Many small business owners in Canada hire their spouses and children, both adults and dependents, to help them with the business. They also pay family members compensation in the form of salary, dividends, bonuses, and equity shares. Business owners withdrew more money from the business by distributing it as salary and dividends to family members in lower-income tax brackets. This act of Income Splitting is tax-efficient. Otherwise, a high-income earner will have to pay higher tax rates on their income.
How Small Business Owners Reduce Tax by Paying Compensation to Family Members
For instance, if John withdraws $200,000 from the business as salary and dividends, he will fall under the 29% tax bracket and pay a federal tax of $43,197. If he splits the withdrawal among his spouse, Mary, and child Anna, who are in the low-income tax bracket, paying them $55,000 and $35,000, respectively, his taxable income will reduce to $110,000. The entire family’s tax liability will be $32,821, bringing tax savings of $10,376.
| Taxable income threshold for 2025 | Federal Tax Rate | Tax on Income of $200,000 | Tax on Income of $110,000 |
| $57,375 or less | 15% | $8,606.25 | $8,606.25 |
| over $57,375 up to $114,750 | 20.50% | $11,761.9 | $10,714.33 |
| over $114,750 up to $177,882 | 26% | $16,414.3 | |
| over $177,882 up to $253,414 | 29% | $6,414.2 | |
| John’s Tax Liability | $43,196.66 | $19,320.58 | |
| Mary’s Tax Liability | 0 | $8,250 | |
| Anna’s Tax Liability | 0 | $5,250 | |
| Family Tax Liability | $43,196.66 | $32,820.58 |
Many business owners used this method and paid unreasonable compensation to family members, with the sole purpose of saving on taxes. To curb this practice, the Canada Revenue Agency (CRA) introduced the concept of “reasonableness” in the Income Splitting Rules. If the CRA deems that the compensation paid to the family member is unreasonable, it will disallow the salary deduction.
What Happens if the CRA Deems Compensation to Family Members “Unreasonable”
If the CRA deems the salary to family members as unreasonable, you will end up paying double tax. In the above example, suppose the CRA believes that Mary and Anna have been overpaid by $30,000 and $15,000, respectively.
- Nothing will change for Mary and Anna. Their overpaid salary will be considered as employment income and taxed at a 15% federal tax rate.
- However, the $45,000 unreasonable amount will be added back to John’s income, and John will have to pay tax on $155,000 ($110,000 + $45,000). He ends up paying double tax on the unreasonable salary.
- If the CRA finds that John paid excessive salaries knowingly or due to gross negligence, it will impose a 50% penalty.
How To Determine If the Salary Is Reasonable
There are no clear guidelines around what constitutes a reasonable salary in income splitting. At the very best, you can ask yourself, would you pay an outsider the salary you are paying your spouse for the work they are doing? If you cannot justify the compensation, you know it is unreasonable.
However, some good business practices can help you pay reasonable compensation to family members. Keep business strictly professional and treat family the way you would treat an employee whom you are not related to.
Clearly Define Nature of Tasks Performed
- Is the work your family member is doing necessary for the running of the business?
- Is your family doing that work?
- Are they qualified to do the task?
Unreasonable: The entire hiring is unreasonable if, on paper, your spouse is doing bookkeeping but doesn’t know how to write journal entries. Another example is that your child is studying abroad and has the task of handling inventory that requires physical presence at the office or store.
Reasonable: When you hire family members, look at their work experience, skills, and qualifications, and give them a task they can perform. You can even train them on the job.
Pay Competitive Salary
Determine the salary of family members based on their relevant work experience, the hours they clock, and the industry-standard and competitive pay. Suppose your family member performs a cleaning job, and the average industry rate for cleaning is $0.10 $0.30 per square foot. Calculate the area of the store and pay them accordingly. A family member with years of experience can be at the upper range, and a fresher can be at the lower range.
Maintain Proper Documentation
As said earlier, keep the hiring of family members professional. Prepare all the documentation for the payroll.
- Draw an employment contract, a detailed job description, a timesheet, and employment details with their bank accounts.
- Make sure you deduct income tax, Canada Pension Plan (CPP), and any other benefits your company gives to other employees, such as health insurance.
- Credit the salary to the family member’s account and not your account, even if they are a minor.
- At the end of the tax year, you must give them T4 forms.
Proper documentation makes the entire process reasonable and motivates family members to give their best to the business.
No Need for Employment Insurance Deduction
Business owners are not required to deduct Employment Insurance premiums from family members’ salaries. The CRA may consider their work as “excluded employment.”
Paying Family Members in Kind
You can also pay your family members, especially children, in kind by buying them a motorcycle or a computer game of the same value as their income. It might make things complicated, but it could be considered a valid point. Note that you cannot claim the value of providing boarding and lodging to your dependents as an expense.
These five points are good practices to help you keep family member compensation reasonable. The CRA can still come knocking at your door if they have grounds to believe that the compensation to the family is unreasonable. This also includes dividends. For instance, the business owner is not in a higher tax bracket but is paying rich dividends to shareholders.
Instead of waiting for the CRA to tell you what’s reasonable and what’s not, which could be a pretty expensive affair, talk to a professional accountant.
Contact Black and Gill LLP in Etobicoke to Help You with Tax Planning and Compensation for Family Members
A professional accountant can help you plan and manage family compensation by keeping strict internal controls. In the case of an audit, the accountant can work with the CRA, providing them with the necessary documentary proof to justify the compensation. At Black and Gill LLP, our accountants and bookkeepers offer services including payroll and tax filing. To learn more about how Black and Gill LLP can provide you with the best accounting and bookkeeping expertise, contact us online or call us at 416-477-7681 to learn more about how we can help you and your business.