Income Splitting Pre Planning
We are now firmly into the 2015 calendar year and with the New Year come new tax laws aimed at reducing your family’s tax burden (eg. recently announced family tax cuts) and changes to existing tax laws that reduce old benefits (eg. higher personal taxes on ineligible dividends).
Ineligible dividends are essentially the type of dividends that most profitable Canadian small business owners get from their corporations. They represent the dividends that are paid out of the retained earnings of corporate profits; profits of which are taxed at the very favorable 13.5% on the first $500,000. For the 2014 tax year, $40,000 of ineligible dividends will result in $1,356 in personal taxes for a taxpayer with only basic personal amount credit. For the same taxpayer, $50,000 of ineligible dividends will result in $3,225 of personal taxes. These taxes are significantly higher than the 2013 taxes on the same income.
Steps a Corporate Shareholder Can Take
Despite the higher person tax costs of ineligible dividends going forward, there are still a few basic steps a corporate shareholder can take to reduce the taxes on their dividends. One way is to share the tax burden with the spouse by remunerating the spouse with dividends as well. This is called income splitting and this tax planning only works for those families where one spouse runs the business and the other spouse primarily takes care of the children and the home. If the other spouse is also high-income earner, different tax planning strategies would likely be more beneficial.
Income splitting can be accomplished by issuing the spouse shares when the company is young and has little value. At this stage, the shares being issued are worth a nominal amount that the spouse can pay for the shares and become entitled to future dividends.
However, in order to reduce legal and accounting fees, many entrepreneurs take it upon themselves to incorporate the business and create a share structure with rights and restrictions. Often, the set up is done incorrectly and fees need to be incurred to fix the problem in the future. Tax planning and income opportunities are also lost until the problem is fixed, so approach this task with the mindset that the company will be successful in due time and seek professional advice at the beginning of the process.
Basic Model for Income Splitting
Generally, to allow for the highest degree of flexibility in income splitting and tax planning, the following should be satisfied:
- Each shareholder should be issued a different class of shares.
- Whoever manages the business should have shares with voting rights.
- Spouses or adult children should be issued shares with dividend participation rights but not necessarily voting rights.
This is a basic model for income splitting. Once business owners begin to plan for the possible sale of the business in the future and benefit from multiplying the capital gains exemption, the rights and restrictions provided to each class of shares and shareholdings become very important.
To add to the complexity, most professional regulatory bodies (eg. engineers, doctors, lawyers) only allow members to have voting rights in the professional corporation. Specifically, a doctor cannot have the spouse or parents own voting rights of the medical corporation, so these corporations generally need to include multi share classes or add another company into the tax planning structure to benefit from flexible tax planning and income splitting with the spouse.
Professional Help is Required to Set Up
As some existing tax benefits are phased out, many old tax planning opportunities continue to be available. The capital structure required to take advantage of these opportunities is not complicated, but professional help is required to ensure it is set up correctly at the onset.
Mew and Company Vancouver Chartered Accountants
If you have any questions, we are Mew and Company, your Vancouver Chartered Accountant and we are here to help.