In Canada, your income tax bracket increases with your income. The tax system uses graduated tax brackets so people who earn more money pay more taxes. Because of this, your family pays more income tax as your business income increases. But it’s possible to lower your overall income tax burden by transferring some of your income to no- or low-earning family members. There are several ways to do this, but you must use a legal strategy.

Paying Family Members in a Small Business

Paying a salary to family members you employ decreases your net business income, which may lower your personal income tax rate if you own the business by yourself or in a partnership. For example, if your small business has an annual net income of $75,000, paying your spouse $30,000 lowers your income to $45,000. This places you in a lower income tax bracket. And with an annual income of $30,000, your spouse pays less taxes than you, which lowers the total amount of income tax your family pays even more.

Paying your child from your business is also possible. But remember, the Canada Revenue Agency requires family members you pay to actually work for you. And you’re required to pay family members the same amount you would pay someone else doing the same job. So basically, you can’t claim your spouse or child earned $50,000 for doing a minimum-wage job or for doing nothing at all. Because of this, the way you process and track payroll is important. Keeping these records up-to-date helps your family avoid tax issues in the future.

Of course, there are also disadvantages to hiring family members. So if employing family members isn’t ideal for your business, you might consider making a family member an equal partner. This allows you to split your earned income, decreasing your overall taxes.

Contributing to Registered Retirement Savings Plans

Contributions to registered retirement savings plans (RRSP) are tax-deductible. So every contribution you make increases the total amount of your annual tax deductions. This lowers your taxable income, which might put you into a lower tax bracket. Also, you don’t have to use your entire RRSP contribution deduction the tax year you made the contribution. You have the option to carry a portion of your tax deduction over to use when filing future tax returns. So if your business is fairly new, you might want to make contributions for the year but carry over your deduction amount. Carrying it to use later is a good way to lower your taxable income when you start earning more money.

You’re allowed to contribute to both your and your spouse’s RRSP. However, your total RRSP contributions for the year can’t exceed your contribution limit. So if your annual contribution and deduction limit is $10,000, the contributions and deductions made to your and your spouse’s RRSP combined can’t exceed that amount. And contributing to your spouse’s retirement account is a good way to lower your family’s tax burden long term. You don’t pay income tax on funds you contribute to a RRSP until you withdraw the money. The CRA bases the amount of taxes you pay on the account owner’s tax rate. So splitting your contributions between your and your spouse’s accounts helps you maintain a lower taxable income well into your retirement years, which offsets your family’s total income tax.

Use a Prescribed-Rate Loan for Investments

A prescribed-rate loan is a low-interest loan you make to your spouse or another adult family member for investment purposes. Any income you earn on the investment amount is taxed at the borrower’s income rate, not yours, making it an effective way to offset some of your family’s income tax burden when you loan the money to someone who is in a lower tax bracket than you. If you create a prescribed-rate loan for your spouse with a 1% interest rate and your spouse invests the money so that it earns a 4% annual dividend, your spouse pays taxes on the dividend payment based on their income tax bracket. The overall duration of the loan doesn’t matter, but the borrower has to pay the interest on the loan back to you annually. If you use this strategy, it’s important to understand the tax implications of income splitting. If your family member earns money that the CRA classifies as split income, that family member may have to pay top-bracket income taxes, which can undermine your efforts to lower your tax liability.

Tax planning is an important part of owning a business because it helps you pay the lowest amount of taxes possible. QuickBooks Online can help you maximize your tax deductions. Keep more of what you earn today.

"Reasonableness test" for family wages

When you pay a family member from your business in Canada (and for other assessments as well), the Canada Revenue Agency (CRA) applies what's informally known as the "reasonableness test." Now, what this essentially means is that for the wages you pay to be deductible as a business expense and for your family member's income to be treated legitimately, two key conditions must be met:

1. Genuine Work Performed: the person has to genuinely have contributed to the business. In other words, they will assess whether this is a "ghost job" or the family member was paid without realizing the work. They should have defined responsibilities and be performing work that directly benefits your business.
2. Market-Rate Compensation: the family members must be paid an amount that is comparable to the amount you pay for someone not related to you for performing the same duties. You cannot pay a family member an inflated salary just to shift income.

What does this mean for you?

• Documentation is key: keep all records related to your family member's job and position, like job description, a log of hours worked, duties, and rationale. It's also a good idea to have research on how their salary is comparable to others.
• Avoid superficial roles: don't create roles just to pay a family member. The work needs to be a legitimate.
• Consequences of non-compliance: ff the CRA determines that the wages paid to a family member are not reasonable, they can disallow the expense for your business, leading to reassessments, penalties, and interest for both you and your family member.

Keep your records in order and optimize tax compliance with QuickBooks

It is common for families and individuals running businesses to overlook potential savings and tax compliance simply because they are not aware of all the eligible expenses they can claim and how to go about it. Understanding the various deductions and guidelines are crucial for optimizing your financial health.

The best way to stay compliant and identify opportunities to reduce your taxable income and keep more of your hard-earned money is by effectively keeping tracking your income and expenses. This is where a financial management tool like QuickBooks Online comes in, to streamline this process and give you control of your financial data. With QuickBooks Payroll, youn also manage income and deductions for family employees or family businesses, generating the required documents to stay on track. Explore how QuickBooks Online can help you turn your business into a well-oiled financial machine.