Owners of business structures either as partners, shareholders or trustees can be employed by the partnership, company or trust company they are part of, and receive compensation income for their work. When a business receives payment for personal services rendered by an employee, a question arises about the nature of the payment, especially when the arrangement is viewed as income splitting to avoid higher taxes.
Income splitting is a practice aimed at avoiding higher income tax rates by sharing the income paid for the personal efforts and skills of a taxpayer with another associate or family member who did not put in substantially or the same effort to earn that income. The concept commonly applies to personal services income which is mainly a reward for one’s personal efforts or skills.
Basis of the prohibition
Common cases of income splitting
- Arrangements where personal services income is paid to your company, trust or partnership and taxed at a lower rate than if you had received the income yourself, and particularly where your salary is less than the value of your services.
- If you split personal services income with an associated person or with another entity associated with you, and your associate did not perform bona fide services to earn it.
- When you use a family trust or company to split personal services income with family members like your spouse, which reduces your tax liability and particularly when your salary is less than the value of your personal services.
Business people have the freedom to choose business structures that provide limited liability and greater asset protection. However, to avoid heavy penalties for income splitting, if you want to operate a partnership or pay salaries to family members, you should be able to show that your arrangements have commercial basis and are not intended primarily to obtain a tax advantage.
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