One of the ways business owners or professionals can reduce their overall tax burden is through income splitting, including paying salaries to other family members who are in lower tax brackets. Knowing the extent to which you can include family members in the income stream will help minimize the tax burden for your family.
Generally, salaries and bonuses are deductible if they are made or incurred for the purpose of gaining or producing income from the business and are reasonable in the circumstances. As long as the principal owner is actively involved in the business and the remuneration is paid out of income from the corporation's normal business activities (as opposed to investment income or capital gains), Canada Revenue Agency (CRA) generally will not challenge the reasonableness of the compensation.
However, this policy does not extend to spouses or children of the business owner who are not involved in the business on a full-time basis. Their remuneration must be reasonable in the circumstances and must relate to services actually rendered in assisting the business to earn its income. Otherwise, CRA will deny the deduction.
In assessing the reasonableness of salaries paid to family members, CRA will examine whether there is a bona fide employer-employee relationship in light of the duties performed and the hours worked. The salary paid generally will be acceptable if the salary is commensurate with the value of the responsibilities and the services performed as if the family member was unrelated to the business owner.
Judicial guidance
The practice of paying salaries to minor children is tempting since it generally provides easy tax savings. But it is a popular target for CRA on audit. CRA's policy in this regard was examined in the recent decision of the Tax Court of Canada in Bradley v. R. The case involved deductions claimed by a self-employed commission agent for salaries allegedly paid to her children. In each of her 2001 and 2002 taxation years, she paid salaries of $5,000 and $2,000 to her twelve-year-old and eight-year-old children, respectively. CRA challenged these salaries on the basis that the amounts paid were not in respect of work performed by the children and were not reasonable in the circumstances.
CRA did not stop there – it also argued that these salaries were never actually paid to the children. The salaries had been deposited into a bank account in trust for the children and under the exclusive control of their mother, though they would discuss jointly how the funds would be spent. CRA adopted the view that there was no actual payment of salaries to deduct.
The Court ruled in favour of CRA and denied the deduction on the basis that the funds remained under the control of the taxpayer and therefore were never paid to the children. The Court did not address the reasonableness issues. Although the children participated in spending decisions, the mother was nevertheless in control.
The decision in Bradley suggests deductibility of salaries paid to family members requires that the amounts paid be reasonable in the circumstances and incurred for the purpose of gaining or producing income. Further, the payments must be made and deposited as they would be in an arms-length situation. The family member must receive and control the payments in his or her name and be able to use them for his or her own purposes without any further control by the payer.
The cost of losing
The implications of CRA challenging a salary can be severe. If CRA denies the deduction as unreasonable or not actually paid, the salary will nevertheless remain taxable in the hands of the recipient. Worse yet, should the business owner retain control of the funds, CRA may well attempt to tax the funds in the hands of the shareholder as a shareholder appropriation or benefit. Not only would the corporation lose the benefit of the deduction, the payment would be taxed to the business owner at a higher personal tax rate – a far worse result than the alternative of simply paying deductible salary to the principal shareholder-manager.
Paying salaries to minor children is an excellent strategy, provided the facts support doing so. Finding useful and productive work for children to perform and earn a salary is not just good tax planning. It also teaches them obvious lessons on the value of work and how to manage an income, and gradually builds RRSP room for future contributions and deductions. Creating salaries where no reasonable services exist, and with the money remaining under parental control, is simply asking for trouble.
Harry Vouitsis is a Senior Manager in Collins Barrow's Montreal member firm.
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