As another tax filing deadline approaches, by reflecting on the past year, avoiding mistakes and seizing tax savings opportunities, you can reduce your tax bill. Here’s a list of tax mistakes that could prove to be costly.
Closing the door on certain tax expensesYou don’t always automatically qualify for tax breaks. Certain expenses have conditions in order for you to benefit. For example, child care expenses require the lower income spouse to have earned income (e.g. salary or business income). If your income includes only dividend and investment income, you may not be eligible to claim child care expenses of up to $8,000 per child (age six or under). Another example is registered retirement savings plans (RRSPs); if you have historically always taken out dividend income from your Professional Corporation (PC), you may not be able to contribute to an RRSP. RRSP contribution room is based on the prior year’s earned income (e.g. salaries or business income), if you have only ever had dividend income, then you won’t have any RRSP contribution room.
Not using your family in the tax savings gameMany dentists know what income splitting is, but not all of them do it efficiently. For example, many dentists will pay an adult child attending University $40,000 in dividends while paying themselves and their spouse $100,000 each. While the dentist is income splitting, they are doing so inefficiently. The family’s overall tax bill would be reduced if all three family members received $80,000 each instead. On the flip side, some dentists split too much income with their family members. Too high an income means government benefits such as old age security and guaranteed income supplement might be reduced or taken away completely.
Failing to document and keep records of your tax transactionsMany dentists issue shares of their PC to their family members, but not all family members actually buy and pay for those shares. The shares may only cost $1 each, but until the shareholder writes a personal cheque to the PC for those shares, they are not shareholders and cannot receive dividends. Another trap is when shareholders use a joint bank account to deposit dividends. Dividend cheques should be deposited into each shareholder’s own personal bank account, not a joint account if you wish to further increase tax savings through income splitting. The lower income spouse should invest their income and the resulting investment income will be taxed at the lower income spouse’s tax rate. The richer spouse should pay for all personal expenses, including vacation, private school fees, food, accommodation, etc. Having separate accounts will help to prove the source of the money used for investment purposes.
If all monies went into a joint account, it may be impossible to prove the source of money used for investment purposes. By documenting your transactions and creating a clear audit trail, this prevents future headaches with the tax department (CRA).
Claiming unreasonable expensesTaxpayers are allowed to claim reasonable expenses incurred to earn income to reduce their taxes, but this doesn’t mean every expense qualifies. For example, paying your spouse a high salary when they don’t work at your clinic is a risky maneuver that could be challenged by the CRA. Instead, consider issuing dividends to your spouse who is a shareholder which cannot be challenged by the CRA. Overly aggressive expenses for meals and entertainment, auto expenses, travel expenses and home office expenses are often on CRA’s radar. Review these expenses regularly and speak with your accountant to determine if and when these expenses qualify for a tax break and how these expenses compare with other dentists.
Living in the extremesSome dentists leave significant money inside their PCs in order to defer taxes for as long as possible, taking out less than $40,000 per year. For those low income dentists who have cash in their PCs, consider taking out more money to make use of the low tax brackets every year. The last federal 2016 budget reduced the tax rates on those making between $45,000 and $90,000. Having too much cash/investments affects your ability to claim the capital gains exemption and may make it more expensive to take out the cash in the future when you have a shorter time frame to do so. Taking out $1 million in a single year before the sale of your PC will result in more taxes than taking out $100,000 each year for the next 10 years. On the other end, those dentists who are regularly taking out $220,000 or more should consider using other shareholders including parents and children in the tax savings game.
There’s no such thing as the perfect tax plan; personal circumstances, tax laws and economic conditions change year-to-year. However, this shouldn’t stop you from reviewing your tax plan and looking for ways to save taxes. Recognizing mistakes from the past is the first step to realizing tax opportunities for the future.