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Income Splitting Shares: What You Need to Know

By October 26, 2014October 21st, 2021Corporate

Income Splitting Shares are important for paying fewer taxes.  Basically, they are shares that your professional corporation can give to you (the dentist), or your spouse, parents or children.  They are non-voting and typically non-participating and redeemable by the corporation for a nominal amount (e.g. $1.00).  The shareholders of these types of shares are entitled to dividends if and when declared by the board of directors, who are elected by the voting shareholders of the corporation (i.e. the dentist or dentists who have the voting shares).

Now, importantly, these shares might appear to be worthless because they can be redeemed by a nominal amount, are ineligible to be used for the lifetime capital gains exemption, and only pay out dividends to the shareholders at the discretion of the board of directors.  So what’s the big deal?  Well, actually, they can be used to declare dividends to a family member of the dentist who earns less income than the dentist, thereby reducing the family’s overall tax burden.  For example, roughly $40k worth of dividends can be declared to a family member (over 18 years old) and that person doesn’t need to work for the company at all; they just need to be a shareholder.  If that person has no other income from any other source, then guess what: they will pay $0 federal tax (they’ll only pay a little bit of Ontario health tax).  And remember that dividends are paid out of after-tax dollars. And since the professional corporation will only pay 15.5% on the first $500k of active business income, you’re saving a lot by not having the shareholder pay any more federal tax on top of the 15.5% tax that has already been paid.

So what could go wrong with using these types of shares?  Well, think about it. If you’re the Canada Revenue Agency, would you be happy with the idea that lots of income can be funnelled to family members and tax-sheltered from their clutches?  Wouldn’t they want the shareholder to pay federal tax on those dividends?  And so there’s a risk: that if you give a family member income-splitting shares that seem worthless but which can pay out big bucks over time (think $40k each and every year for a number of years), the CRA is going to come after you.

So what can and should you do to protect yourself?  Well, your accountant will probably encourage you to make sure that the shares are issued (i.e. transferred from the corporation to the shareholder) when the corporation itself is not worth anything.  This could be, for example, at the beginning stages when the corporation is first incorporated.  If it hasn’t borrowed money or made money, etc., the shares that are issued are not going to be worth much. So how could the CRA complain that they are worth more than the $1 that the shareholder paid for them?  It sounds like a good argument to me for the shareholder; coupled with the fact that it can be redeemed at the option of the corporation and that there’s no guarantee that dividends will ever be declared = good arguments against the CRA challenging the value of those shares.

But what if your corporation is actually worth something and you never got around to having your dental lawyer issue these types of shares to your family members when the corporation wasn’t worth anything?  Well, your dental accountants will likely advise you to do an “estate freeze”.  It’s an interesting legal / accounting manoeuvre.  Let me tell you how it works.  Basically, you start with the idea that one shareholder (e.g. a dentist) has common shares that are voting and not redeemable and are worth a lot of money because the corporation is worth a lot of money.   They grow over time and entitle the dentist to use the lifetime capital gains exemption.  The problem is that if the dentist simply holds onto these shares, they will pay taxes on them when they are sold or when the dentist dies.  Sure, they could use their lifetime capital gains exemption (assuming they qualify) to reduce the tax burden; but that’s only for a certain amount.  The better thing to do is to FREEZE the value of those so-called “COMMON / GROWTH / EQUITY” shares and put all of their value into a type of PREFERRED share whose value doesn’t continue to increase.  You can do that so long as you ALSO issue COMMON / GROWTH / EQUITY SHARES and INCOME SPLITTING SHARES at the same time to either the dentist OR their family members.  And guess what?  Since the value of the original growth/common/equity shares is frozen in the preferred shares, you can now issue INCOME SPLITTING SHARES to your family members and those shares won’t be worth anything.  Why?  Because, once again, the value of the corporation is frozen in those PREFERRED shares which are held by the dentist.

OK, I hope you understand how that operates.  Just keep in mind that if you do an estate freeze, you will need to issue COMMON/GROWTH/EQUITY shares with voting rights to the dentist because, legally speaking, you are required to have issued at least one of the shares issued to the dentist.  You can give COMMON/GROWTH/EQUITY shares that don’t have the right to vote to the spouses, parents, and children of the dentist.  And you can also give these individuals Income splitting shares as well.  Again, the beautiful thing about this move is that the CRA may have a tough time coming after you because the value of those Income Splitting Shares at the time of their issuance was worth only a nominal amount (e.g. $1 per share) because all of the value of the corporation was tied up in the PREFERRED SHARES.

Hope this makes sense!