In certain instances, business owners employ income splitting through salaries. Instead of paying a high salary to the business owner, salaries can be distributed to family members such as a spouse or children. In Canada, reasonable salaries paid to a spouse or children as part of a business operation are deductible business expenses for income tax purposes. Thanks to personal exemptions and tax credits for students, families can potentially save up a lot through this strategy. It is effective due to the difference in tax rates between high and low income earners, with higher earners paying a higher rate of tax.
The Canada Revenue Agency (CRA) is aware of this strategy, and regularly conducts audits to review salaries in family-owned businesses.
Under section 67 of the Income Tax Act, there is a provision stating that expenses must be reasonable to be deductible.
This rule is usually not applied to salaries of unrelated employees, but if the employee is a family member (such as a spouse or child of the business owner), the CRA auditors will assess if the salaries paid to them are reasonable.
If they are deemed unreasonable, the salary deduction will be disallowed, causing the business to pay more tax (and interest). In some cases, the excessive salaries may even be considered as the business owner's income, leading to double taxation. If it is found that the excessive salaries were knowingly paid or due to gross negligence, 50% penalties may also be imposed.
If you pay a salary that is deemed excessive by the CRA, the business may not be able to claim a deduction for it. This could result in the family member still being taxed on the compensation, leading to double taxation on the same amount, which is not ideal.
Unfortunately, there are no clear guidelines for determining a reasonable vs unreasonable salary in income splitting. The most widely used method is to evaluate the services provided by the spouse and children to the business, and then compare each of their salaries to what a similar business would pay an unrelated employee for the same services.
Here are some factors to consider prior to paying salaries to family members:
Nature of tasks performed: Salaries should be based on the services provided and the skills required, which can vary depending on the nature of the business and the support it requires. Tasks may include billing and collections, administrative work, payroll, accounting, and bookkeeping. It's important to consider the nature of the tasks and the time needed to complete them.
- Competitive salary/wage: The compensation received by the spouse and children should be similar to what the business would pay to an unrelated party for the same tasks. For part-time family members, a salary of $10,000 to $15,000 may be reasonable. But for full-time family members, a higher salary of $30,000 or more may be justified if the circumstances support it. Therefore, having clear job descriptions and time sheets showing the hours worked is crucial. Problems may arise if the business owner pays a salary to children while they are studying at university in another city, or if a spouse who does bookkeeping or banking is paid a full-time salary, but the evidence suggests that the work could be done by a part-time clerk for a much lower cost.
- Proper records: Employment contracts, timesheets, detailed job descriptions, T4 forms, and proof of payment deposited into the family member's bank account should be kept on file to ensure proper documentation.
- Ensure that payments are legitimate. In the case of Muhammedi v. R. (2004 TCC 408), the taxpayer claimed deductions for wages earned by their spouse and children as casual labor expenses. However, the deductions were disallowed because the funds remained under the control of the parents or the business, rather than being paid directly to the children who performed the work. In a court case, the kids' earned money was written as a cheque but deposited into the account of either the business owner, the business, or the spouse. In the case of Prunoiu v. QRA (2021 QCCQ 7555), the salary deductions were denied due to the lack of proof that the amounts were actually paid to the family members. It's important to have evidence of payment to ensure the legitimacy of the deductions.
- Paying family members in kind can be acceptable. While paying salary or wages through cheques or electronic transfers is the simplest method to document and keep track of, a court decision in Aprile v. R (2005 TCC 216) showed that compensating children through the purchase of snowmobiles, motorcycles, and gas for these machines can be deemed legitimate. This form of compensation may be complicated, but it can be considered valid.
- You can avoid paying Employment Insurance (EI) premiums by paying family members to work in your business. The work may be considered "excluded employment", which means that they may not be eligible to collect EI in the future and that you and your family members are not required to pay EI premiums. It is recommended to consult with an accountant to confirm whether the employment is excluded.
Note: These factors are general guidelines and may vary depending on specific circumstances.
Income splitting can provide significant tax savings, but it must be planned and documented carefully to avoid risks such as double taxation and penalties.
Proactive planning is often safer than trying to resolve issues after an audit. If the strategy is too complex or risky, alternative tax savings methods, such as family trusts, may be a better option.
“Please note that the information provided in this article is of a general nature and may not be accurate for your specific situation. The information is current as of the date of posting and is not intended to provide legal advice. It's always recommended that you consult with a professional accountant and lawyer for personalized guidance and advice."