another shareholder (a spouse for example) has no taxable income.  For example, a dividend of $30,000 paid out to the spouse (with no other income) instead of to the spouse with the high tax rate income will save approximately $12,000 in taxes.

Some points of caution:

  • The benefits of income splitting with dividends is not available to shareholders who are minors – children or grandchildren for example. In such cases, dividend income distributed, or capital gains arising on the sale of the shares to minor children would be attributed back to the parents (this is often referred to as “kiddie tax”).
  • The company’s rights and restrictions found in the Article of Incorporation should allow for the discretion of paying one class of dividends over another class.
  • It is very important that family members pay fair market value for the shares of the corporation they are acquiring. Furthermore, family members should purchase the shares with their own source of funds.

Often, family members will acquire shares at the time of incorporating the business (before the company has any true value) and pay a nominal amount to subscribe for those shares.  An estate freeze can be performed if the business was already incorporated prior to the family members subscribing for shares.  The estate freeze essentially provides a mechanism that allows the potential shareholders to subscribe for shares at a nominal amount.

The tax advantages of income splitting are, and will continue to be, a motivator for many businesses to incorporate.  Contact your accountant, or reach out to me at BDO, to discuss whether incorporating your business is right for you.

jonathan-mcgraw-bdoArticle provided by:

Jonathon (Tug) McGraw, BCOMM, CPA, CA

BDO Canada LLP

Jonathan can be reached at: jmcgraw@bdo.ca

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