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If you are running a business, you can reduce your tax liability to a great extent by paying salary to your family members. But don't go overboard while doing so, warn experts. "Qualification does not necessarily mean a certificate, degree or diploma. A person having skill, experience and competence in a particular line of work can be regarded as professionally qualified."
Businesspersons can reduce their tax by paying salaries to their family members. But don't go overboard, warn experts. Nimesh Desai has hired two employees to run his sweet shop.
However, without his wife assisting him in his business, he would have found it tough. His two children had also been chipping in whenever they can. But, last year, when Desai was asked by his tax consultant whether he pays salary to his wife and children, he was at a loss for words. It had never crossed my mind. In fact, it was good to know that I was within my rights to pay my family members a salary that they actually deserved. He was equally surprised when he was told that he would save a great deal on his tax outgo. The tax benefit was an added advantage. And, this year, he is in a position to reap the rewards of `hiring' his wife and children when he files his income tax return.
But, does it really translate into considerable savings? Yes, it does, especially so, if the family members are not in the income tax bracket or at the lower tax brackets, because the combined tax liability of the family comes down significantly.
However, you cannot breach certain fundamental norms in your efforts to minimise your tax outgo. First, the expenses should be legitimate. You can claim only legitimate expenses incurred for business as deductions. And, since this is a related party transaction, it should be done using the arm's length rule. Note: The income tax department is wary of "related party transactions" and, typically, runs a check to ensure there's no tax fraud. The terms, "related party transactions" and "arms length", are not defined in the IT Act, but there are several provisions that mention them.
Definition of relative The provisions about "relative" vary according to the status of the entity, i.e., whether it is a proprietary concern, partnership or limited company. In a proprietary concern, "relative" would include husband, wife, brother, sister and any lineal ascendant or descendent of the proprietor. Similarly, relatives of a partner with more than 20% profit share will be defined as "relative" in case of partnership firms or limited liability partnerships. For limited companies, the cut off is 20% of the voting power of the company.
Qualification of the person The "arms length" rule looks into two factors: qualification and reasonable. A proprietor can pay remuneration to a family member, but on the basis of his or her qualification: education, experience and contribution to the business. The IT Act does not lay down any monetary ceiling or restriction on payment of remuneration, but Section 64 (1) (ii) says if the payment is made to a spouse who does not have technical or professional qualification, the remuneration paid would be clubbed with the income of the individual proprietor. However, the Act does not define what the qualification should be for each job.
Courts in India have interpreted that professional qualification does not necessarily be in the form of a certificate, degree or diploma. A person having skill, experience and competence in a particular line of work can be regarded as professionally qualified. Therefore, Desai's wife and children are eligible as long as they have a significant contribution to the business, such as having the skill to make sweets or managing the counter or maintaining the accounts. Keep it reasonable Section 40 A (2) of the Act gives the right to the income tax officer to disallow any expense if he or she feels that the payment made is excessive or unreasonable compared to the fair market value of the services in connection with the legitimate needs of the business. The proposition on which the argument is based is whether the same remuneration would be paid to a person if he or she was not a relative of the proprietor. If the answer is yes, then the payment amount would be considered as reasonable for the purpose of business and, therefore, will be allowed. In the above mentioned example, if the family members were not helping him, the proprietor would have been forced to hire a few more employees and, therefore, the salary given to the family member is reasonable
Additional precautions You can make an expenditure claim as long as you can prove before the income tax authorities that it is a genuine and reasonable claim. With that in mind, you should take several precautions. First, make sure that the payment made to your family members is through cheque and not cash. It is also important for the family member, who gets the salary, to file tax return even if he or she is not required by the law to do it, i.e., it is not compulsory to file tax return if the income is below the taxable limit.
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