School’s out for summer and if you run your own business, you may have decided to hire your kids.
The decision makes business sense: You’ll get tax and financial benefits. Consider that by hiring the children, you can:
Income splitting by redistributing company income may be the greatest tax break in this situation. You (a high earner) transfer money to the kids (low earners). This strategy not only shifts income from your business tax returns, your company also gets business deductions for the salaries it pays them.
And there’s an added bonus: If your children use their earnings to pay for college or university, their tuition and other tax credits will help offset any taxable earnings. If they don’t use all their credits, they can:
Income splitting works with any business organization. It doesn’t matter whether you operate as a sole proprietor, a corporation or a spousal partnership. All three business forms can pay wages to children. There are, however, a few catches including:
“Reasonable” is a crucial concept here. The Income Tax Act contains a rule that states expenses can’t be deducted unless they’re reasonable. When an employee is a relative, red flags may go up at Canada Revenue Agency (CRA) and auditors are likely to examine whether or not the salaries meet the test of reasonableness. If the pay cheques are considered unreasonable, the salary deductions will be disallowed. This will increase the income of the business and create additional tax. And if it can be shown that the excessive salaries were knowingly paid, penalties may be applied.
Unfortunately, there’s no hard-and-fast test to help determine what’s reasonable. A rule of thumb: Pay your children (or your spouse or common-law partner) the same amount you’d pay other employees for the same jobs with the same level of experience. If you pay more, be prepared for the CRA to request justification. Don’t forget to withhold income tax, pension plan contributions and provincial payroll taxes, if they apply.
You may also want to pay a bonus. In that case, if it’s eligible, the money is a deductible business expense that reduces your company’s taxable income and is taxed at the recipient’s lower rate. If your child is a shareholder, year-end bonuses can be paid out in the holder’s next tax year, deferring taxes.
Bonuses still need to be reasonable, given the amount and type of work done, or the CRA may deny them as corporate expenses. The tax agency generally won’t question bonuses paid to shareholders who actively work in the business, but it may question payments to inactive shareholders.
Hiring your kids does require some additional expenses and paperwork. Make sure your company keeps good records of both the services performed and the time worked. While it may seem like a nuisance to track everything, it is critical that you leave a paper trail.
Each child must be listed on the payroll, with salary deductions. Keep attendance records to prove they were on the job when you say they were. Among the critical elements of the paper trail are:
Pay your kids by cheques deposited directly into their bank accounts to indicate that they have control over the money. If you pay “in kind,” with items other than money, the amounts are considered taxable “non-cash benefits.” The fair market value of the payment is considered a benefit to the child and must be reported to the CRA.
You would need to report the value as part of your company’s gross sales, so you include it in income. But you get to deduct the amount as a business expense. Effectively, you’re selling the in-kind item and paying your child in cash.
If you’re in doubt about the child’s status for EI or pension purposes, consult with your tax adviser.
Once your kids file a tax return, even if they don’t owe taxes, they can open a Registered Retirement Savings Plan and start building contribution room. If they start putting money into the plan, they’ll eventually be eligible for the Home Buyers’ Plan that allows them to withdraw as much as $25,000 from their RRSP to purchase a house when they’re ready.
Those under 18 can also contribute to a Registered Education Savings Plan, assuming you open one for them. Of course, you and others may also contribute to the plan. The kids will receive a federal grant equal to 20% of annual contributions made to a maximum of $500 ($1,000 if there is unused grant room from a previous year). The lifetime grant limit is $7,200.
If you’re taking care of all the RESP contributions, the children can put earnings aside for their education to help avoid graduating from college or university with massive amounts of student debt. And to add to their money-management education, it won’t hurt to teach them how to budget and let them start paying for their own haircuts, clothes, smartphones and other discretionary items.
Consult with your accountant if you’ve hired your child or want to. Income splitting can be complex and some techniques may be restricted by corporate attribution rules.