Income Splitting 101: What’s Legal, What’s Not, and What’s Smart

Think you can cut your tax bill by paying dividends to your teenager? Not so fast.

Income splitting (shifting income from a high-earning family member to lower-earning ones) has long been one of Canada’s most talked-about tax planning strategies. On paper, it looks simple: if one family member is paying tax at the top rate and others are paying little to none, spreading the income around reduces the total family tax bill.

However, what seems simple in theory is anything but simple in practice. 

Over the years, the CRA has cracked down hard on income splitting, especially after introducing the Tax on Split Income (TOSI) rules in 2018. Today, what was once considered an easy tax-saving move is now one of the biggest traps for founders and family business owners.

Still, income splitting isn’t dead. Done right, it can save your family thousands every year and set up smarter long-term planning. Done wrong, it can trigger penalties, back taxes, and CRA audits.

This article breaks down what’s legal, what’s not, and what’s actually smart when it comes to income splitting in Canada.

Why Founders Care About Income Splitting

If you’re a Canadian founder, executive, or incorporated professional, chances are you’ve thought about income splitting. Here’s why:

High personal tax rates

Top earners in Ontario, for example, can face combined rates over 53%. Splitting that income with lower-income family members can reduce the overall bill.

Family-run businesses

Many founders involve spouses or kids in the company. Paying them makes sense - if it’s done correctly.

Retirement planning

As founders get closer to exiting, they often look at ways to spread wealth and reduce tax burdens across the family.

Holding Companies (HoldCos) and Family Trusts

Corporate structures often open the door for advanced strategies - but they also add complexity.

Income splitting is attractive because it promises fairness (why should one person shoulder all the tax?) and efficiency (why not lower the family’s overall tax bill?). 

CRA’s job is to ensure that fairness extends beyond your family - to the tax system as a whole.

What Changed: The TOSI Rules

Before 2018, income splitting was relatively straightforward. If you owned a corporation and your spouse and adult children are part of the shareholder group, you could pay dividends to your spouse or adult children, regardless of their involvement in the business. Families often used this to bring everyone into a lower tax bracket and save big on taxes.

The CRA viewed this as “income sprinkling” - and decided enough was enough.

Enter: Tax on Split Income (TOSI)

In 2018, the rules changed dramatically:

• Inactive family members (spouses, kids, siblings) could no longer simply receive dividends. If they did, those dividends would be taxed at the highest marginal rate - wiping out any tax savings.
• The burden of proof shifted. Now, family members had to demonstrate that they were actively contributing to the business.
• Exceptions were carved out, but they were narrow.

In short, what used to be an easy win became one of the most common CRA audit triggers.

What’s Not Legal (and Why It’s Risky)

Let’s start with what not to do. These are the mistakes we’ve seen founders and executives make, and they’re the fastest way to attract CRA scrutiny.

❌ Paying dividends to kids who don’t work in the business

• If your child is under 18, dividends are essentially off the table. CRA applies punitive tax rates
• For adult children, dividends will likely fall under TOSI unless they work 20+ hours a week on a regular, continuous and substantial basis in the current or any five preceding years
  
  

❌ Putting your spouse on payroll without actual work

• A spouse who “holds a title” but doesn’t do real work won’t pass CRA review. They’ll want to see hours worked, job descriptions, and market-appropriate pay

❌ Inflated salaries

• Paying someone $80,000 for data entry that would normally pay $40,000 is a red flag. CRA expects compensation to align with fair market value

❌ Disguised ownership

• Giving shares to family members who don’t participate in the business just to funnel dividends through them is a classic audit trigger.

Here’s an example. 

A Toronto SaaS founder set up shares for his 19-year-old daughter, who was in university and had never worked for the company. 

He paid her $30,000 in dividends to lower the family tax bill. CRA reassessed him, applied TOSI, and added penalties. What happened after? Over $45,000 in back taxes and interest. What looked like a clever hack turned into an expensive lesson.

What’s Legal (and Still Smart)

Despite the restrictions, income splitting isn’t gone - it just requires smarter planning.

✅ Hire family members who actually work in the business

• If your spouse handles admin or your teenager helps with customer support during the summer, you can absolutely pay them a fair salary.
• The key is that compensation must match the work performed.
• Pro tip: Keep records - job descriptions, timesheets, emails. If CRA asks, you want proof.

✅ Use family trusts

• A family trust can allow income allocation to active members and provide flexibility for future planning (we’ve broken down how family trusts work in more detail here).
• Trusts are often used to support succession planning, education funding, and estate structuring

✅ Leverage HoldCos and corporate structures

• A holding company can give you more control over when and how income is distributed (check out our guide to holding companies to see when it makes sense and how to structure it the right way).
• Properly structured, this can smooth dividend planning and protect assets
• However, the presence of a HoldCo doesn’t automatically make income splitting legal - CRA still looks at who’s actually involved.  It can also create difficulties in accessing the Lifetime Capital Gains Exemption (LCGE) in the future - so careful planning is required here (check out our guide to the LCGE).

✅ Retirement income splitting

• At age 65, spouses can split eligible pension income. This is one of the few remaining “easy wins” under current rules.

The Grey Areas

Income splitting isn’t always black and white. Some situations fall into a grey zone where CRA discretion and documentation matter.

Capital contributions

If a family member invested their own money into the business, they may qualify for income splitting benefits. The larger and riskier the contribution, the stronger the case.

Significant labor contributions

Adult children working 20+ hours/week in the business generally fall outside TOSI. But the hours must be consistent and provable.

Industry differences

Service businesses tend to face more scrutiny, while capital-intensive businesses (like manufacturing) have slightly more flexibility.

Tip: Always assume CRA will ask: “What did this family member do for the business?” 

If your documentation doesn’t answer that clearly, you’re exposed.

Myth-Busting: Income Splitting Edition

Let’s cut through some of the most common myths we hear from founders.

❌ Myth: “I can just pay dividends to my kids.”
✅ Reality: Unless they’re over 18 and actively working 20+ hours/week, dividends will likely be taxed at the top rate.

❌ Myth: “Nobody checks.”
✅ Reality: Family-owned corporations are frequent audit targets. CRA is very familiar with these strategies.

❌ Myth: “Everyone does it, so it must be fine.”
✅ Reality: Everyone used to do it. Post-2018, the landscape has completely changed.

❌ Myth: “I can set up a HoldCo and solve this.”
✅ Reality: Corporate structures add flexibility, but they don’t override TOSI. Inactive family members still don’t qualify.

Think of It Like Dessert

Here’s the simplest way to think about income splitting: it’s like sharing dessert at the dinner table.

Everyone wants a slice, but if your spouse or kids didn’t show up for dinner, or didn’t help make it, they don’t get cake. 

CRA is the parent at the table, making sure nobody sneaks a piece who didn’t earn it.

It’s all about making sure the portions are fair, reasonable, and justified.

How Much Is at Stake? (A Simple Example)

Let’s say you own a consulting firm that made $200,000 in net income.

Scenario 1: 

• One spouse reports it all
• Tax bill: approx. $85,000 (top marginal rates)

Scenario 2: 

• Spouse actively works in the business, legitimately earns $80,000 salary
• High-earning spouse reports $120,000 → tax ~$40,000
• Supporting spouse reports $80,000 → tax ~$18,000
• Combined tax: ~$58,000
• Savings: nearly $27,000

The difference between “not legal” and “smart” is documentation and substance. 

The CRA doesn’t oppose income splitting where the family member contributes value.

The Expert’s View: What’s Smart in 2025

After working with hundreds of Canadian founders, here’s what we’ve learned:

Documentation is everything

Job descriptions, timesheets, capital contributions - if it’s not on paper, it didn’t happen.

Plan ahead

Don’t wait until year-end to think about income splitting. Build it into your structure from the start.

Use the right vehicles

Strategies like family trusts and holding companies can add flexibility, but only if they’re structured properly. We cover these in detail in our family trust guide and our holding company article.

Think long-term

Income splitting isn’t just about this year’s tax bill. It’s about succession planning, wealth transfer, and keeping CRA off your back for years to come.

Income Splitting Done Right

Income splitting can still be a smart, legal way to reduce your family’s overall tax burden, but it works best when it’s done with the right structure, strategy, and compliance in place.

Done right, it can:

• Lower your family’s tax bill
• Support retirement and succession planning
• Smooth wealth transfer across generations

Done wrong, it can:

• Trigger reassessments and penalties
• Erode trust with CRA
• Create more stress than savings

If you want to see what income splitting could look like for your family and business - the smart, CRA-proof version - book a call with us. We’ll walk you through it.