It's officially tax season. How can you tell? Well, the Toronto Blue Jays are about to start their season, the NCAA March Madness basketball tournament is just under way, NHL playoffs are on the horizon, and the Masters golf tournament is about to begin. Many great sporting events converge on tax season. It's appropriate, I think. Filing your tax return is something of a sport; a game to be won. Getting a large refund is sort of like winning Game Seven of the Stanley Cup finals, or shooting a hole-in-one at Augusta.
One of the keys to winning the tax game is claiming deductions. Today, I want to share a story that highlights an opportunity to claim deductions – particularly compensation – paid to family.
The story
Don is a friend of mine. He's a true entrepreneur. He started a business last year from his home. It was his first year in business, and so he didn't make a lot of money – about $30,000 in revenue. Don's wife, Michelle, works with him as the office administrator. He paid her $40,000 last year. That's right. He earned $30,000 but paid his wife $40,000. Add to this $20,000 in other business expenses and Don is showing a business loss of $30,000 ($30,000 less $40,000, less $20,000) for 2012. This loss of $30,000 will save Don about $14,000 in taxes in 2012 since he'll apply the losses against other income he has. Michelle will pay tax of $6,000 on her $40,000 of income, so the couple will save a net tax amount of $8,000.
As a couple, Don and Michelle didn't lose money economically. Don earned $30,000 and paid out $20,000 in business expenses. The salary paid to Michelle is money they still kept in the family. Yet, as a couple, they are saving tax over all.
This is a story about self-employment. I've said it many times, but even part-time self-employment can open the door to many deductions – including compensation to family members, or costs you already have, such as mortgage interest, property taxes, vehicle expenses, computer costs and more.
The law
Our tax law will allow you to claim any expense that was incurred for the purpose of earning income from a business – as long as the expense is reasonable. What makes an expense reasonable? The test was set out in the court decision Gabco Ltd. v. Minister of National Revenue (68 DTC 5210), and is whether any reasonable business person would have paid the expense in question having solely business considerations in mind. According to the Tax Court of Canada decision in Burrows et al v. The Queen (2007 DTC 148), the onus is on the taxpayer to show that the amounts in question were paid for services rendered and were reasonable.
If you're going to pay salaries to family, it's important that those individuals actually provide services to your business. In the case Jastrzebski v. The Queen (2008 UDTC 98), the Tax Court of Canada denied a deduction for $25,000 paid to family members because they didn't provide services sufficient to justify the compensation. That is, the amount was unreasonable. Having said this, it's now well established that amounts paid to a sole owner-manager by his corporation will generally be considered reasonable, regardless of amount, given that it was his or her expertise, experience, reputation and managerial skills that gave rise to the profits to make those payments (see the Tax Court of Canada case Safety Boss Limited v. The Queen, 2000 DTC 1767).
In considering whether the salary paid by Don to Michelle in our example above is reasonable – and therefore deductible – the taxman should not simply conclude that the $40,000 salary is unreasonable because Don only earned $30,000 in revenues. The more relevant question is whether $40,000 is fair for the services provided by Michelle. In the case Aessie v. The Queen (2004 UDTC 101), the taxpayer paid amounts (about $3,000 a month) to a corporation owned by his wife and sister for services provided to the taxpayer's business. The judge sided with the taxpayer and commented that many professionals and businessmen make less money than their administrative staff.
The moral
Create your own self-employment, even part-time. Pay family members reasonable salaries or wages to help you in your business. Experiencing tax losses (but not economic losses) in this way is understandable in the early years of a business, and will save you tax. Just be sure the amounts paid are reasonable for services performed.
Tim Cestnick is president and CEO of WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.
Tim Cestnick