TOSI Rules for Private Company Owners: Tax on Split Income Explained

TOSI Rules for Private Company Owners: Tax on Split Income Explained

If you own a private company and are considering paying dividends to family members, issuing shares to a spouse or children, or using a family trust in an estate freeze, you need to understand the tax on split income, commonly called TOSI.

TOSI is one of the main tax rules that affects income splitting in private corporations. It does not prevent all family ownership or all payments to family members. But it can remove the tax benefit of paying private company income to a family member who is not sufficiently involved in the business.

This article explains the TOSI rules in plain language for business owners, family companies, and people considering corporate reorganizations or estate freezes. It provides a general corporate law overview and is not tax advice. Because TOSI is technical and fact-specific, businessowners should speak with their accountant or tax advisor before paying dividends, distributing trust income, or implementing a reorganization.

What Is TOSI?

TOSI means tax on split income.

In simple terms, TOSI can apply when income from a private business is paid to a family member who has not made a sufficient contributionto the business that generated the income.

The rules are mainly aimed at income splitting or income sprinkling. That is where business income is paid to family members in lower tax brackets to reduce the family’s overall tax bill.

For example, a corporation may earn business income. Instead of paying dividends only to the active owner, dividends may be paid to a spouse, adult child, minor child, or family trust beneficiary who has little or no involvement in the business.

That is the type of planning TOSI is designed to restrict.

CRA describes split income as generally including certain dividends, interest, capital gains, and income from partnerships or trusts from a related business.

Why TOSI Matters

If TOSI applies, the income is generally taxed at the highest marginal tax rate.

That can eliminate the benefit of paying income to a lower-income family member. In many cases, it can make the tax result worse than if the income had simply been paid to the active business owner in the first place.

The practical point is this: issuing shares to a spouse, children, or family trust does not automatically allow income splitting.

TOSI must be considered before dividends are paid, trust income is allocated, or private company shares are sold or reorganized.

When TOSI Usually Comes Up

TOSI commonly arises in private company planning involving:

·        Dividends paid to family members.

·        Family trusts holding shares of a private corporation.

·        Estate freezes where future growth shares are issued to a trust or family members.

·        Holding company structures involving family ownership.

·        Partnership income allocated to family members.

·        Certain capital gains involving private company shares.

·        Certain shareholder benefits.

TOSI is especially important where the person receiving the income is related to the active business owner but is not actively involved in the business.

What Income Can Be Caught by TOSI?

TOSI can apply to several types of income, including dividends from private corporations, certain trust or partnership income, certain capital gains, shareholder benefits, and income from certain debt obligations.

For many private companies, the most common issue is dividends paid to family members.

Salary is different. TOSI generally does not apply to ordinary salary or wages, but salary paid to a family member must still be reasonable for the work actually performed. CRA’s guidance distinguishes split income from salary paid by a private corporation from a related business.

What Is a “Specified Individual”?

The TOSI rules apply to a specified individual who receives split income, unless the income is an excluded amount.

In general terms, a specified individual includes an individual resident in Canada at the end of the year, with specific rules for minors. The technical definition is found in section 120.4 of the Income Tax Act.

For business owners, the key point is practical: if a Canadian-resident family member receives income connected to a private business, TOSI should be considered.

The Practical Starting Point: Assume TOSI May Apply

A useful practical approach is to assume TOSI may apply to income received from a private corporation, trust, or partnership unless an exclusion is available.

This is especially important where shares are held by a family trust or by individuals who are not active in the business.

In a typical estate freeze, for example, new common shares may be issued to a family trust. If the corporation later pays dividends to the trust and the trust distributes those amounts to spouse or children beneficiaries, TOSI may apply at the beneficiary level unless an exclusion applies.

The trust itself does not solve the TOSI problem.

Common TOSI Exclusions

TOSI does not apply in every case. There are several exclusions, and the rules vary depending on the person’s age, involvement in the business, share ownership, and other factors.

The most common exclusions include the following.

Excluded Business

An excluded business exception may apply where the individual is actively engaged in the business on a regular, continuous, and substantial basis.

CRA guidance generally refers to an individual working in the business at least an average of 20 hours per week during the part of the year the business operates, or meeting that level of involvement in any five prior years.

This can be important for a spouse or adult child who actually works in the business.

For example, if a spouse has worked substantially in the business for several years, dividends to that spouse may be easier to support than dividends to a family member who has no involvement.

Reasonable Return

A reasonable return exception may apply where the amount paid to the individual is reasonable based on their contribution to the business.

Relevant factors may include:

·        Work performed.

·        Property contributed.

·        Capital contributed.

·        Risk assumed.

·        Amounts previously paid.

·        Other relevant circumstances.

For individuals who are 25 or older, the reasonable return test is generally broader. For individuals between 18 and 24, the rules are more restrictive.

The practical point is that evidence matters. If a family member contributed capital, worked in the business, guaranteed debt, assumed risk, or provided property, those contributions should be documented.

Excluded Shares

The excluded shares exception may apply to individuals who are 25 or older, but only if technical conditions are met.

In general terms, the individual must directly own shares that provide at least 10% of the votes and 10% of the value of the corporation. The corporation must also meet business-type requirements, including that it is not a professional corporation and that less than 90% of its business income is from providing services. CRA confirms that individuals may be excluded from TOSI if income comes from excluded shares and they reached age 25 before the end of the year in which the income was received.

This exclusion can be useful, but it is often not available for professional corporations, many service businesses, or shares held indirectly through a family trust.

Spouses of Older Business Owners

There are also special rules that may assist spouses of older business owners.

In general terms, certain income received by a spouse may be excluded where the active business owner is at least 65, or where the income would have been excluded if received by that spouse. The Income Tax Act includes spouse-related excluded amount rules in section 120.4.

This can be relevant for retirement planning and dividend planning between spouses.

Inherited Property

Special rules may apply where property is inherited.

In some cases, the recipient may be able to rely on certain attributes of the deceased person for TOSI purposes. CRA’s income sprinkling guidance identifies exclusions for certain inherited property and death-related situations.

This can matter in estate planning where private company shares pass to a spouse, child, or trust.

TOSI and Family Trusts

A family trust is often used in estate freezes and private company planning. A trust can help hold shares for multiple beneficiaries and may provide flexibility over future distributions.

However, a family trust does not avoid TOSI by itself.

If a family trust receives dividends from a private corporation and allocates income to beneficiaries, each beneficiary’s circumstances must be reviewed. The question is usually whether that beneficiary would have an exclusion if they had received the income directly.

For business owners, this is critical. A family trust may be useful for estate planning, succession planning, and control, but it does not automatically permit income splitting.

TOSI and Estate Freezes

TOSI is also important in an estate freeze.

In a typical estate freeze, the current value of the company is frozen in the hands of the existing owner, often through fixed-value preferred shares. Future growth may then accrue to new common shares held by a family trust, children, or other family members.

This can be useful for succession and estate planning, but future dividends on those new common shares may still be subject to TOSI.

That means the estate freeze may work from a corporate law and tax-deferral perspective, but dividend planning still needs a separate TOSI review.

TOSI and Holding Companies

Holding companies can be useful for creditor protection, estate planning, investment planning, and sale planning.

However, holding companies can also raise TOSI issues if dividends flow to family members.

The excluded shares exception may be harder to rely on where shares are held through a holding company or family trust, or where the holding company earns income from a related operating company. The analysis is technical and should be reviewed before dividends are paid.

TOSI and Professional Corporations

Professional corporations require extra caution.

The excluded shares exception generally does not apply to professional corporations. That means dividend splitting with a spouse, adult children, or family trust beneficiaries may be more restricted.

Professionals should be particularly cautious about assuming that family share ownership will allow income splitting.

TOSI Checklist for Business Owners

Before talking to your accountant about paying dividends or distributing income to family members, ask:

·        Who is receiving the income?

·        Are they related to the active business owner?

·        Is the income connected to a private business?

·        Is the recipient actively involved in the business?

·        Have they worked in the business in any five prior years?

·        Do they own shares directly?

·        Do the shares qualify as excluded shares?

·        Did they contribute capital, property, work, or assume risk?

·        Is the income being paid through a family trust?

·        Is this part of an estate freeze or corporate reorganization?

·        Is the corporation a service business or professional corporation?

Practical Takeaway

TOSI does not prevent all family ownership, all family trusts, or all dividends to family members.

But it does mean that income splitting with private corporations is much more restricted than many business owners expect.

The safest practical approach is to assume that TOSI may apply unless an exclusion can be clearly identified. This is especially important for dividends, family trust distributions, estate freezes, holding company structures, and private company reorganizations.

Need Help Turning a Tax Plan Into Corporate Documents?

If your accountant has recommended an estate freeze, family trust, holding company structure, dividend plan, or private company reorganization, TOSI should be considered before income is paid or distributed.

At Johnston Franklin Bishop, we help private company owners implement accountant-recommended plans by preparing the corporate documents needed to support the structure. This may include articles, share terms, resolutions, trust-related corporate steps, share registers, dividend resolutions, and minute book updates.

TOSI is tax advice, and your accountant should confirm how the rules apply. Our role is to help make sure the corporate structure and records are properly set up to carry out the plan. Contact us if you would like assistance implementing or updating a private company structure involving family ownership, trusts, dividends, or a reorganization.

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