Income Splitting for Startup Founders

• Income splitting is one of the most powerful ways for Canadian startup founders to reduce their household tax bill.
• Done right, it can save you tens of thousands each year—and potentially millions on the eventual sale of your business. Done wrong, it can trigger the Tax on Split Income (TOSI), which taxes dividends at the highest marginal rate.
• This guide will explain what income splitting is, how startup founders can use it, and which strategies are both effective and compliant.

 

 

Table of Contents

1. What is Income Splitting?
2. Why Startup Founders Should Care
3. Share Classes for Spouse or Partner
4. Strategy 1: Pay Salary to Family Members
5. Strategy 2: Set Up Trust For Future Sale of Company
6. Strategy 3: Pay Dividends to Family Members
   1. a) TOSI: The Tax That Can Ruin Your Plan
   2. b) TOSI Exceptions in Detail
7. Strategy 4: Investing Excess Cash
8. Conclusion and Next Steps

 

What is Income Splitting?

• Income splitting means distributing income across family members who are taxed at lower marginal rates.
• Canada has a progressive tax system, so a household pays less tax overall if income is spread more evenly across multiple people instead of concentrated in one high earner.
• Here’s a simple visual that shows how two spouses earning $100,000 each pay less tax than one spouse earning $200,000 alone:

 

Why Startup Founders Should Care

Startup founders often pay themselves out of their corporation without thinking about structure. But once the business becomes profitable or when you plan to sell, it becomes really important. Proper income splitting can reduce your family’s tax bill now and help you potentially pay no tax when you sell your business.

In fact, 38% of startups fail because they run out of cash according to CB insights. If you pay less tax with income splitting, you can pay yourself less and leave more cash for your startup.

 

Share Classes for Spouse or Partner

When you incorporate your business, your corporation will have ‘shares’. Shares (often referred to as stock) are the ownership of your corporation.

If you are the only owner of your corporation, you may have one set or ‘class’ of shares since you will own all of them. But you could also get flexible and create different classes of shares. This lets you:

• Keep full control with one class of voting shares.
• Allocate non-voting shares to a spouse or partner for tax planning. This lets you pay dividends to a partner without giving them any control (but watch out for some tricky tax rules).

This approach allows you to distribute dividends more flexibly.

Tip: If your spouse.partner owns their own corporation, be careful when issuing them shares because you might run into unintended tax consequences.

 

Strategy 1: Pay Salary to Family Members

If your spouse or children work in your business, you can pay them a salary. The salary must be reasonable for the work done and should actually be paid, not just recorded on paper.

This works well when a family member helps with admin, marketing, bookkeeping, or other real business functions. You’ll get a deduction in the corporation, and they’ll be taxed on the salary at their (usually lower) tax rate.

 

Strategy 2: Set Up a Trust to Avoid Tax When Selling Your Company

If you have future plans to sell your company, become aware of the lifetime capital gains exemption (LCGE). It lets you sell your company tax-free on the first $1.25 million. However, each person get’s their own $1.25 million so you can add family members as shareholders so that they can use their LCGE on the sale as well.

However, if you want to make sure you still keep control, a family trust could be useful here. It will let you keep control while also letting you benefit from their LCGE if you do sell. If you’re interested in learning more about this, you could read our article here about it.

 

Strategy 3: Pay Dividends to Family Members

Paying dividends to family members is another strategy. Similar to paying salary, you can pay dividends to family member, but it comes with more risk because of some tricky rules called the TOSI rules.

 

TOSI: The Tax That Can Ruin Your Plan

TOSI is a set of rules that applies to dividends paid to certain family members. If TOSI applies, the dividend is taxed at the highest tax rate (almost 50% depending on the province), regardless of the family member’s actual income.

This can destroy the benefits of income splitting if you’re not careful. TOSI generally applies when:

• The family member is not actively involved in the business, or
• The family member is under 25 and the business is a services company or earns most of its income from services (like consulting or SaaS).

 

This bring two key exceptions that startups could use to pay dividends to family members.

 

TOSI Exceptions in Detail

Here are the main ways to avoid TOSI when paying dividends to family members:

Excluded Share Exception (the non-service business exception).

This applies if the family member:

• Is 25 years or older
• Owns at least 10% of both the votes and value of the corporation
• And the corporation earns less than 90% of its income from services (along with some other criteria)

There is a question whether this exception applies to SaaS startups. Regardless, this could be very useful if you sell downloadable digital products (i.e. a software where the customer downloads the software on their desktop) or product based companies. Even if your partner is not involved in the business, you can pay them an unlimited amount of dividends just because of what you sell.
You may also want to restructure some of your offerings so that you can get 10% of your sales to be non-service related income to meet this exception.

Excluded Business Exception (Work Test)

If a family member has worked an average of 20 hours per week in the business in the current year or in any 5 prior years, you can pay them an unlimited amount of dividends without triggering TOSI.
This also means once a family member has worked 5 years for the business, they don’t need to be involved anymore and you can still pay them dividends.

This is one of the most useful exceptions for founders whose spouse or adult children help out regularly.

Spouse of Business Owner (Age 65+)

Once the primary business owner turns 65, they can split income freely with their spouse, even if the spouse isn’t involved in the business. This exception can be helpful for retirement planning or for older founders.

 

Strategy 4: Investing Excess Cash

Once your business is profitable, you may not want to keep all the extra cash inside your operating company. Here are a few smart ways to move or use that cash for income splitting and investment purposes:

Startup Lends Cash to another Corporation to Invest

Your startup could potentially lend excess cash to another corporation. That money can then be invested inside the corporation. The investment income stays inside the corporation, and isn’t taxed in your hands. If your spouse is a shareholder of the other corporation, it can potentially pay dividends to your spouse. However, there are tricky rules around this. Please speak to us if you are considering this.

Pay Dividends to a Holding Company (Holdco)

Your operating company can pay tax-free intercorporate dividends to a holding company. This has several benefits:

• Keeps the operating company “pure” for LCGE eligibility
• Allows you to invest corporate cash without tainting your active business
• Provides more flexibility in managing retained earnings

It’s possible that this holding company can also pay dividends to your spouse without falling in the the punitive TOSI rules. Again, there are tricky rules around this so please speak to us if you are considering this.

Use Personal Investment Tools

Here are other ways to income split using investments:

• Maximize your spouse’s TFSA. You can gift funds to your spouse to contribute to their TFSA. There are no attribution rules for TFSAs, and the growth is tax-free.
• Set up a Spousal RRSP. You get the deduction today, and your spouse pays the tax later (usually at a lower rate).
• Open an RESP for your kids. This allows both parents to contribute and receive government education grants while growing funds tax-deferred.
• Use a Spousal Loan. You can lend money to your spouse at the prescribed rate (currently 3%) and have them invest it. As long as the interest is paid annually by January 30, the investment income is taxed in their hands.
• Pay tax-free capital dividends from your corporation to your spouse, if they are a shareholder. This allows them to invest personally with no tax on the withdrawn funds.

 

Conclusion and Next Steps

Income splitting can be a game changer for founders who want to reduce their household tax bill and protect more of their business value. But it must be done carefully to avoid TOSI and to ensure all CRA rules are followed.

Some strategies, like issuing shares or setting up a trust, must be done early, before the business becomes too valuable. Others, like paying salary or investing excess cash, can be implemented at any stage.

If you’re a startup founder, now is the time to review your structure and get a tax plan in place.

 

Next steps:

• Contact us to help you with income splitting today.
• Ask us to evaluate your risk of TOSI and whether your company qualifies for LCGE
• Get support with issuing shares, paying family salaries, and setting up trusts

Additional Resources:

• Refer to the CRA’s TOSI Guide

 

Let us help you keep more of what you earn.