Should you add your spouse as a shareholder of your corporation for income splitting?
Adding your spouse as a shareholder of your corporation and splitting dividend income could save you tax. But is this still allowed under the rules regarding “tax on split income” (“TOSI”)?
Sean Rheubottom, B.A., LL.B., TEP
If your spouse is taxed in a lower bracket than you, it may be possible to achieve tax savings by adding him or her as a shareholder of your corporation so that you can pay dividends to him or her. The after tax amounts could be used to help pay for family lifestyle expenses. The complex “Tax on Split Income” (”TOSI”) rules seek to prevent this form of income splitting by applying tax at the highest marginal rate to such “split income”, much like the “kiddie tax”. The TOSI rules provide several express exceptions, allowing income splitting in certain situations. Below we discuss three possible exceptions: the “over 65” exception, the “excluded business” exception applicable where your spouse is actively involved in the business, and the “excluded shares” exception applicable where your spouse or a family member age 25 or over holds shares representing greater than 10% of the votes and value of the corporation. We also include a reminder about “corporate attribution”, which is another rule that may interfere with income splitting where your spouse is a shareholder.
Dividend income splitting is expressly allowed under the TOSI rules in certain circumstances, a couple of which are discussed below. Whether this can save tax in your situation requires looking at information about your corporation and the types and amounts of income it is producing and paying to you and your spouse, the amount of income you are each receiving from other sources, whether you should be making registered plan contributions, and more.
The TOSI rules have only been in place since 2018 and unsurprisingly, they are complex. The rules can apply differently to different fact situations. Some aspects of the rules are a bit subjective, and using the rules may be based on an opinion that the rules should not apply. We will not address all aspects of the rules here. We’ll look at some basic situations involving a spouse that may present typical planning opportunities.
Income Splitting
One possible motivation for you (“Spouse 1”) to add your spouse (“Spouse 2”) as a shareholder is income splitting. The idea is to create a structure that allows Spouse 2 to receive dividends. Spouse 2 can receive dividends and can use the cash to help pay for the family’s lifestyle expenses.
Before any restructuring is considered, there should be an analysis of the relative tax positions of Spouse 1 and Spouse 2. Generally we would want to ensure that there is a significant and enduring difference in tax brackets between Spouse 1 and Spouse 2, and therefore meaningful potential tax savings, before anything is implemented.
Dividends are not subject to the “reasonableness” test that applies to salary and wages. When paying a salary, bonus or wage to a family member, the amount paid must be reasonable in light of the services actually provided. If an unreasonable amount is paid, the corporation’s deduction for the expense of paying the wage may be denied, resulting in double tax.
However, with dividends there is no reasonableness requirement. A shareholder may receive dividends simply by virtue of being a shareholder.
As noted there are a couple of tax rules meant to interfere with income splitting:
The “TOSI” rules; and
The “corporate attribution” rules.
“TOSI” Rules
The “tax on split income” (“TOSI”) rules interfere with income splitting by applying tax at the highest marginal rate to dividends (and certain other amounts) paid to family members. It’s like the “kiddie tax”, except that it applies to adult family members, not only minors. Salary and wages will not be subject to TOSI but as noted earlier are always subject to a test of “reasonableness”.
There are some express exceptions to the TOSI rules that may allow legitimate income splitting in certain situations.
“Over-65” exception to TOSI
One exception to the TOSI rules provides essentially that dividends received by Spouse 2 are excluded from the TOSI rules if Spouse 2 receives dividends which, if they had been received by spouse 1 would not be subject to TOSI, and Spouse 1 attained age 64 before the year.
“Excluded business” exception to TOSI
Dividends received by Spouse 2 will be “split income” subject to a high tax rate, unless the income is an “excluded amount”. The dividends could be an “excluded amount” if the dividends are from a business that is an “excluded business” from Spouse 2’s perspective.
“Excluded business” - spouse actively engaged in any five years
An “excluded business” of Spouse 2 for a taxation year would mean a business in which the spouse is actively engaged on a regular, continuous and substantial basis in either
a) the taxation year, or
b) any five prior taxation years.
The five-year test in (b) above takes into consideration all of the years in which the business is or was operating and includes any five years (i.e., they do not need to be consecutive years). The tax result can be generous, in that a spouse who meets this five-year test will have his or her dividends from the business treated as “excluded amounts” (not subject to TOSI), indefinitely.
Is the spouse actively engaged on a regular, continuous and substantial basis?
Whether the spouse is “actively engaged on a regular, continuous and substantial basis” is a question of fact. The CRA has commented on the meaning of “actively engaged on a regular and continuous basis” in different contexts.
“Bright line test” deems spouse to be actively engaged
The Income Tax Act additionally provides, for clarity, a test that CRA considers a “bright line” test that will completely determine the question in your favour, if the test is met. This “bright line” test would deem the spouse to be actively engaged in the business if the individual is working in the business for at least an average of twenty hours per week during the relevant year or portion thereof under consideration.
CRA’s view on the “bright line” test
Someone asked CRA about the bright line test at a Society of Trust & Estate Practitioners (STEP) conference in June 2019.
They proposed a scenario in which Spouse 2 owns non-voting preferred shares of XCo. Spouse 2 acts as a part-time receptionist for XCo and on average, works at least 20 hours per week, and is paid a modest salary, $18,000 per year. However, Spouse 2, by virtue of being a shareholder of XCo, receives a dividend of $150,000 each year.
CRA confirmed that because Spouse 2 works for XCo on average at least 20 hours per week, the “bright line test” is met, and the dividend income received by Spouse 2 would be considered an “excluded amount” not subject to TOSI.
Therefore in some cases there is an opportunity to pay a very modest salary to a spouse, while also paying him or her large dividends.
Before switching from salary to dividends, some other financial and tax issues need to be considered. For example, is it worthwhile to consider receiving a higher salary, which is employment income, so that registered plan contributions can be maximized? This needs to be determined case by case. Make sure your tax, legal and financial advisors are working as a team on these issues.
“Excluded shares” exception to TOSI
There is another exception to the TOSI rules that does not involve working full time in the business or meeting the “bright line” test. Income (dividends) received by an individual who is age 25 or older (Spouse 2 in this case, but this can also include a child) will be an “excluded amount” (not subject to TOSI) if the dividends are received on “excluded shares”, provided that ALL of the following criteria are met at the relevant time:
Less than 90% of the corporation’s business income was from the provision of services;
The corporation is not a professional corporation;
The individual (Spouse 2 in this case) owns directly, not through a trust, shares that represent 10% or more of the votes and value of the corporation;
AND
All or substantially all of the income of the business for the last taxation year is not derived directly or indirectly from one or more “related businesses” of the individual, except for the business of that corporation.
The above is paraphrased. The rules are complex and need to be carefully reviewed in each case. A great deal has been written about these rules including analyses of the meaning of “related business” and “business” in the context of the rules. Additionally, there are some other less typical exceptions to the TOSI rules that we are not discussing here. There are many possible issues and facts that may need to be considered in a TOSI analysis.
“Corporate attribution”
Where a spouse is made a shareholder of a corporation (directly or through a trust), the “corporate attribution” rule must be considered. This rule is meant to interfere with income splitting by deeming Spouse 1 to receive annually a certain amount of interest income. This deemed interest income is punitive because it is not actually received by Spouse 1 and the corporation does not receive a deduction for “paying” it. Depending on how the structure is created, in typical situations the deemed interest income is calculated as the value of Spouse 1’s shares multiplied by the prescribed rate under the Income Tax Act including any changes to the prescribed rate which is adjusted quarterly.
An exception to the corporate attribution rule arises at any time during which the corporation meets a 90% “purity” test, essentially meaning that 90% or more of the assets of the corporation by value are assets that are used in the active business of the corporation. Basically, corporations that have passive cash, investments or passive rental properties may be subject to the corporate attribution rule.
One way to reduce the deemed interest income under the corporate attribution rule is to have the corporation pay taxable dividends to Spouse 1. The deemed interest income is reduced by the taxable or “grossed up” amount of such dividends. Note that deemed dividends received as part of a share redemption do not reduce the deemed interest income, but it does reduce the amount on which future deemed interest income is based, since the total value of the shares are reduced. While this reduces the deemed interest income, it interferes with income splitting with Spouse 2.
© Heritage Private Wealth Law
General information only; not intended as legal or tax advice. Readers are encouraged to obtain legal and tax advice before acting in their specific circumstances.