What Is Income Splitting and How Does It Work?

Reducing tax liability is a key goal for many individuals and businesses, and income splitting is one strategy used to achieve this. By redistributing income among family members or business partners in lower tax brackets, the overall tax burden can be lowered. However, strict regulations govern how and when this can be done legally.

Understanding the rules around income splitting is essential to avoid penalties. There are specific eligibility criteria, common methods, and tax filing requirements to consider.

Legal Eligibility

Tax authorities impose strict limitations on income splitting to prevent abuse. In the United States, the Internal Revenue Code (IRC) includes provisions such as the kiddie tax under Section 1(g), which taxes unearned income of children at their parents’ marginal rate once it exceeds $2,600 for 2024. In Canada, Tax on Split Income (TOSI) rules under Section 120.4 of the Income Tax Act apply to certain income received by family members, taxing it at the highest marginal rate unless specific exemptions are met.

Eligibility depends on the relationship between the parties and the nature of the income. In the U.S., attribution rules under IRC Section 267 prevent related parties from generating artificial tax benefits. For instance, if a high-income individual transfers investment assets to a lower-income spouse, the IRS may still attribute the income back to the original owner unless a legitimate sale occurs. Canada’s attribution rules under Sections 74.1 to 74.5 of the Income Tax Act function similarly, ensuring that income transferred between spouses or minor children is reassigned to the original taxpayer unless fair market value consideration is involved.

Business structures also play a role. The IRS scrutinizes reasonable compensation in closely held corporations under IRC Section 162(a) to ensure salaries paid to family members reflect actual work performed. If a business owner pays an excessive salary to a spouse or child to shift income, the IRS may reclassify the payment as a disguised dividend. Canada’s reasonableness test under Section 67 of the Income Tax Act serves a similar function, requiring that payments to family members be justifiable based on the work performed.

Common Arrangements

Income splitting takes different forms depending on the relationship between the parties and the type of income involved. While tax authorities impose restrictions to prevent abuse, certain arrangements remain permissible when structured correctly.

Spousal Splitting

Spousal income splitting is often used in jurisdictions with progressive tax brackets. In the United States, married couples can file jointly or separately, but joint filing often results in lower overall tax liability due to wider tax brackets under IRC Section 1(a). However, direct income transfers between spouses to reduce taxes are generally ineffective due to attribution rules under IRC Section 1041, which treat such transfers as tax-neutral.

In Canada, spousal income splitting is more structured. Pension income splitting under Section 60.03 of the Income Tax Act allows a taxpayer to allocate up to 50% of eligible pension income to a lower-income spouse, potentially reducing the couple’s overall tax burden and preserving Old Age Security (OAS) benefits by avoiding the OAS clawback threshold ($90,997 for 2024). Another strategy is contributing to a spousal RRSP, where the higher-earning spouse makes contributions, but withdrawals are taxed in the lower-income spouse’s hands, provided the funds remain in the account for at least three years to avoid attribution.

Partnership Income Split

Business partnerships allow profits to be allocated among partners based on ownership percentage. Under IRC Section 704(b), U.S. partnerships must allocate income according to the partnership agreement, but allocations must have substantial economic effect to be respected by the IRS. If a high-earning partner assigns a disproportionate share of profits to a lower-income spouse without a legitimate business reason, the IRS may reallocate the income based on actual contributions.

In Canada, partnerships are governed by Section 96 of the Income Tax Act, which allows income to be split among partners based on their agreed-upon share. However, the reasonableness test under Section 67 applies, meaning that if a family member is added as a partner without contributing capital or labor, the CRA may challenge the allocation. A business owner can bring a spouse or adult child into the partnership, but they must actively participate in operations to justify their share of income.

Trust Income Sharing

Trusts are commonly used for income splitting in estate and tax planning. In the U.S., grantor trust rules under IRC Sections 671-679 generally attribute trust income back to the grantor if they retain control over the assets. However, non-grantor trusts can distribute income to beneficiaries, who then report it on their tax returns, potentially at lower rates. The complex trust structure allows trustees to decide whether to retain or distribute income, optimizing tax efficiency.

In Canada, trusts are subject to TOSI rules under Section 120.4, which tax certain income distributions to family members at the highest marginal rate unless an exemption applies. A family trust can allocate business income to adult children or spouses who are actively involved in the business. The 21-year deemed disposition rule under Section 104(4) requires trusts to recognize capital gains every 21 years, making long-term planning essential. Distributing assets before this deadline can help mitigate tax consequences.

Tax Filing Requirements

Accurate reporting is essential when implementing income splitting strategies, as tax authorities closely examine returns for improper allocations. Proper documentation of income transfers, business agreements, and financial transactions is necessary to justify any arrangement.

In the U.S., partnerships must report pass-through income on Schedule K-1 (Form 1065), while trusts and estates use Schedule K-1 (Form 1041). Any discrepancies between these forms and individual tax returns can trigger audits. Closely held corporations must ensure that payments to family members are properly classified on Form 1120 (U.S. Corporation Income Tax Return) or Form 1120-S (S Corporation Tax Return) to distinguish between salary, dividends, and other compensation.

In Canada, corporations must file T2 Corporate Income Tax Returns, ensuring that any salaries or dividends paid to family members comply with the reasonableness test under the Income Tax Act. Trusts must file T3 Trust Income Tax Returns, and distributions must be reported on T3 slips issued to beneficiaries. The new trust reporting rules for 2024 require detailed disclosures, including the names and addresses of all beneficiaries, trustees, and settlors.

Penalties for Noncompliance

Improperly structuring or reporting income-splitting arrangements can lead to financial and legal consequences. Tax authorities scrutinize transactions designed to reduce tax liability, often recharacterizing income or disallowing deductions if an arrangement lacks economic substance.

In the U.S., the IRS may apply accuracy-related penalties under IRC Section 6662, imposing a 20% penalty on underpayments resulting from negligence. If the understatement exceeds 10% of the correct tax liability or $5,000, the taxpayer may also face substantial understatement penalties. More severe cases involving intentional misrepresentation can trigger civil fraud penalties under IRC Section 6663, with a 75% penalty on the portion of underpaid tax attributable to fraud. Criminal charges under IRC Section 7201 can result in fines up to $250,000 for individuals and $500,000 for corporations, along with imprisonment of up to five years.

In Canada, taxpayers who fail to comply with income-splitting regulations may be assessed under Section 163(2) of the Income Tax Act, which imposes a 50% gross negligence penalty on tax avoided through misrepresentation. The CRA also has authority under Section 152(7) to reassess income and disallow improper allocations. If an arrangement is deemed abusive under the General Anti-Avoidance Rule (GAAR) in Section 245, the CRA can retroactively deny tax benefits, leading to back taxes, interest, and penalties.

International Considerations

Income splitting strategies vary across jurisdictions. In the U.S., income earned abroad remains taxable under IRC Section 61. The controlled foreign corporation (CFC) rules under Subpart F of the IRC impose immediate taxation on certain types of passive income earned by foreign entities controlled by U.S. shareholders. The Global Intangible Low-Taxed Income (GILTI) regime under IRC Section 951A ensures that U.S. shareholders of CFCs pay a minimum level of tax on foreign earnings.

Canada’s Foreign Accrual Property Income (FAPI) regime under Section 91 of the Income Tax Act requires Canadian taxpayers to report passive income earned by foreign affiliates. Transfer pricing rules under Section 247 mandate that transactions between related parties in different countries be conducted at arm’s length prices. Failure to comply can result in a 10% penalty on transfer pricing adjustments where proper documentation is not maintained.