Optimal Corporate Income-Splitting Strategies

Preceding posts reviewed an approach to how to pay yourself through your Canadian Controlled Private Corporation. Most corporation owners start by using salary for a number of good reasons. Then, they progressively shift to use more dividends as their corporate investment income grows to release tax refunds. I also hit the main points in a video. However, the opportunity to reduce taxes by corporate income-splitting adds another dimension. Build on that previous knowledge base to balance the salary and dividend mix paid to you and your spouse. Minimize your household taxes now and maximize your combined corporate and personal tax deferral.

The Benefit of Income Splitting

Canada has a progressive personal tax system. That means escalating tax rates as you earn more income. Income is also attributed to individuals. So, households in which both partners earn a similar income may have much more after-tax money to spend than one where the partners earn radically different incomes. This is particularly true with high-income earners as the progressive tax system magnifies that difference.

Having different incomes between partners may not matter much at lower income tax levels. It also doesn’t matter if both partners are in the highest tax bracket. However, many high-income household partners fall somewhere in between.

There are a number of short-term and long-term strategies to income split and reduce taxes that are available to all Canadians. Further, incorporated business owners can control how much income they take personally. That adds another opportunity to income split.

Corporate Salary For Income Splitting

Using a private corporation, the business income is paid to the company. The owners can then decide how to compensate themselves. That is usually with a combination of salary and dividends.

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Paying Your Spouse a Salary

Anyone can pay their spouse a salary from their corporation. However, they must actually perform work for the company. Their salary is a dollar-for-dollar deduction from active business income. So, there is no business tax. Instead, it is taxed as regular personal income in the hands of the spouse. That functionally shifts income that would otherwise be drawn out of the corporation at the marginal tax rates of the high-earning spouse to their lower-taxed spouse instead.

If your spouse’s income is equal to or more than the income that you need to draw from your corporation to support your costs of living, then it is not as beneficial from a tax standpoint. However, there are other benefits to having someone with a vested interest in handling your billing and bookkeeping. If you would have normally paid someone else to do that work, then that is an additional savings. It keeps more money in the family.

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Spousal Salary Pitfalls

If you pay a spouse to work for your corporation, there are a couple of important pitfalls to avoid that draw the ire of Revenue Canada. First, pay a market rate. You may think that they are the most valuable/talented person in the world, but you can only pay them what you’d pay someone else for doing the same job. Compare what colleagues pay for their billing and bookkeeping, but also discuss this with your accountant about what is reasonable.

The second thing that angers the tax collectors is not giving them their money regularly. So, you must set up a payroll and pay your spouse regularly. They cannot bill you as an independent vendor if over 90% of their revenue comes from your business. That is an employee relationship and requires monthly payroll remittance.

If your spouse does legitimately work more than 20 hours per week for the corporation, be sure to not only use a payroll but have them keep a timesheet and work log. The payroll for that >20h work week is evidence to support income splitting with dividends.

Corporate Dividends For Income Splitting

For physicians, the main limitation to income splitting by paying their spouse a salary is that the market rate for simple admin tasks is pretty low. Income splitting using dividends does not have that limitation. Dividends do not need to be related to a market rate. However, the dividend does need to be the same amount for all shareholders of the same class of shares. So, be sure to set the corporation up with a different class of shares for each member. That way, you could declare different dividend amounts for each person to effectively income split.

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Tax On Split Income (TOSI) Rules

Unfortunately, the TOSI rules of 2018 put an end to “dividend sprinkling” for most service-based businesses, including professional corporations. Those rules result in dividends to non-voting inactive shareholders being taxed at the top marginal tax rate.

The rules became extremely complex so that they would surgically target incorporated professionals. Here is a link to “simplified” flowchart of how they work [safety goggles required]. Still, there are a few important exceptions to the TOSI rules.

For service-based businesses, an important exemption to the TOSI rules is if the spouse is an active participant in the business. That is defined as working more than 20h/week for the business. An important wrinkle is that the 20h/week is an average for periods while the business is operating. For example, if you close your practice completely every summer. Then, exclude those months.

To give a dividend without triggering TOSI, the work hours must be in the same year as the dividend. If they have exceeded the 20h/wk threshold for five total years (they don’t need to be consecutive), then they could dividend split permanently moving forward. Once the owner is over the age of 65, then TOSI no longer applies. So, a private corporation is still useful as one of the many retirement-saving options.

These corporation income-splitting rules have not been tested much yet. However, the work-hour threshold is a bright line test. Either you make it or you don’t. If your spouse makes the threshold, then technically you could perfectly income split. Even by giving a spouse a massive dividend. CRA has publicly confirmed that. However, I would definitely want to make sure that my paper trail was solid if I were to aggressively dividend split.

Salary & Dividend Mix For Income Splitting

Even if you can dividend split, you usually do not solely use dividends. Often, hiring your spouse, paying them a market-rate salary, and then using some dividends to top them up and equalize your income is even better. I will explain why I have this opinion in the last section of the post. However, paying enough dividends to release the money from corporate notional accounts is still the first priority. Ahead of corporate income splitting.

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Release Refundable Corporate Taxes Using Dividends First

When your corporation earns investment income, it is taxed up front at a high rate. All or part of that tax may be refundable dividend tax on hand (RDTOH). When you pay out dividends to yourself or a qualifying spouse, RDTOH is released back to your corporation at tax filing. For example, paying $10K of eligible dividends or $8K of ineligible dividends could result in a $3.8K refund to the corporation. Of course, those dividends are also taxed personally when your corporation pays them to get the refund.

Regardless, the net of the corporate refund and personal tax paid is lower than even the lowest tax bracket. For example, the personal tax on $80K of ineligible dividends is $38192 in the top Ontario marginal bracket. The RDTOH refund to the corporation would be $30670, for a combined personal & corp tax of $7522 or 9.4%. Even the lowest marginal rate for regular income in Ontario is much higher at 20%.

So, paying dividends to release RDTOH first makes sense whether you can income split or not. If you can dividend split, then it becomes even more tax efficient by spreading out the dividend income to lower personal tax brackets.

Excess GRIP: Eligible Dividend vs Spouse Salary

Some corporations may still have an unused GRIP balance after releasing all of their eRDTOH. The GRIP is a notional account that tracks the corporation’s ability to give out tax-reduced eligible dividends. A corporation gets GRIP if it receives eligible dividends from investing in other companies that have paid the higher general corporate tax rate. It also receives GRIP if it has paid the higher general corporate tax rate on active income directly. So, a corporation directly taxed at the general rate may have some leftover GRIP without any eRDTOH.

The corporation has essentially paid a higher tax rate up from (~27% general vs ~12% small business rate), but you pay less personal tax when you move the money out as a dividend. If you don’t have any more unreleased RDTOH, still need money, and cannot dividend split, then whether to pay eligible dividends to the higher-income owner vs salary to a low-income spouse is more complicated.

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Corporation With No Access to the Small Business Deduction

If the corporation does not have any access to the small business deduction (SBD), then salary is the most efficient way to reduce taxes. Essentially, salary reduces the corporate income and therefore the amount of GRIP that will inevitably be trapped in the corporation until needed in the future. So, paying a salary to equalize both partners’ taxable incomes as much as possible works well to split corporate income.

The limiting factor can be the market rate for the work done by the lower-income spouse. Alternatively, with a spouse who also earns a significant income outside of the corporation, a salary from the corporation may not be required to meet household cash flow needs. In that case, leaving more in the corporation for tax-deferred growth is often more efficient than taking extra salary out and paying tax now.

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Corporation With Access to the Small Business Deduction

If a corporation has access to the SBD, but has some leftover GRIP due to active business income taxed at the general corporate tax rate, it becomes a dilemma. If the owner takes an eligible dividend, it is taxed at a lower personal rate due to the eligible dividend tax credit. It also uses the corporate GRIP balance. That GRIP is priced in nominal dollars. So, its buying power erodes over time when not used. That said, it erodes pretty slowly. If the lower-income spouse’s tax bracket for getting a salary is below the higher-income spouse’s net tax for eligible dividends. Then, paying some salary to the lower income spouse to meet cash flow needs would mean less tax paid now (tax-deferral).

Salary vs Dividends: Where the money ends up.

The maximum salary payable to a spouse is limited by the market rate that you can pay them. Dividends are not. So, if you can dividend split, then some dividends can be used on top of salary to equalize the taxable income between spouses. Even when a salary and dividend mix is possible, some still advise solely using dividends. That is a simple strategy and leaves the most money in the corporation.

The combined tax rate of either corporate income splitting strategy is similar and favors one or the other slightly depending on the variables. Overall, I favor a mix because of where the money ends up. However, it is close either way and there is controversy. So, let’s explore it further.

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Dividend Only vs Optimized Salary & Dividend Mix

Below is an example comparing two households. Each household has a corporation with $300K of income before owner salaries and they spend $125K/yr personally. One spouse is a physician and an active owner. Their spouse does not work outside the corporation but does work 20 hours per week for the corporation for a market-rate salary of $30K. They meet the criteria to income-split using dividends. One household uses a combination of salary and dividends and the other uses dividends only. I plugged their numbers into my CCPC income dispenser.

As you can see above, there is a massively lower personal tax bill using dividend splitting. That is partly why a dividend-only strategy is often recommended. However, don’t forget that there are corporate taxes too. The combined corporate personal tax bills are very close. In this example, it favors dividends slightly. Despite that, I favor a combined salary and dividend strategy because of where the leftover money to invest is.

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Salary in the mix can lower tax drag & legislative risk

The dividend-only strategy leaves all of the invested money in the corporation. A corporation is an excellent tax-deferral vehicle. However, corporate investment income is taxed annually. If you are paying out lots of dividends relative to the corporation’s size, that can still be pretty efficient. However, it is still not tax-free income like an RRSP. Plus, a corporate investment account also becomes much less efficient if it generates large amounts of income. That could easily happen down the road if you leave all your investments there.

The salary strategy still leaves the bulk of investments in the corporation. However, it also spreads the investments to RRSPs. Those will provide 100% tax deferral & tax-sheltered growth. Plus, a spousal RRSP can be used for further income-splitting flexibility. An RRSP is relatable to the average voter (a less appetizing tax reform target) and the investment income is tax-sheltered. Neither is true of a corporation. In addition to an RRSP now, some salary keeps the door open to switch to an Independent Pension Plan later.

The salary strategy also puts some money into CPP. The CPP would provide a safe, but stable income stream. Sure, you could invest 100% equity in your corporation for a higher risk/return. However, the CPP is a decent addition as a hedge against longevity risk. There was also an opportunity in this case to put a small amount of money invested in the low-income spouse’s name. The investment income tax drag in the lowest tax brackets is usually less than a corporation.

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Short vs long term

Overall, a dividend-only vs salary/dividend mix looks similar for one year of taxes. However, the salary helps to efficiently shift money out of the corporation and spread out your investments into different accounts. That provides options and helps to mitigate some of the legislative tax risks that corporations face. It is hard to really say today what will ultimately prove to be optimal as the future unfolds. However, I do think that a strategy that leaves more options open is better.