Business and Operations
Business Advisor: May 2013
By David D'Cruz
By David D'Cruz
It’s no secret that the Canada Revenue Agency (CRA) doesn’t make it easy
to minimize your tax burden, but there is one often overlooked
opportunity to do just that – if you meet the requirements.
It’s no secret that the Canada Revenue Agency (CRA) doesn’t make it easy to minimize your tax burden, but there is one often overlooked opportunity to do just that – if you meet the requirements. It’s a strategy called income splitting. Think of it as sharing the wealth in order to save on tax.
|Income splitting involves redirecting income from a higher-earning family member to a lower-earning family member, maximizing tax savings. |
Of course, income splitting only works if there is a clear high earner and a lower or no-income earner. That’s because Canada’s tax system is based on marginal tax rates, which ensure higher-earning individuals are taxed at a higher rate than lower-earning individuals. These marginal rates vary between provinces and territories, but it typically holds true that someone who earns $100,000 in taxable income each year can pay up to $10,000 more in personal income tax than two people who earn $50,000 each.
Put simply, income splitting involves redirecting income from higher-earning family members to lower-earning members. This will help lower the marginal tax rate of the high-earning family member, in effect, maximizing the benefits of the lower marginal tax rates.
Of course, the CRA has attribution rules in place to ensure the person who earned the income claims it, but there are a few exceptions. For example, retirees are permitted to income split their retirement income such as Canada Pension Plan, annuities from RRSPs and RRIFs, and life annuities from company pension plans.
Business owners have a few more options. For example, it may make sense to hire family members who have little or no income. This does not mean you can simply add them to the payroll. They have to be earning a reasonable wage. The CRA does not take kindly to any misuse of the income-splitting rules in order to take advantage of lower marginal tax rates.
That said, in Ontario, if you are a business owner and hire your spouse for a legitimate job that they are in fact capable of and carry out, the savings can be significant. Consider this scenario: if you have annual earnings more than $200,000, then you will be required to pay the highest marginal income tax rate of 46 per cent. Now, let’s assume you have a spouse with no earnings at all. By hiring and paying your spouse a salary, you can lower your income and potentially your marginal tax rate, and the income shared with your spouse will be taxed at a lower marginal rate still. In this example, your spouse will be taxed at 20.05 per cent for the first $39,020, 24.15 per cent for the next $3,687 and 32.98 per cent for the next $26,007, eventually reaching 47.97 per cent on income higher than $500,000. If you can pay your spouse $42,707, the resulting savings would be $10,952. On the next $42,707 of income, you could save an additional $5,855.
Since the government allows you to earn $11,000 tax-free, the benefit from income splitting is greatest for the first $11,000. In addition to dollars saved, income splitting has other benefits. It helps build up RRSP contribution room for the spouse who previously had no income. It allows families where there was previously only one income earner to claim child-care expenses up to two-thirds of the lower earner’s income.
That said, there are potential dangers to income splitting if the rules are not followed to the letter. It is absolutely critical that if you do hire your spouse, they make a real contribution to your business and his or her salary is appropriate for that level of contribution. If this is not the case, you risk a CRA audit. If the audit concludes that you have not proven the value of your spouse as an employee to the business, the CRA will deem his or her salary not a bona fide expense for the corporation. This means that he or she will pay tax on the income but the company cannot deduct the salary. In effect, you will be hit with a double taxation.
Keep it real, stay reasonable and make the most of income splitting.
David D’Cruz is partner in Fuller Landau’s Audit and Assurance practice. To contact David directly, please call 416-645-6538 or e-mail firstname.lastname@example.org.