I was having lunch with Demetri Martin this week. Demetri is a well-known comedian, and a funny one at that. We were talking about the joys and trials of raising kids and maintaining a balanced lifestyle to ensure we’re spending time with our families. I pulled out a picture of my kids to show him. “Tim, people often show me a picture of their kids,” he said. “But when I give them a picture of me to show to their kids, they think I’m weird. What kind of one-way street is that?”
“Demetri,” I replied, “you can give me your picture, I’d be glad to show my kids. But you have to autograph it.”
No doubt about it, our families are important – and for more reasons than just tax planning. But let’s be clear, there can be tax benefits to family as well. As we near the end of the year, take the time to set up your affairs to save tax in 2011. I’m talking about splitting income with family members.
The Concept
Income splitting is one of the pillars of tax planning. It involves moving income from the hands of one family member who will pay tax at a higher rate to the hands of someone else in the family who will pay tax at a lower rate. By taking advantage of the lower tax brackets of family members, the overall tax burden for the family can be reduced.
How much tax can be saved? It varies by province, but the average across Canada is $17,000 in potential tax savings annually per family member. Your actual savings will depend on your level of income, your family member’s level of income, and your province of residence. The provinces where the greatest annual tax savings are possible are Nova Scotia ($21,000), Ontario ($19,565) and B.C. ($18,908). Alberta offers the smallest opportunity for annual savings at $13,196.
The Challenge
Here’s the problem: The attribution rules in our tax law are designed to prevent you from simply moving income to someone else’s hands. If you’re caught under these rules, the income earned by your family member will be attributed back to you to be taxed in your hands. The most common situations where these nasty rules will apply are where you give or lend money (at no or low interest) to your spouse or minor children.
The good news? There are quite a few strategies that can be implemented to split income that will sidestep the attribution rules.
The Strategies
Set yourself up for tax savings next year with one of these ideas:
1. Lend money to your spouse or child. You can simply lend money to your spouse or a child for them to invest. In the case of your spouse, all income and capital gains will be attributed back to you, and in the case of minor children, all income (but not capital gains) will face tax in your hands. But second generation income (that is, income on the income) will not be attributed back to you. It makes sense to move the income annually into a separate account so that its growth can be tracked separately from the original loan amount.
2. Lend money to family at interest. This idea is much the same as the one above, except that you can charge interest on the loan to avoid the attribution rules. By charging the prescribed rate of interest (currently just 1 per cent) your family member, not you, will face tax on any income earned. Your family member will have to pay you the interest every year by Jan. 30 for the prior year’s interest charge (if this is overlooked even once, the attribution rules will apply every year going forward). And get this: The current prescribed rate can be locked in indefinitely. So, if you set this loan up before Dec. 31 of this year, the 1-per-cent rate can apply forever. To the extent your family member earns more than 1 per cent on the funds, you’ll effectively split income.
3. Lend or give money to acquire a principal residence. If you help a family member to purchase a home, this will free up the income of that family member for other purposes – such as investing – effectively moving investable assets from your hands to theirs. In addition, if the property appreciates in value, the capital gain could be sheltered using the principal residence exemption of your family member if they are older than 18 or married.
I’ll share more income splitting ideas next week.
