Tax Planning
By Edelkoort Smethurst CPAs LLP
Running a business comes with advantages as well as disadvantages. As your boss, you have the flexibility to work at your own pace and on your own schedule. While in a salaried job, you earn a fixed salary no matter how much time you put in, owning a business provides the opportunity to reap more rewards following greater personal output. However, handling the finances and finding ways to reduce taxes can be tricky. While it may be tempting to withdraw funds from the business to improve your quality of life, you might be hesitant to withdraw too much cash due to the correlating tax obligations those withdrawals represent. While helping your business to grow, you were likely reinvesting a significant portion of your earnings to make that happen. Now that the company has stabilized and gained momentum, you can withdraw some amount to improve your lifestyle. By sharing this additional income with your family members, you can enjoy the benefits it provides while reducing the taxes payable.
How does income sharing help save taxes?
You cannot simply withdraw cash from your business and use it for your personal expenses without increasing your annual personal tax bill. Canada has a progressive taxation system, meaning that people who earn more have to pay higher taxes than people who make less. Even if you do not withdraw too much cash to avoid a hefty tax bill, you will pay taxes on your business income. As your business income rises, so will your tax burden. Now how to save your money from taxes?
One way to reduce your business’s tax billis by paying a certain amount of money to your spouse and/or children. If you withdraw a certain amount from your business and spread that income amongst family members, it will help you to remain in a lower tax bracket.
Considering that the federal tax rate for business income ranges from 9% to 38%, maintaining a lower bracket can represent significant savings.
Hiring Family Members to Reduce your Tax Burden
You can hire your family member in your business to split the income and reduce the tax burden. However, the Canada Revenue Agency (CRA) requires that you meet all the following conditions if you plan to deduct your family member’s income as a business expense:
- You must pay a salary to the family member
- You must pay the same amount of salary to the family member that you would pay a non-family member to do the same work.
- The work that the family member does must be essential to the business’ earnings.
- Any salary paid to a child must be reasonable for his/her age.
After meeting all these conditions, you can hire a family member as an employee and then deduct the family member’s salary as a business expense just like the salaries of other employees. Since the entire amount is being paid to members of the same family, you can retain the benefit of the full amount while still reducing the tax burden.
An Example
Let’s say that Dan runs a retail shop and earns $200,000 per year. He hires his wife Mary to man the cash register and his son Robert to manage the accounts. He pays both mary and Robert $40,000 each per year. This reduces his business income to $120,000, therefore placing him in a lower tax bracket. With an annual salary of $40,000 each, both Mary and Robert will pay less tax than Dan would have paid on the same income, reducing the tax bill overall.
Paying Family Members in Kind Instead of Cash
Dan can also pay Mary and Robert in kind instead of cash. For example, he can pay them by giving them each merchandise worth $40,000 from the business (for example, Dan could provide Mary and Robert with each with a car if his business was a car dealership). Dan will first need to report the $80,000 as sales and then deduct the same as a business expense in such a scenario. These products, worth $80,000, are the salary that Dan pays to his family members who are working for him as employees.
Just like you report the salaries of all your employees on T4 slips, you need to report the salaries of your family members as well. You should always keep a receipt of the compensation that you pay your family member. If you pay him/her via check, keep a cancelled check for records. If you pay them in cash, keep a signed copy of the receipt for tax purposes. Without proper substantiation, the CRA could reject these salary deductions to family members. Please note that you cannot claim the value of boarding and lodging you provide to your family member as a business expense.
Your family members can be your gateway to higher tax savings. But without proper planning and thorough study of rules, you might miss out on opportunities to save taxes even after recruiting family members. Hiring family members is just one of the many ways to reduce taxes on business income.
At Edelkoort Smethurst CPAs LLP, our financial professionals will help you mitigate the tax obligations on your business income while ensuring you remain in compliance with all provincial and federal requirements. To speak with one of our knowledgeableChartered Professional Accountants, please get in touch with us onlineby telephone at905-517-2297orclick here to schedule a free consultation.
FAQs
Income splitting is a tax-planning strategy that can shift income that would otherwise be taxed in your hands at a high marginal tax rate to your lower-income family member(s), taking advantage of their lower marginal tax rate(s).
How to split the income? ›
Poorman suggests the popular 50/30/20 rule of thumb for paycheck allocation: 50% of net pay for essentials: groceries, bills, rent or mortgage, debt payments, and insurance. 30% for spending on dining or ordering out and entertainment. 20% for personal saving and investment goals.
What is income shifting? ›
Income shifting (also known as income splitting) may be defined as dividing income in a way that lowers overall taxes. Typically, income is shifted from higher-bracket taxpayers to lower ones. Income shifting can be a valuable tool for self-employed persons.
Is income splitting worth it in Canada? ›
As your career develops and you earn more, you'll face higher tax rates because of Canada's graduated tax system. One way to lower your household's tax liability is to consider income splitting. This works best if one spouse earns significantly more than the other spouse does.
What is the difference between income splitting and income shifting? ›
Income splitting (also known as income shifting) may be defined as dividing income in a way that lowers overall taxes. Typically, income is shifted from higher bracket taxpayers to lower ones.
How to split tax and tip? ›
It's proper etiquette to split tax and tip evenly among the table. While some people do mind splitting the entire bill, most don't have a problem with splitting the tip evenly, since it is only a small percentage of the total bill and makes settling the bill go quicker.
What is the 50/30/20 rule? ›
The rule is to split your after-tax income into three categories of spending: 50% on needs, 30% on wants, and 20% on savings. 1. This intuitive and straightforward rule can help you draw up a reasonable budget that you can stick to over time in order to meet your financial goals.
What is the 40 30 20 rule? ›
The most common way to use the 40-30-20-10 rule is to assign 40% of your income — after taxes — to necessities such as food and housing, 30% to discretionary spending, 20% to savings or paying off debt and 10% to charitable giving or meeting financial goals.
How to divide profits between partners? ›
There are three common methods: equal sharing, ratio sharing, and salary plus sharing. Equal sharing means that all partners receive the same amount of profit, regardless of their contributions. Ratio sharing means that each partner receives a percentage of the profit based on their contribution value.
Is income shifting illegal? ›
Tax law generally prohibits a parent from shifting income from personal services to a child; however, a parent can in some cases effectively shift income to a child by transferring income-producing property to the child.
Income shifting strategy - high to low tax bracket
You may be able to minimize your federal income tax by shifting income to family members who are in a lower tax bracket. For example, if you own a business and your kids help you with the business, you can pay them salaries or wages for their work.
What is income shifting for taxes? ›
Income shifting involves redirecting a stream of income, such as from an investment or a business. It moves from you to another individual who will not pay a high tax rate on it. You're actually giving them your income, so the practice is most common among family members.
What is RCA income? ›
Definition of an RCA. A retirement compensation arrangement (RCA) is a plan or an arrangement under which an employer, former employer, and in some cases an employee makes contributions to a person or partnership, referred to as a custodian.
Is splitting mortgage considered income? ›
No, this isn't additional income to you and is not taxable. It's merely a cost-sharing agreement. Consider it a non-taxable gift. You'll claim the entire mortgage interest and property taxes (even if the other person helped) unless the other person also owns the house.
Can dividends be split between spouses? ›
In the case of Spouse A, the dividend will be split income unless it is an Excluded Amount. In the circ*mstances, the dividend will be an Excluded Amount as Spouse A holds shares that qualify as Excluded Shares. In the case of Spouse B, the dividend will be split income unless it is an Excluded Amount.
What is splitting income among family members? ›
Income splitting is a tax reduction strategy employed by families living in areas that are subject to bracketed tax regulations. The goal of using an income-splitting strategy is to reduce the family's gross tax level, at the expense of some family members paying higher taxes than they otherwise would.
Can I split my taxes? ›
A split refund lets you divide your refund, in any proportion you want, and direct deposit the funds into up to three different accounts with U.S. financial institutions. Use Part I of Form 8888, Allocation of Refund (Including Savings Bond Purchases) to request to have your refund split.
Can income from a LIF be split? ›
Individuals can also allocate up to 50% of annual income received from these sources to a spouse. RRIF or LIF income however cannot be split while the annuitant is under age 65, unless the individual is receiving the RRIF or LIF income due to the death of his or her spouse or common-law partner.
