How not to split your income: Tactic backfired

National Post

2004-07-17


If you're self-employed and run your own business, no doubt you're aware of
income splitting as a potential tax reduction strategy. Income splitting is the
shifting of income from a family member in a high tax bracket to one in a lower
tax bracket to reduce the overall tax burden of the family.

One way to income split is to hire your spouse and/or kids to help you in the
business. By paying them a "reasonable" salary for their services, you can
reduce the income from the business otherwise taxed in your hands by claiming a
deduction for amounts paid to them. Their salaries are included in the their
incomes and, if they are in lower tax brackets than you, your total family's tax
bill is reduced. The key to making this technique fly with the Canada Revenue
Agency is to ensure that the salaries paid are reasonable for the work done. The
Muhammedi family learned a hard lesson in how not to income split in a Tax Court
case decided last month.

Shamin Muhammedi owned a "smoke and gift shop" which was operated by her
husband, Karim. The Muhammedis have two children, aged seventeen and twelve, who
both helped out in the store after school.

In 1999 and 2000, cheques were made out to the children totalling $12,000 and
$3,500. These cheques were deposited back into the bank account of either the
business or the parents, some of them without ever being endorsed by the
children.

The Muhammedis claimed that the amount deposited back into their bank
accounts represented an interest free loan between them and their children to be
used for their future education; however, no formal written loan agreement
existed.

The CRA disallowed Ms. Muhammedi a deduction for the salaries paid to her
children. It claimed that the parents and children did not have a "bona fide
business arrangement" since the children were not working at "arm's-length." In
addition, the amounts paid were not reasonable on the basis of the children's
ages and the cheques were not issued on a regular basis but rather only in
December when cash was available. In fact, the children did not declare the
salaries on their 1999 and 2000 tax returns. Finally, since the cheques were
deposited into the bank accounts of either the business or the Muhammedis, the
salaries were not considered to have been "paid" to the children since they did
not have possession and control of the money, which remained in the control of
the parents and or the business.

The judge concluded: "One is left with the impression that what was involved
was tax planning designed to reduce, as much as possible, the overall tax burden
of the family. This is not necessarily the end of the matter but when the
operations are carried out in the fashion that they were it smacks of a sham and
does not meet the requirements of ... the Income Tax Act."

So, the next time you think about hiring your kids, ensure the amounts paid
are reasonable. In addition, you may also consider actually giving them the
money.