A typical priority for the owner of an incorporated business is the ability to income split with family members.
Income splitting is important because it allows total family income to be shared among family members in order to take advantage of lower marginal tax rates than would otherwise apply if total family income is received by only one or two members of the family. Other than paying a reasonable salary to the family member for services provided to the corporation, the common approach to achieve income splitting is through the holding of shares of the corporation.
When organizing the corporation initially or on later reorganization, one of the following steps could be used to effectively satisfy the income splitting objective:
- In the case of spouses who are both involved in the business, different classes of participating shares can be issued to each of the spouses to permit the payment of dividends in differing amounts to each of the spouses while holding an equal number of participating shares so that the underlying value the corporation accrues to each of the spouses equally. The shares in each case can be voting so that control of the corporation is shared between the spouses.
In circumstances where one of the spouses does not participate in the business or may be otherwise employed, the same structure may apply. However, the spouse not participating in the business would typically hold nonvoting shares while the spouse participating in the business would hold voting shares and control the corporation.
- If the family includes children, a type of preference share may be issued to a child that would allow the child to receive dividends at the discretion of the parent or parents who are directors of the corporation, but would not otherwise entitle the child to underlying value in the corporation.
The so-called “kiddie-tax” provisions of the Income Tax Act of Canada have the effect of taxing dividends paid to minors at the top marginal tax rate thereby removing any tax incentive to pay dividends to minor children. However once children reach the age of majority, the holding of this type of share by the child allows a payment of dividends to the child which would be taxed at the child’s marginal tax rate.
This structure is particularly effective for children attending a post-secondary education as the child can receive dividends to be applied towards his/her education costs with little or no income taxed payable on amounts received due to available credits and deductions. Where the post-secondary education is financed by payments from a parent, the parent at the top marginal tax rate will require approximately double the amount received by the child to be in the same position, net of income tax, as the child receiving a direct distribution from the corporation.
- As a further alternative to the options referred to in 1 and 2 above, consideration can be given to the creation of a family trust of which the family members would be beneficiaries. The family trust would hold shares of the corporation. Dividends would be paid on the shares held by the family trust and the flow to the family trust. Once in the family trust, the monies are distributed to one or more family members in such amounts as determined by the trustees of the trust [typically including one or both parents].
The use of the family trust has the added benefit of allowing the shares to also be distributed to one or more family members who are beneficiaries of the family trust.
Proper planning for income splitting can result in tax savings for the family generally, but care must always be taken to ensure the planning is properly implemented so as not to result in any unintended income tax consequences. Prior legal and income tax planning advice is recommended.