Income splitting can be quite tricky to achieve in Canada because Canada operates a tax system where every individual must report their income and pay tax. Income splitting is a strategy people employ to move income from someone in a higher tax bracket to another in a lower tax bracket.
What is Income Splitting?
Income splitting is a famous phrase that refers to how two or more persons can share income or profits from income sources. The sources of payment can be property, business, etc. Due to the marginal tax rate in Canada, tax rates increase as your income rise. Hence, when done correctly and legitimately, income splitting can end in substantial tax savings.
However, the regulations governing income splitting in Canada have over the years tightened. Yet, businesses have income-splitting strategies that use to create considerable tax savings.
Saving Through Income Splitting
There are several ways to achieve savings through income splitting since the percent of taxes on income increases as a person’s income increases via the various tax brackets. In Canada, there are federal and provincial tax brackets.
The tax system is based on marginal income, where income below a cut-off point is taxed at a lower rate. And only each dollar above a cut-off point is taxed at a higher rate. Income splitting saves money as it allows the total sum to be shared between two or more people.
Income Splitting Through Family
Depending on the family situation, several strategies are available to families looking to split income. Some of them include:
- Interest-Free Loans for Families
This strategy applies to income from properties like investments and rental units, not gain from a business. So, a gift or interest-free loan can be shared with a spouse, child(ren) or other family members to carry on a business. Note that the income from that business becomes taxable when shared. Below are some strategies in splitting income to families:
- Capital Gains for Minor
The rule does not apply to capital gains made by children, including minors. Though interest, dividends or other income earned in a portfolio might still be linked back to the parent, the capital gains remain taxable to the child.
- Loans or Gifts to Children Who Turn 18 In The Year
Generally, the rule does not concern income earned on gifts or loans made to children in the year they turn 18. For example, if a child was 17 years old when a gift or loan was made to them before they were 17, the rule may not apply to income earned using those funds.
- Income Earned on Canada Child Benefit Payments
Income earned on any funds received as child benefit via the Canada Child Benefit into an account in the child’s name will not be linked to the parent.
- Registered Education Savings Plans (RESPs)
An RESP is a unique way to save for a child’s post-secondary education. When it comes to RESP, there are contribution limits, and no deductions are made from contributions.
Depending on the family’s net income, the government provides equivalent grants of 20% or more towards a child’s post-secondary education. So, the contributions and the income earned within the RESP are taxable only when withdrawn and are taxed on the child’s tax return.
- Registered Disability Savings Plans (RDSPs)
An RDSP is aimed towards family members under age 60 and eligible for the disability tax credit. With RDSP, contributions are not tax-deductible, and there are contribution limits.
However, income and government grants in this plan grow tax-free until they are withdrawn by or for the person’s benefit. These income and grants must be up to 300% of the contribution, depending on family income.
When it is withdrawn, the funds are taxed on the disabled person’s tax return at a lower rate than those who contributed the funds.
- Spousal Registered Retirement Savings Plans (RRSPs)
A spousal RRSP is a registered retirement savings plan that appoints your spouse as the plan owner, even when making the contributions. This plan aims to shift retirement income from the spouse who earns a higher income to the spouse who earns a lower payment.
So, when the lower-income spouse retires and begins to use part of the income, their lower tax rate can help manage the tax burden as a couple. Simultaneously, the tax deduction on the higher-income spouse’s contributions may allow for more immediate tax relief.
Watch out for the three-year attribution rule if you are using this strategy for income splitting in Canada. You can always talk to your financial adviser to appropriate guidance.
- Graduated Rate Estates (GREs)
Revenue Canada has created Graduated Rate Estates (GREs) as an exception to the recent change that requires trusts to be taxed at the highest marginal rate. Any qualifying estate can claim a GRE designation and use the tax rate for the beneficiaries’ income after an individual’s death.
Charitable giving in a will is also rewardable in GREs as donations made on death or after-death are not deemed to have been made by the deceased person. The contributions are now considered to have been made by the estate.
Thus, if the beneficiaries receive any tax credit from a charitable donation, it can balance the deceased personal income or the estate’s income after the death. Income earned on a deceased person’s investments may attract less tax in the GRE than in the beneficiaries’ hands.
Pension Income Splitting For Retirees
Pension splitting allows higher-income spouses to lessen their payable tax by sharing up to 50% of eligible pension income with a spouse. A spouse can decide to split up to 50% of qualified pension income with a lower-income by completing CRA form T1032. The payments are not split between the partners; the transfer is on paper for tax calculations.
The most popular types of qualified pension income include annual benefits from a registered pension plan and payments from RRSPs and RRIFs. These plans are applicable if the pensioner reaches age 65 or older during the year.
- CPP Sharing
Pension sharing under the CPP is a kind of tax-saving plan in the form of income splitting. If one spouse is receiving more CPP and s in a higher tax bracket than the other spouse, it can produce tax savings.
Spouses can decide to split their Canada Pension Plan payment if they file Form ISP1002 with Service Canada.
Income Splitting Through Business
Business owners in Canada face different tax changes that may impact their business significantly. Some of these changes include restrictions on income splitting and small business deduction grind concerning passive investment income.
These changes imply that business owners’ income in Canada and their investment can be taxed at a higher rate. Regardless of the new provisions’ complexity and variation, making preparations can go a long way in easing the financial headwinds.
Income splitting is a tool regularly used by small and medium-sized business owners to lessen the financial risks linked with operating a business. It is also used to generate savings that can be used for expansion and innovation.
There are several ways a business owner can split business income; some of them include:
- Wages paid to family members
Business owners can pay salaries to their spouses and childer for working for them with the related income taxed at the lower proceeded tax rates of those spouses or children. When doing this, business owners should bear in mind that any payments to family members are often an area of concentration during CRA audits.
Also, the CRA may carryout interviews and request documentation like time cards. These requirements will serve as proof that family members are working for what they are paid. If the CRA is not convinced with their evaluation, it may deny the business’s expense. Also, it is advisable to make the amount of the fee reasonable; do not overpay.
- Loans from a private corporation to family members
If it is an incorporated business, any family member’s loan will be included in the family member’s income in the year received. Except if it shows that it was repaid to the corporation with two year-ends.
To this end, corporate owner-managers can loan their children from age 18 and above seeking post-secondary education. These loans may be taxable income to the child. Still, the funds are mostly taxed at a lower rate than the owner-manager rate on a share that would then be required to fund the child’s post-secondary education. In a case where the child’s income is below the basic personal exemption, the loan might be tax-free.
- Discretionary shares held by children
Owner-managers can issue shares to spouse and children to pay dividends to them. By doing this, they can utilize their spouse and children’s tax brackets, especially if they intend to pay for their children’s post-secondary education. To successfully use this strategy, the child(ren) must be turning 18 years of age when they receive a dividend. Else, the kiddie tax may apply to tax the children at the highest marginal rate.
- Family trusts
Family trusts are flexible tax-planning tools most used by owner-managers of private companies. These trusts allow them to claim multiple capital gains exemptions upon the sale of a business.