When is a dollar not a dollar? When you have to give away almost half of it to the CRA, that’s when. That is the harsh reality for a sole proprietor earning business income in this country. Income splitting is the art of structuring one's affairs to take advantage of lower tax rates. It involves the use of partnerships, corporations and trusts, as well as dividing income among family members.
Income splitting must be distinguished from its illegitimate cousins, tax avoidance and tax evasion. Tax avoidance involves, in general terms, a misuse or abuse of the income tax provisions to achieve an improper tax benefit. The General Anti-Avoidance Rule or GAAR is a provision in the Income Tax Act designed to catch tax avoidance schemes. Tax evasion is the more serious of the two and involves the evasion of tax through illegal means whether through misrepresentation, failure to report or other such actions. The result of tax evasion can be a criminal offense. While income splitting is legitimate tax planning, it is important that it is implemented properly to avoid any risk of tax avoidance or tax evasion.
Each of the planning strategies that can be invoked to take advantage of income splitting opportunities could warrant a full article on its own. The purpose of this article is to provide a brief overview of the opportunities that are available and the issues that may arise in the implementation of various income splitting structures.
Before proceeding further, it is important to highlight the concept of the attribution rules which act as a limit on income splitting strategies. Essentially, the attribution rules are designed to prevent income splitting and capital gains splitting through the transfer of property to related parties. The rules may apply whether the transfer of property is made using corporations or trusts or directly to the individuals. As a result of these rules, income splitting is not as simple as a transfer of property to a lower income taxpayer to allow them to earn the income going forward. Once again, this highlights the importance of proper planning and implementation of income splitting strategies to achieve the desired results.
Let's begin with some basic principles. As I mentioned at the outset, the top marginal rate on income is close to 50%. The lowest marginal rate is 20%. In simple terms, for every dollar shifted from a high marginal rate income earner to a low marginal rate income there is a savings of $.30. When multiplied several times over by thousands of dollars, the savings can be significant.
In Ontario, the combined federal and provincial corporate tax rate on the first $500,000 of active business income is 15 1/2%. Once again basic math would show that there can be significant tax savings earning business income in a corporation rather than individually. It should be pointed out that this savings is, in actual fact, a deferral of tax. This is due to the fact that once the corporate after-tax income is distributed to individuals, it is subject to another level of tax through their personal income tax. It is intended through the concept of integration to match the total tax paid to that which would have been paid by the individual earning the income directly.
Even though it is only a deferral, the lower corporate tax rate can still present significant savings opportunities where the after-tax income is reinvested in the corporation or used to pay off debt. Stating it at its most basic, the reinvestment or debt reduction is happening at almost $.85 on the dollar versus only about $.50 on the dollar for an individual. To achieve this result, the transfer of business assets from an individual to a corporation can be done on a tax-deferred basis through a mechanism referred to as a "rollover”. The rollover provisions of the Income Tax Act are highly technical and must be strictly complied with, failing which the transaction can trigger immediate tax consequences.
While it is true, as noted above, that the lower corporate tax rate is simply a deferral, when it is combined with income splitting strategies using dividends paid to lower income earners, the result can be an absolute reduction in overall tax paid. As an example, an individual in Ontario who is not earning any other income can receive almost $40,000 in dividend income without paying any tax. This is due to the combination of the dividend tax credit along with the various personal tax credits which are available.
Trusts are often used to manage income splitting strategies. A trust is a legal term to describe a relationship between an individual, called the Settlor, who gifts property to a group of one or more persons, called Trustees, to manage the property for the benefit of a third group called Beneficiaries. Often these trusts are discretionary which allows for tremendous flexibility in administering income splitting strategies year-to-year. A reminder about the attribution rules and the need for proper implementation of any strategy using trusts. Often, the implementation of a trust follows what is referred to as a “freeze”. A freeze is designed to avoid the attribution rules by locking in the current value of the corporation before adding new shareholders, including trusts, for income splitting purposes.
When discussing the use of a trust in these circumstances, it is important to note the existence of the so-called “Kiddie Tax”. This tax provision was added to the Income Tax Act in 2000 in an effort by Finance to limit the use of income splitting strategies with minors. Basically, the result of the Kiddie Tax is that income received by minors through private company dividends, whether through a trust or otherwise, is taxed at the highest marginal rate. Furthermore, the minor would not be able to claim any tax credits other than the dividend tax credit. The result is that any advantage to income splitting with minors would be eliminated.
As tax professionals, we are always looking at tax rate comparisons to determine whether there are any new opportunities as tax rates change over time. With the implementation of the Kiddie Tax, for the most part it was a foregone conclusion that there was no longer any benefit to using dividend strategies with minors. However, with the advent of the Ontario Surtax and the Ontario Health Premium, it appears that for income levels of greater than $200,000 there may be a 3 to 4 1/2% spread on the rates payable by a minor as compared to the high income earning parent. While the benefits may not seem that substantial, in situations where there are multiple children, and the parent’s income is high enough, there could be significant savings. It is also an excellent example of why it is important to challenge conventional wisdom on a regular basis to make sure that there are no opportunities that may be lurking under the surface.
Another income splitting strategy that may be available, particularly in this period of unprecedented low interest rates, is what is called the prescribed rate loan strategy. This strategy is used to take advantage of a specific exemption from the attribution rules. Basically, the individual with the available funds, who is a high marginal rate taxpayer, lends the funds to a trust. The terms of the loan mandate that the trust must pay the prescribed interest rate under the Income Tax Act. Currently, that prescribed rate is 1%. Any income earned by the trust in excess of the prescribed rate can be distributed to lower income taxpayers to take advantage of their lower marginal rates.
The bottom line in this discussion is that business owners work very hard for their money. CRA and Finance, in turn, work very hard to get their fair share of the hard-earned money. At the end of the day, what matters most from an income perspective is how much money is left in the jeans of all the family members after taxes have been paid. Income splitting is a collection of strategies designed to ensure that the jean pockets remain as full as they can be.
Harold Feder is a partner with the law firm of BrazeauSeller.LLP. He practices in the areas of tax and estate planning for individuals and business owners. Harold can be reached at (613) 237-4000 ext. 242 or at hfeder@brazeauseller.com. For more information about Harold, visit www.brazeauseller.com.
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