Paying family members and the tax on split income (TOSI)

A salary paid to your spouse or children for real work is a business expense, taxed as their employment income. Dividends and some other payments from a family business can instead be caught by the tax on split income (TOSI), which taxes them at the top rate unless an exclusion applies.

Paying a salary to your spouse or children

If you’re self-employed, you can deduct a salary you pay your child as long as:

• you actually pay it
• the work your child does is necessary to earn your business income
• the amount is reasonable for your child’s age and is what you’d pay someone else to do the work

The same rules apply to a salary you pay your spouse or common-law partner. Keep proof: the cancelled cheque if you pay by cheque, or a receipt your child signs if you pay cash. You can’t deduct the value of board and lodging you provide to your dependent children or your spouse or common-law partner.

A corporation can also put family members who work in the business on payroll, and TOSI doesn’t apply to salary. In a CRA example, a 20-year-old student works full time in the family company’s warehouse over the summer: a dividend passed to them through a family trust is caught by TOSI, but the same amount paid as salary isn’t.

Payroll rules when the employee is family

Paying a relative makes you an employer, with the usual payroll account, remittances and T4 slips; see hiring your first employee. A few rules change when the employee is related to you by blood, marriage, common-law partnership or adoption, or is considered related to your corporation or partnership:

• Income tax. Deduct it as you would for any employee.
• CPP. Deduct contributions as usual, unless the employee is your spouse or common-law partner and you can’t deduct their pay as an expense.
• EI. Because you aren’t dealing at arm’s length, the job may not be insurable, and then you don’t deduct EI premiums. It can still be insurable if it’s reasonable to conclude you’d have offered a similar contract to someone you deal with at arm’s length, judged by the pay, the terms (such as hours), how long the work lasts, and the nature and importance of the work. A shareholder who controls more than 40% of a corporation’s voting shares doesn’t have insurable employment with it.

If you or the worker aren’t sure whether the job is pensionable or insurable, either of you can ask the CRA for a CPP/EI ruling.

What TOSI is

TOSI targets income sprinkling, which the CRA describes as high-income owners of private corporations diverting income to family members with lower tax rates. It applies to anyone resident in Canada at the end of the year who has split income that isn’t excluded: adults, and children under 18 if at least one parent was resident in Canada at some point in the year.

Split income includes:

• dividends and shareholder benefits on shares that aren’t listed on a designated stock exchange (other than mutual fund corporation shares), received directly or through a partnership or trust
• income from a partnership or trust that comes from a related business, or from certain rental activities that a relative actively takes part in on a regular basis
• interest from a corporation (other than a listed or mutual fund corporation), partnership or trust whose dividends or other payments to you would be caught (not bank or credit union deposits, publicly traded debt or certain government debt)
• taxable capital gains from selling property whose income would be split income, such as unlisted shares

A business is a related business if a relative who lives in Canada is actively engaged in it, owns shares worth at least 10% of the total value of the corporation’s shares, or has an interest in the partnership that runs it.

The main exclusions

The exclusions depend on your age at the end of the year.

At any age:

• capital gains from selling qualified small business corporation shares or qualified farm or fishing property, and gains from the deemed sale of your property at death
• income from property you received under a court order or written separation agreement when your relationship broke down
• amounts that would have been excluded for your spouse or common-law partner, if that spouse was 65 or older at the end of the year, or died during the year

For a child under 18, though, a taxable capital gain from selling certain shares, directly or indirectly, to a relative or anyone else they don’t deal with at arm’s length is taxed as split income: twice the taxable capital gain is treated as a non-eligible dividend.

Age 18 or older:

• amounts that don’t come from a related business at all
• amounts from an excluded business: one you were actively engaged in on a regular, continuous and substantial basis in the year, or in any five earlier years (not necessarily in a row). Working an average of at least 20 hours a week during the part of the year the business operates counts automatically; otherwise it depends on the facts. For gains from selling property, only the five-year test works.

Age 18 to 24: a safe harbour capital return (a return of up to the prescribed interest rate on the fair market value of property you contributed to the business), or a reasonable return on arm’s length capital: your own property that wasn’t borrowed, given to you by a relative (other than through an inheritance), or earned from the related business.

Under 25: income from property you inherited from a parent, or from anyone if you were a full-time post-secondary student or eligible for the disability tax credit.

Age 25 or older:

• income and gains from excluded shares: you own at least 10% of the corporation’s votes and value, it isn’t a professional corporation of accountants, dentists, lawyers, doctors, veterinarians or chiropractors, less than 90% of its business income comes from services, and its income doesn’t come from another related business
• a reasonable return, judged by the work you did, the property you contributed, the risks you took and what you’ve already been paid. The CRA says it generally won’t second-guess the amount unless there was no good-faith attempt to set it using these factors.

How TOSI is calculated

If TOSI applies, you complete Form T1206, Tax on Split Income. You report the income as usual, deduct your split income, and tax it separately. Federal TOSI is 33% of your split income, the top federal rate, with no lower brackets. Only three credits can reduce it: the disability tax credit, the dividend tax credit and the foreign tax credit. Each province and territory also taxes split income at the high tax rate listed for it on the same form; Quebec residents should check with Revenu Québec for the provincial part.

Split income is added back to your net income when working out some credits and benefits, such as the GST/HST credit and the Canada child benefit, and when someone claims an amount for you, such as the spouse or common-law partner amount.

What to do

• Pay family members only for work the business needs, at the rate you’d pay anyone else, and keep proof of every payment.
• Before your corporation pays dividends to family, check each person against the exclusions for their age. The CRA accepts timesheets, schedules or logbooks as proof of the 20-hour test, and also considers payroll records.
• Settle whether a relative’s job is insurable before the first payday.
• Compare salary and dividends, and if you’re not incorporated yet, read should I incorporate? before counting on dividends to family.