Income Splitting: Here, and has always been here.

Did you hear that in 2015 Canada is "introducing" a form of income splitting for Canadians? That's false. Do you think it will mainly benefit the wealthy? Likely false again.

Income splitting is not new and business owners, lawyers, accountants, doctors, contractors and many other top earners have had access to income splitting for years and likely most of the richest Canadians already structure their businesses to ensure their spouses, adult children, and others take advantage of the progressive tax system in Canada.

Essentially anyone whose work allows them to be classified as a contractor or independent business instead of an employee can take advantage of income splitting by using dividends to distribute profit.

How does dividend income splitting work?

To begin with, an individual will choose to incorporate a company. It may be a numbered company or it could be named after them, ie. Jim Doe Contracting Ltd, or any other name. To incorporate, it will generally cost around $1200 in legal fees, and we tend to charge about $300-$400 a year to handle the annual report and filing.

When we create a company for a client, we tend to create a number of share classes and structures, so the main shareholder of the company may give themselves all of the voting shares, and then have their spouses purchase, for a nominal amount, a class B share, or other class of shares. Similarly, you can have your adult children (such as one going to university or under employed) have another class of shares. The government taxes dividends issued to children at a full tax rate, so there is no gain to splitting it with your quintuplets.

As you earn money through your company, you can then pay yourself a salary, and also split any profit you have made (which may be everyone in the case of companies where the owner is the only employee) by issuing dividends to each family member as it makes sense from a tax issue. Or, even better, if you earn more than you wish to spend in any year, you can retain your profits in the company, and split the profits between future tax years when you may possible earn less. As a director of a company, you can determine how to distribute profit amongst the share structure each year.

Each shareholder can then take advantage of their tax brackets on the dividends which are taxes at 50% of their value (15% on the first 43,953, 22% up to $87,907, 26% up to $136,270 and 29% afterwards) after the profit is initially taxed within the company.

* Note: I am over simplifying the taxing structure, but benefits are still there. *

Depending on how much a company earns (and subject to rules regarding related companies) the company may take advantage of some of the small business deductions to pay less tax within the company.

The limits of income splitting

Dividend income splitting only works for those who are in position where they can provide a contract for services. Salaried individuals and those whose jobs reflect a standard employee (typically lower and middle income employment) may not be able to form their own company or their employers would risk facing adverse tax consequences if the Canadian Revenue Agency found their "contractors" to in fact be employees. Others may find the benefit packages offered through an employer or avoiding managing their own accounting may outweigh the taxation benefits of splitting profits amongst family members.

Employee income splitting

The income splitting package offered by the Canadian Government in 2015 expands income splitting to some families (those, like me, with a kid at home) and unlike dividend income splitting is capped at a certain amount. It's an added bonus to help with soccer and diapers, but is pennies to the dollar of dividend income splitting and it's mainly going to benefit the middle class families with varied income or who are in a position where one partner is able to work reduced hours. It won't help the poorer families and it won't benefit richer families who are already dividend splitting, but it will provide some fairness between middle and upper class families who cannot take advantage of dividend splitting and those that can.

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