Income sprinkling and your taxes – what’s changed?
The Federal Budget in February has tweaked some of the rules
By John Bleasby
Changes to taxation of passive income — the accumulation and investment of a company’s retained earnings, and the subsequent income earned from those retained earnings — were the big media focus in February’s federal budget. As much as these new rules may impact some small businesses, of more interest and perhaps more concern to our contractor and trades readers are the changes to what is called “income sprinkling.” Why? Because many of these businesses are family owned, successful and profitable. Consequently, owners often use income sprinkling as a strategy to reduce the overall income tax paid by the family.
What exactly is ‘income sprinkling’?
It’s the term that describes taking the income of the business owner who is in a high tax bracket and spreading it among family members to bring the overall tax rate down. For example, an owner earning $150,000 or more would pay higher overall taxes than if that amount was ‘sprinkled’ among the spouse and a teenage son or daughter. Income sprinkling goes beyond actual earned income or salary to include taxable dividends, taxable capital gains and income from trust or partnerships that might have been set up as a tax strategy.
Here’s what changing
Previously, the highest marginal tax rate of 33 per cent was applied to anyone under 18 years receiving this type of income splitting. It’s officially called Tax on Split Income (TOSI).
Under the new rules, the TOSI can now also be applied to anyone over the age 17 years. That’s means pretty much anyone deemed to be a “related individual” receiving income from a what is called a “related business”, that is a business in which that person is either actively engaged in the business or owns a significant portion of the equity in the corporation that carries on the business. When does this start? The new rules are proposed to apply to the 2018 and subsequent taxation years.
That’s huge! But there are exception and exemptions
First, if you are over 65 years and made meaningful contributions to the business over the years, your spouse can receive split income without being subject automatically to the TOSI tax rate. That allows for retirement planning and aligns with the existing pension income splitting rules.
Second, individuals who are over 18 years and were engaged on a regular, continuous and substantial basis in the activities of the business will be exempt. What does that mean in real terms? Generally, it means that individual must work an average of 20 hours each week over the course of a full year, or during any previous five years. There are special rules for seasonal businesses, but that won’t likely impact most in the residential housing industry.
How can one establish that 20 hour minimum?
Here it is, straight from the horse’s mouth, the CRA website:
“Records such as timesheets, schedules or logbooks retained by either an individual or a business will be sufficient to establish the number of hours the individual worked in a given year. Where the individual also receives a salary or wages from the business, the CRA would also consider information contained in payroll records that supports the number of hours the individual worked.”
Wait! There’s more!
It has been suggested that these TOSI changes were initially aimed at professionals who set up professional corporations within which they operate their services. Think doctors, lawyers, dentists and so on who earn substantial income. They split off their high income to family members to reduce tax even though those family members neither work in the business nor own shares in the corporation. However, those proposals changes were wide in scope and gathered in small and medium sized family owned and operated businesses, so it was modified.
Both ownership and activity are important
Ownership and active participation in the business — if it’s not a professional corporation — now play key roles and can lead to further exemptions.
According to a recent Grant Thornton report to clients, an individual can be exempt if they are, “25 years old or older, own 10 per cent or more of the votes and value of a corporation that earns less than 90 per cent of its income from the provision of services and is not a professional corporation.”
There are also exemptions for individuals between 18 and 24 years. “In certain cases, individuals aged 18 to 24 years old who have contributed to a family business with their own capital will be able to use the reasonableness test on the related income” will be exempt, the Grant Thornton report explains. As an example, a son or daughter between 18 and 24 will be exempt if they can establish that they invested their own capital in the company on an arm’s length basis.
Call your tax professional!
There are further TOSI exemptions for capital gains taxes in certain events such as death, inheritance, marital or common-law relationship breakdowns. Rather than get into those here, it’s advised that you call your tax professional start planning.
This post should not to be regarded as professional tax advice. While we acknowledge and thank Grant Thornton LLC for certain references contained in their report, you are strongly advised to seek a tax professional to consider your individual situation.
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