It’s exhilarating and liberating to watch your small business grow and become a success. After long hours of stress and hard work, you’re finally on the map.
But as your unincorporated small business begins to thrive, its increasing revenue may begin pushing you into a higher tax bracket. The potential for income-splitting within the family can lower the tax impact of that higher income.
Fortunately, there are a couple of strategies the Canada Revenue Agency (CRA) recognizes to split income generated from a small business around the family. At the same time, CRA is vigilant about tax avoidance; the words to live by here are fair, reasonable and documented.
Put them on payroll. This is probably the first impulse a small business owner would have when considering income-splitting strategies. Family members have usually made sacrifices and contributed to the success of the business; why not put them on staff? It may also be one of the most helpful – putting a spouse or children on payroll allows them to start their retirement savings planning, and could have a positive impact on Canada Pension Plan (CPP) benefits down the line. The money belongs to them and they decide how to spend or save it. And it cuts your marginal tax rate at the same time.
However, if the CRA thinks it’s a smoke-and-mirrors ploy, you’re not going to be able to deduct those salaries from your business income. A family employee has to be treated like any other. For a start, it’s a rare retail cashier who gets paid $40 an hour, so your son or daughter shouldn’t be either. Family members have to be paid at fair market value, and while there’s some latitude in that, it must be a reasonable amount. Internet research can help.
Also, the paperwork has to be in order. There has to be a written offer letter. All new hires have to fill out federal and provincial TD1 forms, and deductions for tax, CPP and Employment Insurance (EI) payments have to be withheld and remitted to the CRA monthly, and everyone gets a T4 at the end of the year.
And the work has to be done, with documented time sheets signed by a supervisor.
Make them partners. Your spouse has likely already put in some hard work to make your business a success, so why not recognize that sweat equity with a share of the profit? You can make a family member a partner in the business, but again, the circumstances have to be reasonable and well-documented.
A signed partnership agreement must spell out responsibilities, duties and profit allocations of each partner. Those partner profit allocations have to be based on fund and non-fund contributions to the business, not just the time spent on business activities. And capital contributions to the partnership must come from each partner independently, either from his or her own funds or money borrowed by the partners separately.
Bear in mind that, especially in a situation in which your spouse has lent capital to the business, income can be allocated before getting to the percentage split. Your spouse can be allocated income based on seniority or expertise, according to capital contributed, and by the number of additional hours worked throughout the year, before income is allotted on a percentage basis.
There are plenty of good reasons to split SMB income – reducing your marginal tax rate, investment opportunities for family members and avoiding complex attribution rules for simply giving money to family members. But there are also good reasons to tread carefully when going down this road.
If there’s the possibility of a change in marital status in the future, there will be repercussions from making a spouse a partner or employee in the business. And there may be privacy issues with friends and family: you don’t want your 14-year-old blabbing company secrets at Uncle Joe’s on Thanksgiving.
And it’s also important to make sure the way you’re distributing income is tax-advantageous. Obviously, you want to shift income to family members in the lowest marginal tax brackets; if your spouse already has a high income, you could just be pushing him or her into a higher bracket. And you also have to consider the benefits and exemptions your family could be denied because of the increase in their incomes. In possibly a worst-case scenario, a CRA audit rules your family working arrangements are bogus and disallows claims for their wages.
So it’s not as simple as getting your teenager to work the cashbox a few hours a week. You should research your options and decide what scenario makes the most sense for your business, and your family.
This list is compiled based on my discussions with a tax adviser at H&R Block Canada who has sponsored this blog post. The information provided here is a general list for information purposes. Taxes vary among people so always consult a tax professional for certainty. I invite you to visit hrbtaxtalk.ca to view tax queries posted by others or post your own question. Therefore, no responsibility for loss caused by any person acting or refraining from action as a result of the material contained in this bulletin can be accepted by H&R Block Canada, Inc. or Larkycanuck.com
Thank you for taking time to read this post. Blogging is a labor of love. Reader donations in the form of comments or sharing on other social media channels below are much appreciated.
How to save money during an unemployment period (larkycanuck.com)
Enjoying some holiday benefits at work? You may need to tell the taxman (larkycanuck.com)
Two simple tips on tax savings over holiday season (larkycanuck.com)