Mark Twain once said that the only difference between a taxman and a taxidermist is that the taxidermist leaves the skin.
For many Canadians the pursuit of tax avoidance strategies has become an obsession and over the years, I have seen some people do some crazy things to avoid paying income tax. In the end, the government has the upper hand and often we are limited to a few programs designed only to delay the inevitable.
However, for the truly savvy wealth planner, there are some strategies that are available to can help you reduce your tax bill through income splitting.
What is Income Splitting?
Income taxes are assessed on each individual at graduated rates. This means that as you earn more income, the tax rate gets progressively higher on each additional dollar earned.
Income splitting simply means that you transfer some of your income to a family member to have part of your income taxed in their hands.
Assume you have $150,000 of taxable income. If you live in Ontario, the basic income tax is $48,752. If you could split that 50/50 with your spouse, the combined tax bill would be reduced by more than $15,000!
In reality, it is not as simple as it sounds because there are a number of rules that limit or prevent a simple transfer of income. However, this does not mean that it is impossible.
Lend Your Spouse Money
This well-known strategy involves the higher income spouse lending the lower income spouse a substantial amount of money. The loan is documented and carries an annual rate of interest at the CRA’s prescribed rate (currently 1%).
The lower income spouse then invests the loan proceeds, and provided they make interest payments on the loan from their own funds (i.e. from the investments), the investment income is then taxable in the lower income spouse’s hands.
At the same time, the higher income spouse reports the interest received on the loan as income.
The Family Trust
A trust is a legal arrangement where one person (the settlor) transfers their property to another person (the trustee) who manages the assets for another person (the beneficiaries).
This structure has a number of characteristics that make them flexible tax planning vehicles.
One such feature is that the trust can allocate income to the beneficiaries and have it taxed in their hands. Of course, this is not always as simple as it sounds because of the various attribution rules in the Income Tax Act.
To help avoid attribution, you can extend a loan at the prescribed rate to the trust. The terms are similar to the spousal loan above, and since the loan is callable at any time, the settlor holds the right to recall the loan from the trust for any reason.
By structuring the trust with the loan the attribution of income to your spouse and children do not apply and you have the maximum income splitting potential without losing control of the assets.
The corporation is an often-overlooked tool to help reduce taxable income.
In this strategy, you establish a corporation and it sells its shares to you and your family members (be cautious if issuing shares to a minor child). To retain control, you should consider issuing non-voting shares to your family.
Next, you lend the funds to the corporation in exchange for a note payable at the prescribed interest rate following the same basic principle as we would for a trust or spousal loan.
Now the corporate tax rate on investment income is close to the top personal tax rate. However, when that income is paid out of the corporation in the form of dividends, there is a refund paid back to the corporation. When the income is paid to family members with low or no income, there can be a substantial tax benefit.
With the corporate structure, caution must be exercised when shares are issued to minor children since the dividends paid to minor children will be subject to an income splitting tax. With his tax in mind, the corporate structure is generally effective with your spouse and adult children.
These strategies can produce dramatic savings in larger family groups with a substantial amount of wealth but implementing them does come with additional costs. Legal fees will be required to set up trusts and corporations and each would require additional tax returns and annual filings. It is important to consider these costs to make sure there is a net benefit of the arrangement.
Another important consideration is the so ensure that the structure is set up correctly to avoid application of the income attribution rules and in the case of minor children, the so-called “kiddie tax.” The application of this tax can eliminate any benefit of income splitting and you should discuss your situation carefully with your accountant.