New Rules for Paying Dividends to Family Members.
The rules for paying dividends from private corporations to family members have significantly changed in 2018. The government introduced the Tax on Split Income (TOSI). We present a very simplified summary of the new tax rules applicable to small business owners.
In general, the dividends paid to a family member will be taxed at the highest marginal tax rate unless an exception applies. In Ontario that rate is 46.84%. Fortunately, there are a few exceptions that still exist and proper tax planning is essential.
Please take note that these are new regulations that haven't been assessed by the CRA. Some rules can be confusing and not clear. There may be uncertainty coming in the following years that will concern your tax filing position.
- Excluded Business
If a family member is actively engaged on a regular, continuous and substantial bases (the CRA considers it to be 20 hours a week), the dividends can be paid in any amount to that individual and TOSI rules will not apply. In our opinion, it is a good strategy to pay dividends. However, engagement of the family member in the business should be well-documented. If that family member has another full-time employment job or is a full-time student, it can get harder to prove that they work 20 hours a week in the business.
If the Excluded Business exception is used, the dividends can be paid either from an operating company, a holding company or a trust. It's worth mentioning that in order to achieve maximum flexibility in dividend payments, you should have various classes of shares to be issued to shareholders.
Dividends can be paid only to individuals who are 18 and over.
- Excluded Shares.
This exception cannot be used by professional corporations (lawyers, doctors, accountants, etc.) and companies that have more than 90% of business income derived from provision of services. The CRA didn’t provide any guidance as to what business is considered “provision of services”. We estimate that about 75% of small business corporations can fall under the “service” category and will not be able to use this exception. However, manufacturing, retail, food and other non-service businesses will likely have this option.
In order to use the Excluded Share exception, a shareholder must own shares of the corporation that represent 10% of voting rights and 10% of Fair Market Value of the company. Dividends can be paid in any amounts only to individuals who are 25 and over. The individual must directly own Excluded Shares in the corporation. The individual doesn’t have to be engaged in the business. In our opinion, dividends can’t be paid through a holding company or a trust.
- Reasonable Return. Individuals who are 25 and over.
The dividend amount paid is reasonable for the amount of work performed, property contributed, risk assumed and other relevant factors. In our opinion, this exception will require significant amount of supporting documentation and will be subject to uncertainty in the coming years.
- Reasonable Return. Individuals who 18 – 24 years old.
This exception is called “Safe Harbour Capital Return.” Fair market of the property contributed by an individual is multiplied by the prescribed interest rate. We don’t see this exception to be used often.
- Taxpayer with a spouse who are 65 and over.
This exception generally allows for a business owner who is a senior to split their income by paying dividends to a spouse.
The new TOSI rules are very complex. Keep in mind that this article has a very general overview of the new tax rules. Please contact us if you feel that the TOSI rules will apply to your tax situation.