This strategy can be used if you are running your business as a sole-proprietor and have a family member who is in a lower income tax bracket than yourself. For example, if you have:
You are a sole proprietor if you are self employed (or in a partnership) and you are filing your self employment income as personal income and taxed the same rates as an employed salary/wage earner.
As a self employed individual, you are able to claim certain business expenses when calculating your business or professional income, which will be considered as your annual wage or salary.
One of these expenses that you can claim are the wages and salaries for any employees that you have.
The concept is simple and is referred to as income splitting. You have a family member who is at a lower income tax bracket than you because they are not working or for whatever reason. The goal is the effectively transfer a portion of your income (which would be taxed at a higher income tax bracket) to them (which will be taxed in a lower income tax bracket).
As a comparison, your child will be receiving $9,495 at a cost of $10,000 of your before tax income. If you were to give your child the same amount of money as an allowance, it would cost you $16,136 of before tax income!
Unfortunately, it is not that simple in practice! If you gift the income to a family member, the Canada Revenue Agency (CRA) will attribute it right back to you with your higher tax bracket!
The CRA does not allow taxpayers to abuse income splitting strategies, after all, the government is entitled to your tax dollars first!
Read the CRA guidelines or Income Splitting/Income Sprinkling here
The key is to have that family member as an employee. Now this does have some other implications as well. As an employee you will be responsible to:
There are two very key things to consider when you are declaring a family member as an employee:
In fact, the combined employer and employee contribution rates in 2020 are 5.25% and 1.58% for CPP and EI respectively. This means that 6.83% of that the income you are transferring will now by paid back to the government.
But generally this amount is significantly lower than the marginal differences between yourself and the beneficiaries tax brackets. In our example above, we are saving 36.11%, which is far more than the 6.83% cost here.
On top of that, CPP and EI are actually programs are highly beneficial to the employee. As a taxpayer contributes to CPP, they are boosting their pension benefit they are entitled to when they reach retirement age. Contributions to EI add in protection for the employee so they can qualify for more unemployment insurance if they were to lose their job.
This is VERY IMPORTANT, because when you report a family member as an employee, the CRA will likely to want to take a look to verify that is indeed the case to ensure you are not just trying to get around income splitting.
You MUST be able to retain and provide satisfactory records to show that both money has transferred hands and that the family member employee has done the work. This means that if you hired your child as an employee to deliver food for your own food delivery business, they must have actually went out to deliver the food and have it recorded on a time sheet.
If you are not able to provide satisfactory records to the CRA, then you RISK THE PENALTY OF DOUBLE TAXATION. This means that your employee has paid the taxes as they have originally reported, and then that amount will be added back to your income and you will be charged tax on it (with interest).
Well an extra pair of hands is still more work done! And you keep the expenses and the tax savings within the family.
If you are employing a child, it is a great way to help teach them the value of labour at young age while being able to more efficiently reward them on a dollar for dollar basis.
Another benefit that needs to be mentioned is you are able to set the wage yourself. As along as it is within a reasonable range, you can give a higher wage for a greater benefit.
If you manage an Airbnb, instead of hiring an outside cleaning service at $25 per hour, you can have a retired relative go in and do the job for $25 or $30 per hour. You may incur a higher expense because you will have to pay out that money to them, but on next family vacation, they may decide to help cover your accommodations!
In summary, if there is an opportunity to have a family member employee to help reduce the overall taxes, you should definitely consider looking into it as there are financial benefits. It is very important to take precautions and make sure you understand what you are doing otherwise you might get hit with tax penalties.
As always, if you are unsure, talk to a professional tax accountant to make sure what you are doing is complies with the tax code. Tax minimization is strategic planning, but tax evasion is ILLEGAL and sometimes the line can be a bit blurry.
