Today, we are diving deep into the world of income splitting. As Canadian taxpayers, I’m sure you’re all curious about how you can use this strategy to potentially lower your family’s overall tax liability!
You see, we operate under a progressive tax system here in Canada – meaning the more you earn, the more you pay. But what if there was a way to distribute that tax load more evenly? Spoiler alert: There is, and it’s called income splitting!
What is Income Splitting and Why Should You Care?
As you may know, Canada operates under a progressive tax system. In simple terms, the more you earn, the more you pay in taxes. Seems fair, right? But what if there was a legal and straightforward way to distribute your family’s income more efficiently, potentially saving thousands of dollars in taxes each year? This is where the concept of income splitting comes into play.
Income splitting is a tax strategy where a higher-earning individual transfers a portion of their income to a lower-income family member (usually a spouse). By spreading the income between two people, the family can potentially fall into a lower tax bracket, resulting in significant tax savings.
Income Splitting in Action
Let’s paint a picture to understand this better. Let’s say we have two families: In Family A, the husband makes $200,000 a year while the wife is a stay-at-home parent. In Family B, both the husband and wife make $100,000 each.
Despite both families earning the same total income, Family B pays less tax than Family A. Why? Because Family B has divided the income between two people, allowing them to enjoy lower marginal tax rates.
The Court Case
Recently, a court case about income splitting was made to the Financial Post. The court case involved a taxpayer who attempted to split income with his mother-in-law and wife in order to lower his overall tax liability. The taxpayer worked as a general sales manager and finance service manager at a car dealership during the years 2015 and 2016. In 2015, he claimed $24,000 administrative expenses as employment expenses, which he stated was paid to his mother-in-law for assisting him with paperwork. In 2016, he claimed another $24,000 deduction, claiming it was paid to his wife for performing the same tasks.
By splitting his income with his mother-in-law and wife, the taxpayer reduced his taxable income, resulting in lower tax payable for the entire family. However, the Canada Revenue Agency (CRA) challenged the legitimacy of the arrangement. The taxpayer failed to provide proper documentation, such as proof of work performed, hours worked, and justification for the amount paid. Additionally, there was no actual money changing hands between the parties involved.
Moreover, when the taxpayer was asked to provide evidence that the payment was made to mother-in-law, he claimed that such payment for services rendered were done via an offset arrangement for the rent that he charged his mother-in-law. When asked to provide evidence that payment was made to his spouse for service rendered, again, he claimed that they shared a joint account and hence it wasn’t possible to have money changing hands.
In addition, as an employee claiming employment expense deduction, the taxpayer was required to have a T2200 form signed by his employer, indicating the need for an assistant to qualify for employment expense deduction. However, the taxpayer did not have this form or an employment contract specifying the requirement for an assistant.
Due to the lack of documentation, reasonable amounts, and proper money transfers, the taxpayer’s income-splitting strategy was disallowed by the CRA.
Tread Carefully: The Rules of Income Splitting
While income splitting can be an effective strategy to reduce your tax liability, it’s crucial to follow the rules set by the Canada Revenue Agency (CRA).
- Proper documentation for work performed: when you are paying your family members to perform work, it is important that proper documentation of the nature of the work performed, hours performed, compensation, etc.
- Regular Money Transfer: Actual money must be transferred between the parties involved. Separate bank accounts to keep track of all the income and expenses are a must for employment expense deduction.
- Reasonable Amounts: The amounts paid to your family members should be reasonable and justifiable. This means that the amounts paid must be comparable to the market rate.
- Documentation: Proper documentation is crucial. If claiming it as an employment expense, a T2200 form must be completed and signed by the employer. If family members are working as subcontractors, a subcontracting agreement should also be included.
Income Splitting: The Tax Strategy You Need
Income splitting can be a game-changer for many Canadian families. It’s not just about saving money, but about understanding the tax system and making it work for you. Remember, the path to financial freedom starts with knowledge and strategic planning.
I hope this blog has helped shed some light on the benefits and rules of income splitting. As always, consult with a tax professional before implementing any tax strategies. For more real estate tax tips, stay tuned to this space!
Until next time, happy Canadian Real Estate Investing.
Cherry Chan, CPA, CA
Your Real Estate Tax Accountant