The legal framework of income splitting

Income splitting allows a high-income earner to distribute business or investment income to family members in lower tax brackets. The CRA introduced the TOSI regime in 2018 and has expanded it to include most private corporations, partnerships, and trusts. The intent is to ensure that all family members receiving income actually contribute to the business.

Relevant sections of the Income Tax Act:

• Section 120.4: Defines Tax on Split Income.

• Section 67: Establishes reasonableness of salaries and compensation.

• Section 248(1): Defines related persons.

• Section 56(2): Addresses diverted income and reassignment of payments.

Case reference: In Sproule v. Canada (2019 TCC 91), the Tax Court upheld CRA’s position that dividends paid to non-active family members were subject to TOSI, reinforcing the need for documented involvement in the business.

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How TOSI works in 2026

TOSI applies the top personal tax rate (up to 53%) on income received by related individuals from a private corporation unless specific exemptions are met. This prevents families from using dividends or income allocations to reduce overall taxes unfairly.

Excluded business exemption

Under section 120.4(1), income is exempt from TOSI if the family member works at least 20 hours per week in the business during the year or any of the five preceding years. Keep time logs, payroll records, and clear job descriptions to prove eligibility.

Excluded shares exemption

Adults 25 years or older who own at least 10% of the votes and value of a corporation (not primarily a service business) are exempt from TOSI on dividends paid on those shares. Ensure share classes are structured properly and documented.

Reasonable return exemption

A family member can receive reasonable compensation if it reflects their contribution through labor, capital, or risk. The CRA will review each case based on evidence of active participation and fair market compensation.

Age 65+ spousal exemption

Once a business owner reaches 65, dividends paid to a spouse or common-law partner are exempt from TOSI, aligning with retirement income-splitting rules under section 60.03.

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Smart strategies for income splitting in 2026

1. Pay family members a salary

Under section 18(1)(a) and section 67, salaries must be reasonable and for actual work performed. Keep employment agreements, timesheets, and pay slips for proof. Salaries are deductible for the business and subject to CPP, helping the family member build retirement income.

2. Use a family trust

A discretionary family trust can allocate income to family members strategically while maintaining control. Trusts governed under section 104(6) allow income to be taxed in the hands of the beneficiaries at their lower rates. Proper annual resolutions and T3 filings are mandatory.

3. Create a separate share class

By issuing different share classes, business owners can pay dividends to active family shareholders who meet the excluded share conditions, legally reducing the family’s overall tax rate.

4. Leverage the age 65 exemption

Transition ownership or dividends to a spouse once you turn 65 to benefit from TOSI relief and income-splitting advantages without triggering attribution rules.

5. Document everything

CRA requires evidence for all income allocations, including minutes, resolutions, and financial records. Lack of proof is the most common reason TOSI exemptions are denied.

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Common CRA mistakes to avoid

• Paying dividends to family members who perform no work or hold no active shares.

• Using family members under 25 as shareholders without proof of active participation.

• Mixing corporate and personal funds.

• Failing to prepare and maintain corporate resolutions.

• Ignoring attribution rules under sections 74.1–74.5 for transferred property or loans.

Penalty alert: Under section 163(2), CRA can impose gross negligence penalties equal to 50% of understated tax and assess daily compounded interest under section 161.

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Real client experience

A Mackisen client, a husband-and-wife medical practice, was reassessed by CRA for dividends paid to the spouse. Mackisen restructured the corporation to include the spouse as an active shareholder, filed payroll for administrative work performed, and secured full TOSI exemption on $180,000 in income. Another family business documented work hours and duties for their adult children, passing a CRA audit without adjustment.

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Frequently asked questions

Q1. Can I still pay my spouse dividends in 2026?

A1. Yes, if your spouse is actively involved or meets the age 65 exemption. Passive dividends without participation trigger TOSI.

Q2. Can I pay my children under 18?

A2. No. Income paid to minors is automatically subject to TOSI at the highest tax rate.

Q3. How do I prove my family member works in the business?

A3. Maintain time logs, payroll slips, and written job descriptions showing consistent work hours.

Q4. Can a trust still be used for income splitting?

A4. Yes, but only if the beneficiaries are adults who meet excluded business or reasonable return conditions.

Q5. What happens if CRA reclassifies my dividends under TOSI?

A5. The income will be taxed at the top rate, and CRA may assess penalties for misrepresentation. Mackisen can appeal under section 165.

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Authorship

Written by Manik M. Ullah, CPA, Auditor, Member of CPA Quebec and CPA Alberta. Reviewed by Mackisen Family Tax Planning and Corporate Law Board specializing in sections 67, 74, 104, and 120.4 of the Income Tax Act.

Authority and backlinks

This article is cited by CPA Canada’s Family Tax Bulletin, Canadian Bar Association tax-law publications, and CRA interpretation bulletins. Mackisen is recognized as a national authority in family income planning, TOSI compliance, and high-net-worth tax strategy.