• Home

Income Splitting

Definition of Income Splitting

In a jurisdiction that utilizes progressive taxation, income splitting is a method by which a family’s income tax is reduced. It is the act of distributing income amongst family members instead of all of it going to one person. Practically, in a household where an individual earns more than the others, it is likely that they will be taxed highly. Therefore, by apportioning income, it will allow the highly earning member to go to a much lower tax bracket where taxable amount will be lower. An income splitting strategy in other words reduces a family’s gross tax level, at the cost where certain family members pay higher taxes than they would otherwise.

Income splitting normally applies in family trusts where they are used to apportion income to non-working spouses and children. The major effect of income splitting in couples is to lessen the total tax liability. You will find this tax practice in many countries which require spouses to file joint tax returns.

In jurisdictions that do not allow joint tax filling, income splitting or directly transferring funds to spouses is highly prohibited. However, in these jurisdictions, there are other ways of reducing the tax burden. For instance, if one owns a company, he can hire family members and therefore reduce the tax burden by shifting the company’s income to a low taxed wage of the employee from the higher taxed profits of the company.

Equally, registering all investments under the name of the lowly taxed family member will considerably reduce the tax burden. Another application is the transfer of tax credits from the lowly earning family member to the high earning individual. For instance, a student can transfer tuition credits to either parent who is funding their post-secondary schooling.

Advantage and disadvantage of Income Splitting

The fundamental merit of income splitting is that it creates an overall view of a household as the essential economic unit rather than the individual. For example, a family that has two individuals earning $40,000 each is equal to a family that has only one individual earning $80,000. Yet, due to progressive taxation, the family with two individuals will be taxed substantially at a higher rate. The basic disadvantage of income splitting is that the government will incur high expenditures annually.

Corporate Income Splitting

A corporation is a different entity from its owners and therefore pays income tax on its own. This therefore means that if corporate owners keep some earnings in the corporation and do not pay themselves as either bonuses or salaries, the income is subject to taxation using corporate income tax rates.

Therefore, the owners of a lucrative small corporation can save a substantial amount of money in their overall income taxes by maintaining a diffident amount of proceeds in the corporation and paying themselves with the remainder as employee bonuses and salaries which will be subject to personal taxable income and not corporate taxable income.

One can thus use salaries and bonuses to control taxable income of the corporation. Remember, the amount of money you pay yourself escalates your personal taxable income and decreases the company’s taxable income. On the flip side, lowering your salary and bonuses subjects the money to corporate taxable income as it places the money on the corporation consequently reducing your personal taxable income and escalating that of the corporation.

Conclusion

Income splitting, especially corporate income splitting should be practical. This is to say that the owner will need enough money to live comfortably, the corporation requires enough money to cover expenses and the IRS has placed a limit on the amount the corporation can retain.

Tags: credit, government, Income, money, tax, Taxation

Comments

Copyright ©2010 itaxrebate.com - Privacy