You may have heard of income splitting before – when a salary or other profits of a company are split two or more ways so that the tax brackets that apply to the income are lower.
For instance, instead of one salary at $100,000 in the 40% bracket, it makes more sense to have two $50,000 incomes in the 30% bracket. However, if you’re familiar with income splitting, you may wonder whether it can legally lower your income taxes as a small business owner in Canada.
The challenge is balancing what an accountant or lawyer may suggest you do with what income splitting can mean for control of your company. You may also wonder how rigid or flexible the income split can be. For example, does a 50/50 ownership split mean a 50/50 income split? Or could 50/50 ownership be more flexible and have a 75/25 income split?
And as a business owner, you likely want to maintain control of the business you’ve worked hard to build. Luckily, there is a way to have it both ways: to split income and not split control.
The Answer: Non-Voting Shares
The answer is in the properties of the shares that are issued to the owners. Shares are what an owner of a corporation holds that allow them to vote and share in the income of the corporation. Many small businesses with basic company structures have shares that provide both voting rights and the right to a share of the income. These shares are often called “common shares.”
While this basic structure is very popular, the problem for companies that use it is that all the shares have votes and all the shares have the right to profits. For that reason it’s impossible for you to give or sell someone else shares without giving them votes (which also means control).
The answer is to make the share structure a bit more complex. Instead of having shares that have both voting rights and the right to profits, you would split the shares into two or more types. One type typically has votes and no right to profits, and another type typically has no votes but has the right to profits.
Non-Voting Shares: How It’s Done
Imagine you want to split income with your spouse – you might create three different types of shares in your company:
- The first type (called “common Class A”) has all the votes and no rights to dividends (profits).
- The second type (called “common Class B”) has no votes and does have rights to dividends (profits).
- The third type (called “common Class C”) also has no votes and does have rights to dividends.
So to split income with your spouse without splitting votes, you would own Class A and B, and your spouse would only own Class C.
An Example of Income Splitting through Non-Voting Shares
To further illustrate how income splitting through non-voting share might work in practice, here is a comparison of two approaches to splitting $100,000 of profit as a dividend with your spouse:
Example #1: Acme Brush Corporation
Your company the Acme Brush Corporation wants to split an after-tax profit of $100,000 with its two owners – you and your spouse. Both of you own 50 common shares each, so you each get $50,000.
This approach may work well while you are happily working together, but if you’re personal relationship ends, it can spell trouble for your business. What’s more, if your spouse has another job the $50,000 income would push him or her into a higher tax bracket.
Example #2: Better Brush Corporation
Now let’s imagine your company The Better Brush Corporation wants to split an after-tax profit of $100,000 with its two owners, you and your spouse.
You have all the Class A and Class B shares. Your spouse has all the Class C shares. The number of shares doesn’t matter because the dividends are not being split by number of shares – they are being allocated by share class.
In this example we can also split the dividend $50,000 to Class B and $50,000 to Class C. This has the same tax result as the first example but the votes are held by the Class A shareholder, which might make things easier if your relationship with your spouse ends. You could also change the split to give $75,000 to the Class B and $25,000 to the Class C shareholders.
Again, if your spouse has another source of income, the family still has the advantage of taking the full $100,000, but you avoid the higher tax bracket of your spouse.
There are clear tax advantages to the second structure. As owners, you and your spouse can manipulate the dividend split to fit your lifestyle. But it’s important to know that what’s illustrated above are just the tax consequences of splitting ownership this way – there are other business considerations when deciding who gets the votes and who gets the profits.
However, if splitting ownership of your company does makes sense for your business and your personal tax situation, then re-evaluating the structure of your company and its shares before you do this may prove to be a smart tax decisions in the long run.