You need to hire an assistant. And after interviewing several candidates, you realize your spouse is best suited for the role. As long as he actually works for you and is paid a reasonable salary, you can deduct the wages you pay him from your business income.

In fact, hiring a spouse, partner or child (i.e., someone who is “non-arm’s length”) to work for you can be a great way to income split. But if you do, be sure you follow the rules. Otherwise, you may find your spouse’s salary expense denied as a valid tax deduction.

Read: Tax problems with employing a spouse

Take the recent case (Burlando v. The Queen, 2014 TCC 92) of a British Columbian automobile dealership sales manager. In 2008 and 2009, he reported gross commissions of more than $135,000 and $115,000, respectively, and deducted employment expenses of $39,000 and $40,000, respectively. Nearly half of the employment expenses were for wages paid to his spouse.

Both the manager and his wife testified at trial. He stated his wife worked from home and put in between 4 and 4.5 hours daily, five days per week, at an hourly wage of $18. She was “paid by cash or set off.”

He explained to the judge that since he and his wife had only one bank account, and it was a joint account, there was no “sense of paying her by cheque, which she would deposit in their joint account. Instead, any amounts [that she] withdrew from the bank account or purchased with the debit card or…credit card were set off against the wages she earned.”

His wife testified it was her job to call people who had recently immigrated to Canada to see if they were looking for a vehicle. She also checked Craigslist and would refer potential purchasers to the dealership where her husband worked. She estimated that some days she made four to six calls, while other days she made no calls. She also sent birthday cards to her husband’s customers.

Read: When spouse = business partner

Not believable

The judge found the testimony “self-serving and unbelievable,” especially since it contradicted earlier evidence about what her duties were. Further, the judge found the lack of any documentary evidence to support actual payments from the sales manager to his wife problematic, stating, “he randomly chose amounts from his bank statements and stated these amounts were [his wife’s] wages.”

One discrepancy cited by the judge was that, in some months, the manager included his daughter’s gym membership as part of his wife’s wages, while in other months, the gym membership cost was excluded.

Read: Email your clients: Give professional clients an advantage

The judge denied the deductions, finding the evidence of a true employment relationship “implausible.” And the judge warned others who may try a similar scheme: “Where there is an alleged working relationship between non-arm’s length parties, there should have been some documentation or independent evidence to support that working relationship. In this case, neither was given.”

So, if you’re an advisor who tries to income split with your spouse or child, you should ensure the amount paid is reasonable. You’ll also want to keep good records, such as copies of cancelled cheques or electronic fund transfers, to prove to CRA a working relationship truly exists.

Jamie Golombek, CA, CPA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Financial Planning and Advice in Toronto.

Originally published in Advisor's Edge Report

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