Revised Tax Rules on Split Income
Business Income Splitting
It is a relatively common practice for business owners to arrange to have shares in their private corporation issued to a spouse and/or child (or a family trust under which they are beneficiaries). This permitted the payment of dividends to those family members, which would be taxed at their marginal tax rate rather than at the higher tax rate of the business owner. It was also possible for family members to shelter any capital gains arising from the disposition of their shares by using their separate lifetime capital gains exemption, with any excess gains taxed at their lower marginal tax rate.
However, these income splitting opportunities have been restricted due to the expansion of the tax on split income (TOSI) rules to adult family members, which takes effect in 2018. These rules will apply a special tax at the highest marginal tax rate on dividends and capital gains realized on those shares by family members, unless that person qualifies for an exception under the TOSI rules. Needless to say, being eligible for an exception to the TOSI rules can lead to significant tax savings while the business owner is alive.
But perhaps even more important, there are several exceptions to the TOSI rules which have significantimplications, as they are triggered by the death of the business owner. Below is a summary of the main exceptions applicable on death and related planning considerations:
Beneficiaries Under the Age of 25 in the year
Where a business owner gifts through their will shares to a child who is under the age of 25 in the year, or to a testamentary trust for that child, any income or capital gains realized by theon those shares in the year will not be subject to the TOSI rules. However, this exemption ceases to apply once the beneficiary has attained the age of 25, even though the gift was made when the beneficiary was younger. As well, it is unclear whether this exemption will be available if the shares are held in a family trust and are distributed to children due to the death of a parent.
Business owners will therefore need to carefully consider how share transfers takes place on death and who will receive those shares. For example, an estate plan that requires the transfer of all the shares to the surviving spouse (or spousal trust) may result in the loss of income splitting opportunities that would otherwise be available if those shares were transferred to children under the age of 25.
Beneficiaries between the ages of 18 and 24 in the year
The TOSI rules don’t apply to individuals 25 or older in the any year where they own “excluded shares” in the corporation. This exception requires the shareholder to directly own shares which represent 10% or more of the “votes and value” of all shares in the corporation.
The TOSI rules also don’t apply to dividends payable to adult shareholders to the extent the dividend represents a “reasonable return” based on a number of criteria. The reasonable return criteria are broader in scope if the person has attained the age of 25 in the year.
These exceptions are expanded for beneficiaries of the business owner’s estate between the ages of 18 and 24 in the year, where such beneficiaries receive shares in the corporation due to the death of a person who is 25 or older in the year of death. In this situation, the beneficiary will be deemed to have attained the age of 25 for purposes of determining if their shares qualify as excluded shares. As well, the deceased’s contributions to the corporation while alive will be considered in determining the reasonable return for the beneficiary.
The expansion of these two exceptions for beneficiaries between the ages of 18 and 24 can create additional income splitting opportunities within the family unit. Again, this requires careful consideration of how best to transfer shares between family beneficiaries upon death to maximize the potential income splitting opportunities.
Death of a spouse
Where a spouse has passed away, and shares in a private corporation are owned by the deceased’s surviving spouse, all future income and gains on those shares will be exempted from the TOSI rules, provided the deceased would not have been subject to the TOSI rules had that person owned those shares in the year of death. This exemption applies whether or not the surviving spouse’s shares are received as a result of the death of the surviving spouse. In effect, the surviving spouse steps into the shoes of the deceased spouse for purposes of determining if the TOSI rules apply to the shares in the future. This exemption once again reinforces the point that structuring the distribution of shares upon the death of the business owner is very important, as it will influence the tax treatment of future dividend and capital gains realized by the estate beneficiaries.
Despite the expansion of the TOSI rules to adult family members, a number of opportunities continue to be available for business owners to split investment and business income with family members. For example, it is possible for business owners to shelter income within a personal or corporate-owned exempt insurance policy. Where the policy is personally-owned, the(including any accumulated income) can be paid to a family member on a tax-free basis, which can then be utilized for personal and investment purposes. If the policy is corporate-owned, the death benefit will be received tax-free by the corporation, and a significant portion of the insurance benefit can be paid to family members (who are shareholders) as a tax-free capital dividend.