Tax changes affect income splitting for incorporated clients

Last week, we learned how recent tax changes will affect the Zhangs, a family of four where both parents are employees. This week, we meet the Gonzales family.

The facts

Dr. Gonzales has an incorporated practice; his wife is a domestic engineer and their three adult children attend university.

What has changed?

Dr. Gonzales incorporated his practice for three reasons: to provide an income deferral opportunity, to be flexible when determining his compensation (salary versus dividends), and so he could split income with his family. While these reasons remain, Finance and the various provincial and territorial finance departments have introduced various tax measures over the years that may have affected Dr. Gonzales’s and his professional corporation, resulting in the need to continually review and monitor his affairs.

There are two types of dividends. Ten years ago, Finance introduced eligible versus non-eligible dividends paid by Canadian corporations to fulfill the goal of achieving integration (when someone earning income through a corporation is in the same after-tax position had they earned the income personally). Generally, dividends paid by active small business corporations such as a professional corporation are non-eligible in nature.
Small biz tax rates have changed. Budget 2015 reduced the small business tax rate 2% over 2016-2019 (0.5% annually), and to adjust the non-eligible dividend gross up from 18% to 15% (1% decrease annually) and the dividend tax credit from 11% to 9% (0.5% annually). But Budget 2016 proposed to discontinue the aforementioned tax changes for 2017-2019 and to leave the 2016 federal small business tax rate, non-eligible dividend gross up, and dividend tax credit in place.
Combined federal and provincial tax rates on salary versus non-eligible dividends have varied. For 2016, Dr. Gonzales should discuss with his tax advisor whether a tax benefit exists if he were to pay himself dividends versus salary, given the new corporate small business tax rate, and personal tax rates for salary and non-eligible dividend personal tax rates. He should then determine his compensation accordingly to meet his personal lifestyle needs.

As for the Gonzales children attending university:

Tax credits will be eliminated. For 2016, Canadian students enrolled in qualifying post-secondary or educational programs are eligible for three non-refundable tax credits: the tuition, education and textbook tax credits. If there are unused credits after bringing the student’s tax payable to zero, unused portions of the credits can be transferred to a parent, spouse or grandparent, or carried forward. Budget 2016 proposed to eliminate the education and textbook tax credits starting in 2017. If each of the Gonzales children attended university full-time for eight months a year in 2016 and 2017, each would be entitled to federal education and textbook non-refundable tax credits of $558 (15% of ($400 * 8 months) + ($65 * 8 months)) in 2016 and $0 in 2017.

Read: Budget could sting biz owners, zap advisor AUM

What income splitting or effective tax planning measures remain?

With his professional corporation, Dr. Gonzales has additional flexibility in determining how he is compensated – salary versus dividends, and the potential to split income with his family. If Dr. Gonzales reports $150,000 in income, he is going to pay more tax and can access only one set of personal tax credits. But if he, his wife, and three adult children report a combined $150,000 in income, the average tax rate on the income will be lower and they will have access to five sets of personal tax credits. The tax savings generated will generally translate into more investment savings.

In the instance that Mrs. Gonzales or any of the Gonzales children work in Dr. Gonzales’ practice, they can be paid reasonable salaries. In addition, if Mrs. Gonzales or any of the Gonzales children can be paid dividends as long as they are shareholders of the professional corporation.

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With the professional corporation, Dr. Gonzales can allocate income between him and Mrs. Gonzales to cover their personal lifestyle needs, and instead of helping his three children with their university tuition in after-tax dollars, the professional corporation can pay salaries, where warranted, or declare and pay non-eligible dividends to each of his three adult children to fund their university tuitions. The salary or dividend is taxable in their hands, and it is likely that they will be in a lower marginal tax bracket then Dr. Gonzales, will have access to their own personal tax credits and, in the instance of dividends, the dividend tax credit.

It is also possible for the professional corporation to provide a loan to its employees or children of its employees for post-secondary education. This is detailed tax planning and a tax advisor should be consulted since it’s easy to contravene the punitive shareholder benefit tax rules.

Takeaways

Working with the Gonzales family, there are multiple clients and taxpayers to consider – the incorporated practice, Dr. and Mrs. Gonzales, and each of their three adult children. With the corporation, possibilities to split income and implement effective tax planning do exist.

As always, if a small business owner is supporting adult children, or even perhaps elderly parents, consider:
- whom the potential shareholders of the corporation could be, and having the appropriate number of share classes available to choose and provide flexibility in who receives dividends, if need be;
- that payment of salaries must be reasonable, meaning the business would pay the same salary to an arm’s length person.
On a personal level:
- Gifts of cash to adult children should not trigger attribution of income or capital gains, nor a taxable event in Dr. and Mrs. Gonzales’s hands.
- Dr. and Mrs. Gonzales should consider funding their adult children’s TFSAs, or paying the children from the professional corporation to fund their annual contributions to a TFSA.

Read: Budget narrows access to small biz deduction