Special thanks to Thicken My Wallet for this guest post.
Thank you to Canadian Tax Resource for allowing me to guest post.
Being an entrepreneur has many advantages from a tax perspective. The most obvious advantage is that entrepreneurs (whether taxed on an individual level as a sole proprietorship, or on the corporate level) pay tax only after deducting legitimate business expenses.
In other words, non-deductible expenses that employees incur, such as stationery and phones, are tax-deductible to entrepreneurs, as long as those expenses relate to the business.
But what are some other ways to minimize taxes legally?
Income splitting is a term generally used to describe the reduction of a family’s taxable income by shifting income from higher earners to other members of the family. Rather than one member of the family earning substantially more than the others, the general goal of a well-designed income splitting strategy is to have all family members earn approximately the same income. In a progressive taxation scheme such as Canada’s, this should ideally result in a lower household tax bill.
Although there are various ways to carry out income splitting, the following are the two most common strategies.
1. Put your family on payroll
Since salary is a deductible business expense, many entrepreneurs put their family members on payroll. For example, your spouse can provide book-keeping services to the business or your children can stuff envelopes for marketing mail-out to your clients.
From a practical perspective, the business the money earns is kept in the household and, if planned properly, it can be a strategy to minimize the personal income tax paid by the household. As opposed to one spouse performing multiple roles for a business and being paid compensation reflective of the time and effort expended, which may place the spouse in a higher tax bracket, some business functions can be delegated to the other spouse, and his or her work compensated at market rates. This potentially moves the higher-earning and higher-paying spouse to a lower tax bracket.
However, there are wide a variety of rules to keep in mind if you are thinking of pursuing this strategy:
- Your family member on payroll actually has to carry out work.
- The family member must perform work related to the business.
- The pay must be reasonable, given the competitive wage rates of the job function, age, experience and skill-set of the family member.
Assuming you have met the three conditions above, a family member being put on payroll can form a legitimate business deduction. Evidence matters, so be sure to document this employee relationship, and produce business cards, time-sheets, emails, and payroll stubs (don’t pay in cash).
This strategy is premised on the concept of reasonability. The job description must be reasonable, the pay reasonable and, therefore, the deduction is reasonable. As such, this deduction is very contextual in nature.
As a result, CRA tends to audit these types of deductions carefully. Thus, be reasonable on how you utilize this strategy and be sure to consult an accountant beforehand.
2. Dividend Sprinkling
Available only to corporations, dividend sprinkling, as the term implies, allows the corporation to sprinkle dividends to shareholders in whatever amount of proportions the corporation desires to the exclusion of any or all other shareholders if warranted. With careful tax planning, more dividends can be sprinkled to a family member in lower tax bracket.
Dividend sprinkling is accomplished by filing or amending the articles of incorporation of the corporation to allow for the issuance of a multiple class of shares. The number of classes of shares is typically equal to the number of family members.
Usually, the corporation issues one class of voting shares and the remainder are non-voting (if both spouses are involved in the business then either the voting shares are issued to both spouses or each spouse is issued a separate class of voting shares). The voting shares are issued to the owner-manager(s), and the other members of the family are each issued shares in other classes of shares.
For example, assume an owner-manager has a spouse and two kids who are not involved in the business. Four classes of shares are created (Classes A to D). The owner-manager is issued Class A voting shares. The spouse is issued Class B non-voting shares and each of the kids are issued Class C and Class D non-voting shares.
On a periodic basis, the corporation declares a dividend in whatever proportion is most tax efficient, given the tax bracket and credits available to each family member. Given that each family member owns different classes of shares, the corporation can sprinkle dividends in whatever amounts it wants (or not at all to some classes).
Since the test for declaring dividends is whether the corporation can meet its obligations as they become due after the declaration of the dividend, there is no need or requirement for CRA to assess the reasonableness of the dividend. Consequently, dividend sprinkling is not subject to the same audit scrutiny as putting your family on payroll.
There is one big caveat to the implementation of dividend sprinkling. Since 2000, children under 18 who are paid dividends by corporation controlled by family members are subject to the “kiddie tax.” The result is that minor children are taxed at the top marginal tax rate on income on dividends received (as opposed to the lower tax rate on dividends paid by publicly-traded corporations or non-family controlled private corporations). Thus, the strategy tends to have maximum impact if the children are not minors.
The preceding are two common examples used by shrewd entrepreneurs to legally minimize taxes. As usual, please consult a qualified tax accountant or lawyer if you wish to discuss these, or other income splitting strategies, at length.