Income splitting

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consultantjournal
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Income splitting

Postby consultantjournal » Fri May 25, 2007 4:56 pm

You often read articles that suggest business owners pay their spouses a salary, in order to split income (assuming the second spouse actually does work at fair market value). But what if both spouses are self-employed? Can one spouse subcontract to the other? For example, what if Jane has a modest home business she runs on the side, which results in a loss when she pays Jack. She would see her overall taxes (which are mostly from her regular job) decrease. Jack would have to pay more taxes, since he earned income. Is this allowed? It seems fraught with problems. Jack could show higher income, even though the total household income is unchanged. Jack could then apply for a larger mortgage, since his income is higher. Of course, he actually did the work, so it's not as though they are cheating anyone.

How does this work? Jack and Jane could live in Canada, although I'm not sure US tax rules would be so different as to not be used to understand the situation.

I must stress that this is hypothetical.
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Postby MossySF » Sat May 26, 2007 9:09 am

Depends on what your strategy is. If the goal is to eliminate possible taxes that phase out as income increase, a business owner should split off income if his/her spouse makes even more money. Social security in the states caps out at 97.5K. If either partner is above/close to that number, pile the income onto that partner and get a 12.4% tax discount. (I see Canada also has a income cap for the CPP.) If both partners are above, doesn't matter either way.

If the goal is to maximize retirement contributions, both directions could be helpful depending on what kind of plans are used. Splitting off income so the spouse has income to qualify for a Roth IRA. Or adding the spouse as an employee so both could contribute to the business's SEP-IRA or SIMPLE-IRA or 401K. Under a self-employed situation, you can contribute up to 45K per year versus the puny 15.5K working peons are limited to.

I can see changing income weightings if one partner has horrible credit and the other partner must always apply for everything. But otherwise, seems pointless to apply for credit separately.

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Postby consultantjournal » Sat May 26, 2007 9:26 am

I'm talking about a situation where the spouse who will pay out consulting fees is the one earning less from a home business but substantially more from their day job. So say their home business earns $1500 a year, but they earn $100k a year from their job. She needs some work done, so she pays her husband $30k to do the work, for example. The husband's home business usually earns $20k a year, but, because of this payout, he now earns $50k a year. (Before expenses in all cases.) The wife's business ends up with a loss of almost $30k, which offsets what she's earning at her day job. The husband earns more than before and pays more taxes, but less so than the wife would.

Meanwhile, their joint income is now shown to be $100k + $50k=$150k, as opposed to the $120k from before. Now they can qualify for a larger mortgage. Jack could apply on his own or they could apply together, but their overall income would be higher, even though it's all the same money. Does that make sense?

This certainly also affects the husband'svarious contributions for taxes and CPP (social security) and the like.
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Postby MossySF » Sat May 26, 2007 9:38 am

consultantjournal wrote:Meanwhile, their joint income is now shown to be $100k + $50k=$150k, as opposed to the $120k from before. Now they can qualify for a larger mortgage. Jack could apply on his own or they could apply together, but their overall income would be higher, even though it's all the same money. Does that make sense?


I see what you're saying. Going by US tax law, somebody running their business as a full corporation could play these accounting tricks at the company level and repay the loss later with future income -- just make sure you have a plausible story in case of a tax audit. Any other structure, both income and losses automatically pass up to the business owners and hence the taxable reported income will not change. (Unless you report phantom income and pay taxes on income you didn't make.)

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Postby consultantjournal » Sat May 26, 2007 1:17 pm

MossySF wrote:I see what you're saying. Going by US tax law, somebody running their business as a full corporation could play these accounting tricks at the company level and repay the loss later with future income -- just make sure you have a plausible story in case of a tax audit. Any other structure, both income and losses automatically pass up to the business owners and hence the taxable reported income will not change. (Unless you report phantom income and pay taxes on income you didn't make.)


Well, if you're both sole proprietors, why would that make a difference? Perhaps Canadian tax law is entirely different, but Jane would experience a loss in business income, which would reduce her taxes. Jack would see an increase in income. Oh, I see, the net income for Jane would be less. But Jack and Jane could go to their bank, show Jane's pay cheque stubs and prove her $100k income, while Jack could produce his year-end tax statement to show his income. So, to the bank, the total income would be $150k.

(To be clear, I'm not talking about phantom income. Jack is seriously doing work for Jane and getting paid. Jane seriously hopes to make money off the work Jack does, but down the road.)
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Postby MossySF » Sat May 26, 2007 1:27 pm

consultantjournal wrote:Well, if you're both sole proprietors, why would that make a difference? Perhaps Canadian tax law is entirely different, but Jane would experience a loss in business income, which would reduce her taxes. Jack would see an increase in income. Oh, I see, the net income for Jane would be less. But Jack and Jane could go to their bank, show Jane's pay cheque stubs and prove her $100k income, while Jack could produce his year-end tax statement to show his income. So, to the bank, the total income would be $150k.


A year ago, two years ago, this would have been no problem -- you could just declare your income and have cash thrown at you. With lending criteria getting stricter, the bank might require paystubs and tax returns for both spouses and note the discrepancy in income and reported as taxed. It all depends on how desparate the lender is to write more loans or how diligent the underwriter is at reviewing the documents. Who knows until somebody tries?

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Postby brad » Sat May 26, 2007 1:44 pm

Yeah, for the mortgage I just received here in Montreal, my bank required me to fax them our federal tax notices of assessment for the past three years, plus the last three months of bank statements (from another bank), and they called my employer to verify my salary. I was kind of surprised!

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Postby consultantjournal » Sat May 26, 2007 2:37 pm

Okay -- that all makes sense. Thanks. I was just wondering about the above. Although there are legitimate reasons for hiring one's spouse, it just seemed to me that there were scammy issues associated with it, too. Of course, there are certainly perfectly reasonable reasons to hire your spouse and many people have their spouse do unpaid work, which should actually be recognized.

When we got our (second) mortgage, I wasn't even asked to prove my self-employment income. On the other hand, my husband (who has a regular job) was asked to show paystubs and bring a letter from his employer. The mortgage broker said they don't necessarily ask for notices of assessment, since there are so many write-offs that your true income is never shown. (For example, my income is distorted by $20k in past tuition write-offs that I've carried forward.)
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Postby jdroth » Tue May 29, 2007 6:43 am

I have a similar question. Kris has offered to be my "assistant" at GRS providing I pay her something. This is an awesome idea, but I'm worried about the legal/tax implications. So far I've been very careful to dot my i's and cross my t's. I want to keep going by the book. How can I "hire" her and make it advantageous while still following the rules? I suspect I should ask my CPA...

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Postby Kate » Sat Jun 02, 2007 8:30 pm

CRA expects any business to have a reasonable expectation of profit. This might work for a while, but eventually CRA may stop allowing the losses.

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Postby pf101 » Sat Jun 02, 2007 10:25 pm

jdroth wrote:I have a similar question. Kris has offered to be my "assistant" at GRS providing I pay her something. This is an awesome idea, but I'm worried about the legal/tax implications. So far I've been very careful to dot my i's and cross my t's. I want to keep going by the book. How can I "hire" her and make it advantageous while still following the rules? I suspect I should ask my CPA...


JD,

Since this is more of a tax question than an accounting question you might be better served to talk to an EA than to a CPA. From what I understand EAs receive much more tax training than most CPAs and they can represent you in front of the IRS if it comes to that.

pf101

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Postby consultantjournal » Sat Jun 02, 2007 10:39 pm

Kate wrote:CRA expects any business to have a reasonable expectation of profit. This might work for a while, but eventually CRA may stop allowing the losses.


The business would definitely have a reasonable expectation of profit. And would likely be profitable as soon as R&D was done...within the 3 year limit.
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