Tax Problems with Salaries for Spouses and Children
Businesses are only required to pay income tax on their net income, which allows businesses to deduct expenses including wages, salaries and benefits. Family-owned and operated businesses will often pay salaries to family members for services provided to the business.
In some cases, the business owner will use salaries as a means of income splitting. Instead of paying a large salary to the business owner (who could be paying as much as 43.7% tax on that salary), salaries are paid to family members such as the business owner’s spouse or children. For example, if the business owner normally takes a salary of $180,000 per year, it is possible for the tax to be reduced substantially by reducing the business owner’s salary by $50,000 and instead paying a $50,000 salary to the spouse and/or children. As a result of the personal exemptions available, and the tax credits for students, it is possible for a family to save up to $22,000 per year with this simple strategy. It works because the tax rate on the high income earners is much higher than the tax paid by low income earners.
The Canada Revenue Agency (CRA) is aware of this strategy CRA auditors routinely examine salaries in family-owned businesses. Under section 67 of the Income Tax Act, there is a special rule that says a deduction for an expense is not deductible unless it is reasonable. This is rarely applied to salaries of unrelated employees, but if the employee is related (for example, the employee is the spouse or child of the business owner), the CRA auditors will examine whether or not the salaries to the family members are “reasonable”. If they are considered unreasonable, the deduction for the salaries will be disallowed. This will increase the income of the business and result in additional tax (and interest) owing by the business. In some cases, the salaries may even be added to the business owner’s income at the highest rate without any corresponding deduction resulting in double taxation. And if it can be shown that the excessive salaries were knowingly paid, or circumstances amounting to gross negligence, 50% penalties may also be applied.
Unfortunately, there are no hard and fast rules as to what level of salary is reasonable and what is unreasonable. The most common test is to consider what services to the business were provided by the spouse and children and then to compare each of their salaries to what a similar business would pay to an unrelated employee to do the same thing.
As a result, detailed job descriptions for each family member are very important. As well, time sheets showing hours worked are important. We have seen problems where business owners pay children while the children are at University in another city. Often, justifying a salary in such circumstances is difficult to support. Or a spouse who does bookkeeping or banking and is paid a fulltime salary (for example $40,000 per year), and evidence shows that such work could actually be done by a part time clerk for a fraction of that cost.
This income splitting strategy has the potential to provide excellent annual tax savings, but must be planned and documented carefully. Planning before the fact is often safer than trying to fight this after you are audited. With the potential downside being double taxation and even penalties, it may not be worth the risk if you are too aggressive.
Income splitting is an excellent tax savings strategy. If this type of income splitting strategy is too difficult to do safely, you may want to consider less risky strategies such as family trusts.