Canada's graduated income tax system means that the more you earn, the higher your marginal rate. Income splitting — the strategy of shifting income to a family member in a lower tax bracket — can significantly reduce a household's overall tax burden. For self-employed Canadians, there are legitimate ways to split income and important rules to understand, particularly the Tax on Split Income (TOSI) rules introduced in 2018.
The most straightforward income-splitting strategy for sole proprietors is hiring a spouse, partner, or other family member to perform genuine work for your business. The work must be real and the pay must be reasonable — what you would pay any arm's-length employee for the same work. Paying your spouse $60,000 when the going rate for their contribution is $25,000 will not survive a CRA audit.
When done properly, the salary or wages paid to a family member are a deductible business expense on your T2125, reducing your net business income. Your family member reports the income on their own T1 and pays tax at their lower marginal rate. They accumulate RRSP contribution room on this earned income and may be eligible for Canada Pension Plan benefits based on their employment income.
Since 2018, the TOSI rules significantly limit income splitting through private corporations and family trusts. TOSI applies when income is paid to a family member who didn't meaningfully contribute to the business. Income subject to TOSI is taxed at the top marginal rate regardless of the recipient's actual tax bracket, eliminating the tax benefit.
TOSI does not apply to employment income paid for genuine work performed. If your spouse does actual bookkeeping, marketing, client service, or other legitimate work and is paid a reasonable wage, that employment income is exempt from TOSI. The key is genuine work at market rates.
TOSI is most relevant when you incorporate — dividends paid to family members who are shareholders may be subject to TOSI unless they meet the exception criteria (over age 24 and made meaningful contributions, or the income is related to capital invested, etc.).
One of Canada's clearest and most legitimate income splitting tools is the Spousal RRSP. You contribute to an RRSP in your spouse's name using your own contribution room. You get the deduction at your higher marginal rate; when your spouse withdraws the money in retirement (after a required three-year seasoning period), it's taxed at their (hopefully lower) rate.
This is particularly powerful if you expect your retirement income to be significantly higher than your spouse's. Contributing $100 to a spousal RRSP when you're in a 43% combined marginal bracket saves $4,300 in current taxes. If your spouse withdraws at a 20% rate in retirement, you've shifted $100 of income at a net savings of approximately $2,300.
Some self-employed Canadians operate as partnerships with family members, with each partner reporting their share of business income on their own T1. A partnership can legitimately distribute income according to each partner's capital contribution and active involvement in the business. Again, the distribution must reflect actual contributions to survive scrutiny.
Incorporation opens additional income-splitting possibilities — particularly paying dividends to a spouse or adult children who are shareholders. However, post-2018 TOSI rules have made this significantly more complex. The key exemptions are:
Get professional advice from a tax lawyer or CPA before incorporating specifically for income splitting, as the rules are complex and errors can be costly.
If your spouse owns the home and you run a business from it, paying rent to your spouse for the home office space may be a legitimate expense. The rent must be reasonable (market rate for comparable space) and your spouse reports the rental income. This can shift income if your spouse is in a lower bracket. The CRA scrutinizes these arrangements, so keep documentation of the rental agreement and the basis for the rent amount.
A family trust can hold shares of a private corporation and distribute income to beneficiaries (family members) in lower tax brackets. Post-2018, TOSI significantly limits the tax advantage of distributing income through a trust to family members who aren't actively involved in the business. Family trusts are expensive to set up and maintain, so they generally make sense only at higher income levels and with proper legal and accounting advice.
Canada's tax law includes attribution rules that pull income back to the transferor when assets or income are transferred to a spouse or minor child. For example, if you give your spouse money to invest, the investment income and capital gains are attributed back to you. These rules must be considered in any income-splitting strategy. Loans between spouses at the CRA prescribed interest rate are one way to avoid attribution.
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