Income Sprinkling under the Microscope

The common small business practice of income sprinkling – distributing business income among the owner’s family members using dividends, with the aim of reducing the family’s overall tax – has been very much in the news lately. In an effort to curb what it views as overly aggressive tax planning, in July 2017 the federal government announced proposed changes that will tighten the rules around distributing dividends from private corporations to family members in low tax brackets who are not working in the business. The changes are slated to take effect in 2018.

The government is hoping to bring in up to $250 million more in income tax revenue from the estimated 50,000 high-earning families using the perceived loophole of income sprinkling as a tax planning strategy. The number of private corporations in Canada has soared in the past several years, and the feds want to reduce the number of small businesses that incorporate largely to improve the family’s tax scenario without, as the government’s report on the topic describes it, contributing to the Canadian economy.

As things stand now, private corporations are allowed to pay dividends to share-owning family members of the business’s primary shareholder. Often, dividends are paid into a family trust that owns shares. The trust can then distribute the dividends among family members to best advantage each year. For example, if an adult child is pursuing post-secondary education, with low income and available tuition credits, that person would likely pay no tax at all on dividends received but could use the money to cover living and school expenses. Non-working spouses of primary shareholders can similarly pay little or no tax on dividends.

The proposed changes will target just such cases, likely extending the so-called kiddie tax, or tax on split income (TOSI), to certain adult children. The TOSI applies the highest individual tax rate to dividends paid to minor children and was imposed to prevent payment of significant dividends to young children, who could shelter the cash from tax. To be exempt from the TOSI, under the new rules adult children will likely be expected to participate in the business.

Private corporations can also pay salaries to family members, but there are already strict rules for ensuring the amount paid out is reasonable. The rules are intended to prevent businesses from paying salaries to people who don’t actually work in the business. The new rules for dividend payments will have a similar effect.

If you have a private corporation and currently pay dividends to family members, it is critical that you meet with your accountant or other tax advisors to examine how the new rules might affect your family’s tax situation. You may need to make some adjustments to avoid an unexpected tax bill. In addition, if you are currently considering incorporating your small business, talk to your advisors about the proposed new rules first. Some experts have gone as far as to say the changes to dividend taxation will remove a major advantage of incorporating. Make sure it still makes sense for you.

Sources (in addition to CI Investments article):