Our kids have a way of giving us pause for thought. Take Joel Miggler, 23, who is a body art enthusiast. Mr. Miggler has many piercings, but outdid himself recently by creating “portholes” in his cheeks that are currently about 3.5 centimetres in diameter. He says that he uses custom plugs for the holes when he’s eating. I feel for his parents.
My kids don’t cause me much grief – except when they jump off the garage roof onto the trampoline in the backyard (which has now stopped). In fact, the kids are helpful in many ways, including saving us tax dollars – through income splitting. Here’s a primer on income splitting, and some ways to accomplish it.
Income splitting is the idea of moving income from the hands of one family member to another to save tax. The tax savings arise because each taxpayer resident in Canada is entitled to a basic personal tax credit and also pays tax at progressive rates, meaning that the lower your income, the lower the rate of tax you’ll pay.
So, having two people each pay tax on, say $10,000, will often result in less tax than one person paying tax on the full $20,000. If all family members are in the highest tax bracket, then shifting income from one person to the next doesn’t accomplish anything, but if any family members are in a lower tax bracket due to a lower level of income, splitting income can make sense.
Now, the taxman won’t simply allow you to hand income to your spouse or children to report that income on their tax returns. The “attribution rules” in our tax law will stop this. These rules say that when you try to pass income to your spouse, common-law partner, children, in-laws, nieces or nephews by transferring income-producing property to them, you’ll face tax on the income – not them. That is, the income will be attributed back to you. Not to worry: There are legitimate ways to sidestep the attribution rules.
1. Lend money and charge fair interest.
Consider lending money to a family member and charging interest on the loan. If you charge the prescribed rate of interest under our tax law (currently just 1 per cent), any income earned by your family member on the lent funds can be taxed in your family member’s hands without attribution back to you. The interest must be paid to you by Jan. 30 following any year the loan is outstanding. You’ll face tax on the interest, but your family member can claim a deduction for it. As long as your family member is earning more than the prescribed rate on the invested funds, you’ll save tax as a family. And one last thing: You can lock in the current low rate on the loan indefinitely when you set up the loan.
2. Transfer funds for business purposes.
You’ll avoid the attribution rules if you lend or give money to family members for use in a business. There’s no need to charge interest here. If you’re lending money to, or investing in, a corporation owned by a family member, be sure to speak to a tax pro first. You may be able to set it up so that, if you can’t collect on the loan later, you may be entitled to claim a loss (called an “allowable business investment loss”) against any type of income later.
3. Lend money, then take repayment.
If you’d rather not charge interest on money lent to family members, you could structure the arrangement this way: Lend money to a family member for investment purposes – say, $15,000 – then take back those funds after a few years – say, five years. Those funds will earn, say, $1,000 each year, which in most cases will be taxed in your hands because of the attribution rules. But the $1,000 can be reinvested each year, and any second-generation income – that is, income on the income – will not be attributed back to you.
4. Swap assets with a family member.
Consider “selling” some of your income-producing investments to your spouse or child in exchange for another asset from them. The asset you take back should have a value at least as high as the investments you’ve transferred, and should not produce income of any kind. The swap is considered to be a sale at fair market value, so there could be tax to pay on accrued gains on the assets when you make the swap, but can still make sense if there is little or no tax to pay.
I’ll share more ideas next time.