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tax matters

I've never really thought about Thomas and Stephen as being employable. These teenage boys are the sons of my good friend John. These are the boys who stole about 30 orange pylons from a construction site and decided to re-route traffic in their neighbourhood. Then there was the time they sat in John's car while it was parked on the side of the road, rolled down the window and pointed a hair dryer at cars as they went by to see if they'd slow down.

"John, do you really employ your boys in your business?" I asked. "Yes. They don't do a heckuva lot, but my accountant told me I should get them to do a little work to pay them some income. This saves me a little tax, but I can't justify paying them much. I wish I could pay them more, but I can't get them to work any more hours."

John and I started talking about ways to get more income into the hands of his boys. I shared with him a strategy that can do the trick, and can provide other benefits at the same time.

The EPSP

Consider an Employee Profit Sharing Plan as one way to put more income into the hands of family members than might be justifiable based on the work they do in your business. An EPSP is an arrangement, established by setting up a trust, to which an employer will contribute out of the profits of the business. The employees (or a select group) will be beneficiaries of the EPSP and will receive allocations out of the EPSP annually.

Here's how it works: An employer must make contributions to the EPSP in years when profits exist, but the amount contributed can be based on profits (1 per cent of profits is the minimum), or based on some other formula that is not tied to profits, as long as certain conditions are met and a special election is filed by the employer in this latter case.

The trustees of the EPSP will have to allocate all of the employer contributions plus any income and capital gains to the employee beneficiaries. The employer can deduct its contributions provided they are made within 120 days of its fiscal year-end. Amounts contributed to the EPSP must be allocated to the employee beneficiaries and are taxable to them in the year of the allocation. It's not required that the amounts allocated to each beneficiary be the same, so John could allocate more income to his sons than he does to his wife or himself, in order to split income.

The benefits

I've already talked about the benefit of income splitting with family members. But there's a tax deferral available as well. Suppose, for example, your company year-end is Sept. 30. So, you establish an EPSP and accrue a contribution at your Sept. 30, 2011 year-end. This contribution will be deductible provided it's paid into the EPSP by Jan. 28, 2012 (120 days after year-end). The EPSP must allocate that contribution to the beneficiaries in that same calendar year, by Dec. 31, 2012. There's no requirement for taxes to be deducted at source on amounts paid out of an EPSP. The allocated amounts will be taxable to the beneficiaries on their 2012 tax returns, which don't have to be filed until April 30, 2013, at which time they'll pay the tax on the EPSP income allocated to them - over one year after the amounts were paid into the EPSP.

Now, a beneficiary who reports an EPSP allocation may be required to make tax instalments in the next year. The way to solve this problem is to contribute amounts to the EPSP every second year instead (and pay regular bonuses on the years in between). You see, the beneficiary can base his tax instalments on the prior or current year's income - it's his choice. With an EPSP contribution every second year, the employee will always be able to choose the method that results in no instalments required.

But there's more. You can avoid Employment Insurance and Canada Pension Plan contributions on the compensation contributed to an EPSP. If you don't care to contribute to these plans, this can save a bundle. Three family members working in a business could save, collectively, $13,306 in 2011 by avoiding CPP contributions (employee and employer portions) alone. Finally, creditor protection may be available when EPSP terms are structured properly.