The federal government announced new tax rules for small business earlier this year and now they have released details on the new rules on income sprinkling. Kim Parlee speaks with Pierre Letourneau, High Net Worth Planner, TD Wealth, about the changes and who is affected.
The final rules have come through on income sprinkling. And it really does affect a number of Canadians who have family members working in their business of a certain structure. And the timeline apparently is pretty tight on this. We're just getting the release in the details. Pierre, tell us a bit about these rules again. Who does it specifically affect?
So it affects family members of business owners that receive amounts from a corporation, from a small business corporation, and amounts that are deemed not to be reasonable, right? So in those situations where the amounts aren't reasonable-- so we're looking at dividends or any other sources of income-- those amounts would be taxed at the highest marginal tax rate if they're deemed to be not reasonable.
Got it. And reasonable, we're going to get into what actually that means, according to the CRA. And what is the CRA trying to do-- or the minister of finance trying to do-- around this? I mean, what are they trying to prevent?
So they're trying to prevent income splitting between family members. So business owners that have incorporated and then have family members as shareholders of that business-- of that corporation-- would normally pay out dividends to other family members that may not have that much income so that those dividends would be taxed at a lower tax rate.
OK. So let's run through what we know right now, and that is we have some examples here of when income sprinkling would be allowed. So the first one, if a family member is 18 or over and has made a substantial labor contribution to the business. So they're actually working in the business.
Right. They're working in the business. And what the government has-- or the finance has-- proposed is a bright line test that says that if they've been working 20 hours during a week, then-- 20 hours a week with the business-- then there wouldn't be any income sprinkling rules that would apply to them. They've also said for seasonal businesses that they would only focus on the part of the season-- a part of the year where the corporation is actually operating.
Right. I'm even thinking fishing. There's certain reasons you're not doing it.
They also said if a family member is 25 or older or owns a percentage of the business that is equal or greater to 10%.
Right. So the rules wouldn't apply in that situation. And the 10% ownership, they're looking at the amount of votes. So 10% of the votes of all shareholders. And 10% of the value of the business as well, too. So you need to meet both those tests. But there are some exclusions. So the business can't be earning more than 90% of its income from services that it's providing. So services-- so maybe consulting services. And the other, I guess, exclusion where the rules would apply is in a situation where there's a professional corporation.
So regardless of the amount of income that they're earning and the share ownership of any family member, a tax on split income would apply.
And the third one that they talked about-- and you could give me some more color on this one-- is if the business owner, I believe, is 65 or over. And this regards their spouse.
Right. This regards their spouse. So if they're 65 and over and dividends are being paid out to their spouse, the income splitting rules wouldn't apply to them. And that's really to match up with the pension income splitting rules. So allowing business owners to split their income with their spouses, whereas pensioners are able to as well.
Some clarity around those specific situations. So if you follow those situations, you know what you can do. What if you don't?
If you don't, then we go back to the initial rules where they have provided some clarification but the amounts being paid need to be reasonable. And in determining what's reasonable, the CRA would look at a few different factors. They'll look at labor contributions, capital contributions, the risks that the family members are assuming within the business. And they'll also look at previous payments as well-- historical payments made to those family members.
One thing I know when you and I were chatting that popped out of this announcement was the timing.
It's quick, but we were expecting it a bit earlier, too.
Yeah. So January 1, 2018 is when these new rules will take effect.
Why should people be thinking about, again, getting ready for that?
So I strongly recommend to speak with your tax advisor or investment advisor to determine if it's worthwhile paying out a dividend before the end of the year, before these rules kick in. And also, going forward, I think it's going to be very important for business owners that have family members that are contributing to the business to document all those contributions. Make sure that they can substantiate any amounts that were being paid if the family member is providing labor contributions or capital contributions to the business.
Pierre, great having you here. Thanks so much.