A Summary of the New Split Income and Passive Income Rules for Professionals
There have been several income tax developments that have impacted professional corporations over the last few years. The purpose of this article is to provide a quick synopsis of the following:
- Tax On Split Income rules (TOSI)
- The changes to the small business deduction where the company, or an associated company, earns passive income
Tax on Split Income (TOSI)
Income splitting is basically the transfer of income from a family member in a higher tax bracket to a family member in a lower tax bracket. In the professional corporation context, this was typically done by issuing non-voting shares to family members and paying dividends on those shares. The family’s overall tax was reduced by having the dividends taxed in hands of the lower income family members. This worked well for any family members aged 18 or over. For children under 18, “kiddie tax” would apply and the dividends would be taxed at the highest individual tax rates.
Effective January 1, 2018, the government has attempted to curtail income splitting. The purpose of the new TOSI rules is to expand “kiddie tax” to all family members, regardless of age. In its simplest form, dividends paid to all family members would be taxed at the highest individual tax rates and therefore remove any benefit of income splitting. However, there are certain exclusions that will allow the dividends to be taxed normally.
What are the relevant exclusions for a professional corporation?
- Excluded Business
Income derived from an excluded business is not subject to the TOSI rules. In order for the excluded business exclusion to apply, the family member must be 18 years of age or older and meet the following conditions:
- They must be actively engaged on a regular, continuous and substantial basis in the activities of the business in the current year or any 5 preceding years
- An individual is considered to be actively engaged when they work at least 20 hours per week during the part of the year that the business operates
Therefore, if the family member aged 18 or over is working (or has worked in any 5 prior years) 20 hours or more per week, dividends can be paid to them without triggering the TOSI rules.
- Reasonable Return
While there is no definition of reasonable return, the CRA has indicated that reasonableness will be evaluated on the following criteria for adult family members who are 25 years of age and older:
- Labour contribution
- Property contribution
- Risk incurred
- Historical payments
Therefore, a family member can receive a reasonable dividend if they have performed labour, contributed capital or assumed risk related to the professional corporation’s business. However, due to the current ambiguity inherent in this provision it is unclear in some circumstances how the CRA will assess any of the above as ‘reasonable’.
- Age Exclusion
If the professional is aged 65 or older, then dividends received by their spouse or common-law partner would not be subject to TOSI. This exclusion only applies to spouses or common-law partners and not other family members. Therefore, even though a family member may fall into the TOSI rules for a period a time, there may be value in including them as a shareholder to take advantage of this exclusion in order to income split on a discretionary basis in retirement with a spouse.
- Excluded Shares
This exclusion requires multiple conditions to be met concurrently, including that the shares held are NOT shares of a professional corporation. Therefore, this exclusion is not applicable to professional corporations. It’s also not available to corporations that derive 90% of their income from the professional corporation (such as a rental company that rents a building to the professional corporation).
In many cases, the TOSI rules will have a significant impact on a professional’s ability to split income with family members. We note that the TOSI rules do not apply to salaries or wages paid to family members. However, an overall reasonableness rule can apply to deny the deduction provided when paying a salary if the CRA finds the salary or wage unreasonable. Therefore, a professional that has no options for dividends may want to consider reasonable wages to family members for work performed.
Small Business Deduction Changes for Passive Income
The 2018 Federal Budget proposed new rules regarding the mechanism to access a dividend refund where passive income is earned in a corporation (beyond the scope of this article) and the clawback of the small business deduction (SBD). These new rules come into effect for year ends beginning after January 1, 2019.
What is the Small Business Deduction?
The small business deduction allows up to $500,000 of active business income (e.g. practice income) to be taxed at the lowest corporate rate of 12.5% for 2019. Income in excess of the small business limit, would be taxed at the general corporate rate of 26.5%.
Depending on the amount of passive income (eg. investment income such as interest, dividends and capital gains), a private corporation may be subject to a reduction of their SBD. The clawback is based on the amount of passive investment income in the prior taxation year, referred to as Adjusted Aggregate Investment Income (AAII). For every $1 of AAII earned by the corporation in excess of $50,000, the small business limit will be reduced by $5 the next year. Therefore, the small business limit of a corporation will be calculated as 5 x (AAII – $50,000). For example:
|AAII from the prior taxation year||Small business limit reduction||Small business limit available|
It’s important to note that dividends paid from the after tax pool of income that benefitted from the 12.5% corporate rate are “ineligible dividends” and have an individual tax rate higher than “eligible dividends”, which are paid out of the pool of income taxed at the general corporate rate. Therefore, having the small business deduction clawed back exposes the corporation to the higher corporate tax rate but an ultimately lower individual tax rate on the dividends. Therefore, this clawback does not increase the total income tax when extracting dollars from the corporation, but reduces the deferral of dollars taxed at the corporate level.
Should I still incorporate or stay incorporated?
Certainly, if you fit within one of the TOSI exclusions and your spouse or family member is in a lower tax bracket, incorporation will make sense.
If there is no ability to income split, incorporation becomes more about a professional’s ability to defer taxation. Once a professional gets to a point where they are earning more than what is required to live, the corporation will make sense. The highest personal tax rate is 53.53% and the highest corporate tax rate is 26.5% which can provide for a significant deferral even if the small business deduction was entirely clawed back due to high passive income.
If you need help regarding this topic, or would like to learn more about our professional services, please contact one of our Professional Specialists.