Will paying salary to your spouse lower your tax liability?

If you are running a business and your wife is assisting you, paying salary to her if she is not in the income tax bracket or at a lower tax bracket will definitely lower your tax liability because the combined tax liability of your family shall be decreased significantly.
If you are self-employed or you are running a small business and earning more than your close relatives, paying them for their assistance in the business can easily help you in saving your taxes.
The tax benefit of ‘hiring’ a relative such as wife, children, etc. in a small business is remarkable.

Who is a “relative”?
The definition of “relative” depends upon the status of the entity, i.e., whether it is a proprietary company, a partnership firm or a limited company.
In a proprietary concern, “relative” means and includes spouse, brother, sister and any ascendant or descendent of the proprietor. In the same manner, relatives of a partner having more than 20 % share shall be considered as “relative” in case of a partnership firm as well as in case of a limited liability partnership firm. In case of a limited company, the cut off is 20% of the voting power of the company.

Qualification of the “relative”:
The relative should have the following qualifications-
1. He or she should file his income tax return even if he or she is not required to file the same;
2. He or she should have technical or professional qualification.
The Act does not define the qualification required for every job. But according to Courts in India it is not necessary that professional qualification should be in the form of a certificate or a degree. An individual having skill or experience in a particular field can be considered as professionally qualified. A relative is eligible as long as he or she has a significant contribution to the business, like having the skill to maintain the accounts or having the skill to manufacture a product.

The “arms length” rule:
The “arms length” rule is not defined in the Income Tax Act, but it has been mentioned in many provisions. The “arms length” rule states that two factors are to be considered – qualification and reasonableness. A proprietor can pay salary to a family member working in the business, but the same should be based on his or her educational qualification, experience in the field and contribution to the business.

Limit of paying salary:
The Income Tax Act does not provide any limit or restriction to the payment of salary, but Section 64 (1) (ii) of the Act states that if the payment is made to a spouse not having technical or professional qualification, the amount paid shall be clubbed with the income of the said proprietor.
However, the expenses should be justified. You can pay only legitimate salary for the work done by your relative in the business and claim deductions.
Section 40 A (2) of the income Tax Act confers the right to the Assessing officer to reject any expense if he or she considers that the payment shown is excessive when compared to the fair market value of the work with the requirements of the business. It is taken into account that whether the same salary would be paid to anybody if he or she is not a relative of the proprietor.