With tax rates seemingly increasing all the time, it’s no wonder people are looking for ways to split income with family members. One income-splitting strategy that is available – prescribed rate loan planning – can result in significant tax savings to a family unit in each year by allowing high-income earners to split income with their family members who earn no, little or even less income.
And there is no better time to implement this strategy, as the prescribed rate of interest is at its lowest possible rate of 1 per cent.
Prescribed rate loan planning is a simple and effective strategy that involves a loan made by a high-income-earning individual directly to one or more family members paying tax at lower rates or, more commonly, to a trust established for the benefit of such family members. To avoid the application of the attribution rules – which would cause all of the income earned by the loaned property to be taxed in the high-income earner’s hands – the loan must bear interest of at least the prescribed rate, a rate set by the government every three months determined with reference to short-term government of Canada T-bill rates.
With the prescribed interest rate at a historically low rate of 1 per cent, now is the ideal time to implement (or top up) a prescribed rate loan if you haven’t already done so.
Once the loan is made, the borrower – whether the family member(s) or a trust on their behalf – can invest the funds, and any income earned in excess of the prescribed rate can be taxed in the hands of such family members. The tax-saving opportunity thus lies in the spread between the prescribed rate and the rate at which the invested funds earn income.
Further, once the loan is made, it can bear interest at the prescribed rate, at the time of the loan, forever. As a result, as interest rates rise (and with it, the prescribed rate), so too should the spread and, accordingly, the tax savings.
The tax impact of this strategy can be best explained through an example.
A spouse with investible capital of $1 million who is paying taxes at the top marginal tax rate has a spouse and three young children with no income. Each of the children attends private school and summer camp and participates in extra-curricular activities, the annual cost for which is $10,000 per child.
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If the investments earned 5 per cent annually, taxes of ~$26,765 on the $50,000 of investment income would be owing in each year by the top-tax-rate spouse. If this income were used to pay for the children’s expenses, other income (of ~$15,000) would have to be utilized to make up the ~$6,765 shortfall for the children’s expenses.
If prescribed rate loan planning is used instead, $10,000 of income (1 per cent of the $1 million) would be taxed in the top-tax-rate spouse’s hands, resulting in taxes in the range of $5,353, while $40,000 of income could be divided equally and taxed in the low-tax-rate spouse and children’s hands, completely eliminating the balance of the taxes that would otherwise be owing each year so long as the “tax on split income” rules do not apply to the low-tax-rate spouse and/or children, which will depend on the nature of the investments.
As a family unit, the annual savings would be in excess of $20,000!
Grandparents can use it, too
All of the income taxed in the low-tax-rate spouse and children’s hands must be paid to, or applied for the benefit of, the low-tax-rate spouse and the children. While the portion allocated to the children can be used to pay for their private school, summer camp and other activities, the portion allocated to the low-tax-rate spouse can simply be put in an account in that spouse’s name.
The subsequent income earned on such amounts can also be taxed in future years at the low-tax-rate spouse’s graduated rates. While the amount of such income may be minimal in the early years, it can result in meaningful tax savings down the road, especially if more income is allocated to the spouse in future years as the children get older.
And you don’t need $1 million of investible assets to take advantage of the planning. It can be done at a smaller scale and still result in annual tax savings for the family. The planning also isn’t limited to just spouses and children. For example, grandparents who wish to pay for their grandchildren’s education or take them on family trips can use this planning to fund these expenses using their grandchildren’s marginal tax rates instead of their own.
Don’t miss the interest payment
In order for the strategy to work, it is imperative that the prescribed rate of interest actually be paid in each year to the lender by January 30 of the following year. If that interest payment is missed even once, the benefits of the planning will be undermined forever. Conversely, there may be instances where attribution is desired (i.e., if the investments go bad), in which case missing an interest payment could purposely cause the attribution rules to apply.
Any future loans can only be made at the prescribed rate at the time of the loan , so proper recordkeeping is critical to ensure that the appropriate amount of interest is being paid to the lender each year.
Finally, it is critical that U.S. tax consequences be considered when implementing a prescribed rate plan where one or more of the borrowers or the beneficiaries of a trust are U.S. citizens, U.S. residents or U.S. green card holders. The tax implications in this regard may be far-reaching, and the importance of considering them cannot be understated.
Matthew Getzler is Partner, Tax, Wills & Estates, at Minden Gross LLP in Toronto. For further information, please contact the author at firstname.lastname@example.org or 416-369-4316.
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