There was a time when tax on split income (TOSI) was just for minors and known as the “kiddie tax.” Effective the 2018 tax year, the rules were expanded to include adults related to the business owner. Now simply known as TOSI, the change in nomenclature is only the tip of the iceberg.
Split income generally includes dividends, interest and certain capital gains, conferred benefits, and trust and partnership distributions — but not salary — paid to an individual from a private corporation owned by a family member (known as a related business). The recipient is taxed at the top personal marginal tax rate.
To avoid TOSI, you simply need to receive an excluded amount — easier said than done.
Excluded amounts generally include the following:
- An amount received from a related business if the recipient is actively engaged in that business (working at least an average of 20 hours per week in the current year or in any of the previous five years). This is the test for an “excluded business.”
- If the recipient is between 18 and 24 years old and
- the amount does not exceed a return up to the prescribed interest rate multiplied by the fair market value (FMV) of the property the recipient contributed to a related business (safe harbour capital return); or
- the amount is a reasonable return on capital contributions that were made with arm’s-length capital.
- If the recipient is 25 or older, their shares will be considered excluded shares if an amount received is from a related business and all of the following apply:
- less than 90% of the business income is from the provision of services;
- it is not a professional corporation;
- they own shares representing 10% or more of the corporation’s votes and FMV; and
- the corporation’s income in the last tax year didn’t come from another related business (directly or indirectly).
- If the recipient is 25 or older:
- the amount represents a reasonable return (derived directly or indirectly) based on their labour, capital contributed, risks assumed and historical payments;
- the income or taxable capital gain is from the sale of excluded shares; or
- the amount is a reasonable return from a related business.
Finally, excluded amounts can also include:
- income from property transferred as a result of marital breakdown;
- taxable capital gains from the disposition of farm, fishing property or qualified small business corporation shares, including deemed disposition at death;
- for those under age 25, the capital gain on the disposition of property inherited from parents or someone else if they were enrolled full time in a post-secondary institution or eligible for the disability tax credit; and
- income or taxable capital gain from the disposition of property if the amount was included in a spouse’s income and they are at least 65 years old, or the amount was included in the final tax return of a spouse who died that year.
Case study: Meet Claire, Frances’s sister
Your client, Frances (from the previous article, Advisor.ca/newTOSI ), has referred her older sister, Claire. Claire owns OverMetal Inc., a robotics company. Claire and her husband, Doug, each own 25% of the shares in OverMetal directly, while a family trust owns the remaining 50%. The beneficiaries of the family trust are Claire and Doug’s two children: Annette, 26, and Bill, 23.
Claire is concerned that dividends paid directly to Doug and the children via the family trust will be subject to TOSI rules. Here’s how everyone is involved in OverMetal:
- Claire founded OverMetal and manages its operations. She receives dividends as compensation.
- Doug has no direct involvement in any aspect of the business. He has never worked for or loaned money to OverMetal, nor has he contributed property to it.
- Annette assists Claire with administration and marketing. She works at least 20 hours per week during the year.
- Bill is a full-time graduate student and is away from home most of the year. He has never worked for OverMetal, nor made any other contribution.
Who’s paying TOSI?
Unfortunately, TOSI will apply in this situation. Here’s how.
Claire will not be caught by TOSI. She is actively engaged (works 20+ hours per week) in what’s considered an excluded business. Her shares also qualify as excluded shares, so TOSI wouldn’t apply even if she wasn’t actively engaged.
Doug doesn’t meet the actively engaged requirement so OverMetal is not considered an excluded business. However, his shares are excluded since OverMetal’s operations meet the requirements from #3. Doug dodges TOSI.
Annette will also avoid TOSI because, like her mother, she is actively engaged in the business.
Bill is not engaged in the business. Neither is his father, but because Bill’s under 25, he must meet the requirements in #2, not #3, for his dividends to be excluded. Without contributing any capital, he can’t rely on the safe harbour capital or reasonable returns. Therefore, his dividends will be taxed at the top marginal tax rate.
Not all business owners and their families will be as lucky as Claire’s. The best course of action is for clients to revisit the business setup and compensation mix for all family members and make adjustments where possible.
Curtis Davis, FMA, CIM, RRC, CFP, is senior consultant for tax, retirement and estate planning services, retail markets at Manulife Investment Management.