As a business owner, you may have the opportunity to split income with your family. It is very common for business owners to employ their spouse or children in their business, and the salaries or wages paid are often taxed at a much lower rate in their hands. It is important to understand the rules with respect to reasonable compensation before making these payments.
According to the Income Tax Act, an expense is only deductible if it is reasonable. This term is not clearly defined and requires an assessment of the facts on a case-by-case basis. Generally, a transaction between unrelated parties is considered reasonable as it is assumed to be made at market rate. Why would a profit-seeking business owner pay more than necessary to an unrelated individual? However, an expense between related parties may be subject to scrutiny, such as a salary paid to a family member.
Reasonableness with respect to salaries is assessed based on the nature of the services provided and the prevailing market rates. You should ask yourself one important question each time you pay salaries or wages to a family member: what would you pay an unrelated individual to perform the same work? It is a good idea to document job descriptions for each position, complete time sheets to support the hours worked and retain proof of payment documents. Proper record-keeping can ensure that you are not subject to adverse tax implications.
If some or all of the payment is determined to be unreasonable, the unreasonable portion will not be allowed as a deduction when calculating the taxable income of the corporation. This is a one-sided adjustment; the unreasonable amount will still be included as taxable income on the personal tax return of the recipient. As a result, the earnings will be subject to double tax as taxes will be assessed at both the corporate and personal level. If it is determined that payment was never made to the family member, the salary may be included in the personal income of the business owner instead and subject to tax at a higher rate.
Salaries paid to the owner-manager of the business typically are not subject to the same level of scrutiny. It is generally assumed that any salary is reasonable as the company’s profits are a result of the expertise, know-how and managerial skills of the owner-manager. This applies to any owner-manager who is a Canadian resident and actively involved in the day-to-day operations of the business.
Employing family members in your business is often a wise decision both personally and financially. It provides the opportunity to employ individuals that you trust and allows your children to gain valuable work experience. You may also receive the benefit of lower tax rates as long as all salaries are reasonable given the circumstances, but paying unreasonable amounts can be very costly.
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