Reducing Your Business Taxes With A Family Employee

If you are running your own business in Canada, your family members can help you reduce the overall tax incurred as a family unit!

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:

• A child who is in school and not earning any full time income
• A spouse who is currently not working or working with extra time available and filing taxes separately from you as an individual
• A parent who is retired and/or no longer working

What Does It Mean To Be A Sole Proprietor?

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.

How Does It Work?

The concept is simple and is referred to as income splitting. You need to have a direct family member who is at a lower income tax bracket than you. Simply you are transferring a portion of your income (under the higher marginal tax rate) to that family member (under a lower marginal tax rate).

As an example:

1. Assume you are running your own food delivery service business in Ontario, Canada
2. Your net profit for the year is $200,000 CAD after all other expenses
3. You will be facing a federal marginal tax rate would be 29% (2020) and 12.16% (2020) at the provincial level totaling 41.16%.
4. You have a teenager who is in school with no income and you wish to transfer over $10,000 of income to them this year.
5. The result is your taxable income is reduced by $10,000, while your child will now have an income of $10,000.
6. Your child will be facing a federal income tax rate of 0% (after the basic personal income tax credit) and a provincial income tax rate of 5.05% (2020).
7. Instead of paying $4,116 in taxes on that $10,000 increment, now your teenager pays only $505 in taxes. That's $3,611 in savings for the family!

Is It Really That Simple Though?

Unfortunately, it is not that simple in practice. There are guidelines in how to income split and if you don't follow them the Canada Revenue Agency (CRA) will make sure to tax you along with a few penalties as well.

Read the CRA guidelines or Income Splitting / Income Sprinkling here

The CRA makes sure that taxpayers are not abusing the income splitting strategies. If you gift the income directly, the CRA considers this as income sprinkling which is not allowed.

How Am I Able To Reduce My Taxes?

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:

1. Prepare pay stubs for your employees
2. Remit and pay the employer's side of the Canada Pension Plan (CPP) and Employment Insurance (EI)
3. Remit employee's side the CPP, EI and Income Tax unless the employee qualifies to elect out of withholding tax
4. Prepare the T4 tax slips at the end of the tax year and provide it to your employee

There are two very key things to consider when you are declaring a family member as an employee:

1. CPP/EI contributions are not free

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 goes straight 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 getting 36.11% tax benefit, which outweighs the additional 6.83% CPP/EI cost.

2. The family member must be a REAL employee

This is VERY IMPORTANT. When you designate a family member as an employee, the CRA will want to verify that is indeed the case. They don't want you to get around income splitting that easily.

This means that you MUST be retain and provide satisfactory records to show that both money has transferred hands and that the family member employee has actually worked. This means that if you hired your teenager as an employee, they cannot just sit around. For example, your employee must have actually went out to deliver the food for your business and have it documented 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 if the CRA disagrees with the income splitting, you will need to include that income source on your statements without your family member taking it off their statement. You would have to cover the additional tax liability with late interest penalties too.

So If They Are Still Putting In The Work, What Are The Actual Benefits?

Well, an extra pair of hands is still work being done. With the added benefit of keeping all the savings within the family through effectively allocating the income.

If you are employing your children, it is a great way to teach them the value of labour at young age. You are also rewarding them with your before before tax dollars as opposed to your after tax dollars

For Example:

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. You may even decide to a pay them a higher than market rate, such as $35 per to maximize the benefits retained in the family.

Summary

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 the line can appear blurry at times.