Running a business comes with advantages as well as disadvantages. As your own 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 major portion of your earnings to make that happen. Now that the business has stabilized and gained momentum, you can withdraw some amount to improve your lifestyle. By sharing this additional income with members of your family, 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 compared to people who earn less. Even if you do not withdraw too much cash to avoid a hefty tax bill, you will end up paying 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 the tax bill of your business is 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.
Let’s say that Peter runs a retail shop and earns $200,000 per year. He hires his wife Rosie to man the cash register and his son Robert to manage the accounts. He pays both Rosie 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 Rosie and Robert will pay less tax than Peter would have paid on the same income, reducing the tax bill overall.
Paying Family Members in Kind Instead of Cash
Peter can also pay Rosie and Robert in kind instead of cash. He can pay them by giving them each merchandise worth $40,000 from the business (for example, Peter could provide Rosie and Robert each with a car, if his business was a car dealership). In such a scenario, Peter will first need to report the $80,000 as sales and then deduct the same as a business expense. These products worth $80,000 are the salary that Peter 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 salary that you pay your family member. If you pay him/her via check, then keep a cancelled check for records. If you pay them in cash, then 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 Sloan Partners 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. Contact us online or by telephone at 416-665-7735.