Over the past 2 years, I've been blogging extensively about the various advantages of using a Family Trust for business owners and owners/managers - On a daily basis, I spent a considerable amount of time educating people on the benefits of using such structure. Today, I would like to share an excellent article written by Chaya Cooperberg published in the Globe & Mail.
The Truth about Family Trusts.
The perception of family trusts as vehicles for only the extremely wealthy is one of the misperceptions about trusts that Ms. Blades wants to put to rest. Here are her top five myths and realities about the structure.
Myth #1: They are inflexible.
Reality: Trusts can be quite versatile and are often the best option to provide for disabled beneficiaries or for children of blended marriages. The terms of the trust can vary. There can be a fixed-interest trust, where an amount is invested and the beneficiary gets the money. Or a trustee can be appointed to pay it out. You can also stagger the payments so that funds are paid out when the beneficiary reaches certain age milestones.
Myth #2: They are mainly used to avoid estate taxes and probate costs.
Reality: Trusts can offer significant tax benefits and avoid probate costs, but they also have other benefits like asset protection, investment management, and protection for disabled family members or the client if they become incapacitated.
“It’s always a cost benefit analysis with a trust,” says Ms. Blades. “You would never just look at the financial benefits such as how much tax is saved; you would also look at the beneficiary benefits. You need to do the analysis to see when and where it is worthwhile.”
Myth #3: They are only for the very wealthy.
Reality: Trusts can be set up for anyone with specific needs and are useful vehicles for passing funds to children or grandchildren. There are multimillion-dollar trusts and there are much smaller trusts.
Myth #4: You lose control.
Reality: Trusts are customized vehicles designed in line with your wishes and ensure that cash is ultimately transferred to beneficiaries as desired. While you no longer own the money, you can say when and how you want it used. Your control comes in under the terms and conditions you’re drafting.
Myth #5: Trusts are complicated and onerous to manage.
Reality: The provisions of a trust can be as simple or as complex as you want or need. To set up a trust, you would first need to meet with a will and estate planner or a lawyer to draft the agreement. It is also important to get separate tax advice from an accountant to ensure the trust is a worthwhile vehicle for you. If you make the trust a part of a will – this type of trust is called a testamentary trust – the cost will be built into the cost of the will. If you create a trust that takes effect while you are alive – known as a living trust or inter vivos trust – it will cost at least $1,000 to set up and establish. For a large trust, you will need to appoint a trustee to oversee it and manage investments held within the trust. This comes with a typical annual fee of 1 per cent.
Monday, August 30, 2010
Family Trust: Discretionary vs. Non-Discretionary
A family trust can be either discretionary or non-discretionary. A discretionary trust gives the trustee full discretion to allocate income and capital among beneficiaries.
In a non-discretionary trust, the trust deed sets out the parameters within which income and capital are allocated. For example, if a trust has three beneficiaries, each beneficiary could be entitled to one-third of the income on an annual basis, and
one-third of the trust capital when capital allocations are made.
Most trusts are irrevocable, as the tax rules deem any income or capital gains earned by a revocable trust to be those of the contributor and taxed in his or her hands, and not income or capital gains of the trust.
As previouly explained, Trusts can be an effective part of your tax and estate planning. This posting is a brief summary of some features of trusts and is not a thorough examination. Always contact your lawyer and/or accountant for more information.
In a non-discretionary trust, the trust deed sets out the parameters within which income and capital are allocated. For example, if a trust has three beneficiaries, each beneficiary could be entitled to one-third of the income on an annual basis, and
one-third of the trust capital when capital allocations are made.
Most trusts are irrevocable, as the tax rules deem any income or capital gains earned by a revocable trust to be those of the contributor and taxed in his or her hands, and not income or capital gains of the trust.
As previouly explained, Trusts can be an effective part of your tax and estate planning. This posting is a brief summary of some features of trusts and is not a thorough examination. Always contact your lawyer and/or accountant for more information.
Thursday, August 26, 2010
Shifting taxable income to someone else? You still might foot the bill
Today I would share an excellent article written by Tim cesnick published in the Globe and Mail.
Shifting taxable income to someone else? You still might foot the bill.
Some things just seem a little backward. Take my cousin Julia’s situation for example. Julia is an environmentalist – a self-proclaimed “tree-hugger,” to use her words. Her husband is a competitive swimmer. She doesn’t shave her legs, but he shaves his. It just seems backward to me.
The folks at the Canada Revenue Agency (CRA) often take offence to things when they’re backward. No, I’m not talking about personal grooming habits – CRA doesn’t care much about whether or not you shave your legs. But CRA does care when someone else pays a tax bill and it should be you paying the tax instead.
The rules
Let me tell you about subsection 56(2) of our tax law, which can cause real problems in certain situations. Specifically, this subsection will cause certain amounts to be taxed in your hands even when the amounts were received by someone else. Subsection 56(2) applies when the following conditions are met:
1. There is a payment or a transfer of property to a person other than you.
2. This payment is made at your direction, or with your concurrence.
3. There is a benefit to you, or a benefit you wish to confer on the other person.
4. You would have been taxable on the amount had you received the payment or transfer of property.
In situations where these conditions are met, subsection 56(2) will cause the amount to be taxed in your hands rather than the hands of the other person who received the amount. If subsection 56(2) applies, the amount in question will need to be added to your income; CRA will however reduce the income of the person who initially received the amount, in order to prevent double taxation.
The examples
Clear as mud so far? Let me share a few examples where 56(2) might apply.
* Sale of an asset. If you sell an asset but direct the sale proceeds to be paid to your spouse or a family member with the hope that they’ll pay the tax instead, 56(2) could apply to cause you to pay the tax anyway.
* Business income. Perhaps you own a business, provide goods and/or services to a customer, and then direct the customer to make payment to your spouse or family member and not you. Beware of 56(2).
* Rental income. If you own a rental property, or part thereof, and you instruct a tenant to make payment to your spouse, child, a charity, or some other party, subsection 56(2) could apply.
* Employment income. As an employee you could be subject to 56(2) if your employer makes a payment to one of your family members for services provided by you.
* Gifts by a corporation. Perhaps you’re a shareholder and the corporation makes a gift of cash or property to one of your family members. Subsection 56(2) could apply to tax you on the value of the gift because the gift would likely have been taxable to you as a shareholder benefit had it been made to you.
* Property sold to family. If you’re a shareholder and your corporation sells an asset to a family member at an amount below fair market value subsection, 56(2) could apply.
* Dividends paid to shareholders. Consider a situation where dividends are paid to a shareholder who is not entitled to receive dividends and/or you had a pre-existing right to dividends. Or where you might waive your dividend entitlement for the purpose of transferring income to other shareholders. Subsection 56(2) could apply to tax you on those amounts.
Now you get the drift. Subsection 56(2) is not to be confused with the other attribution rules in our tax law that can cause investment income to be taxed in your hands when you give or lend investment assets to a family member. This provision is broader. It can even apply to tax you on payments made to unrelated third parties.
The solutions
You should note that there’s often a way to accomplish the same tax savings without triggering 56(2).
This might mean receiving a payment yourself and then paying a deductible amount to a family member, properly transferring an asset to your spouse or child to allow them to pay tax on a sale later, restructuring your employment contract to allow payments to an assistant who might be a family member, or revising the terms of your company’s share classes to allow a more flexible sprinkling of dividends, among other ideas.
It’s also worth noting that there’s an exception for the splitting of CPP benefits, which is specifically allowed under our tax law.
Shifting taxable income to someone else? You still might foot the bill.
Some things just seem a little backward. Take my cousin Julia’s situation for example. Julia is an environmentalist – a self-proclaimed “tree-hugger,” to use her words. Her husband is a competitive swimmer. She doesn’t shave her legs, but he shaves his. It just seems backward to me.
The folks at the Canada Revenue Agency (CRA) often take offence to things when they’re backward. No, I’m not talking about personal grooming habits – CRA doesn’t care much about whether or not you shave your legs. But CRA does care when someone else pays a tax bill and it should be you paying the tax instead.
The rules
Let me tell you about subsection 56(2) of our tax law, which can cause real problems in certain situations. Specifically, this subsection will cause certain amounts to be taxed in your hands even when the amounts were received by someone else. Subsection 56(2) applies when the following conditions are met:
1. There is a payment or a transfer of property to a person other than you.
2. This payment is made at your direction, or with your concurrence.
3. There is a benefit to you, or a benefit you wish to confer on the other person.
4. You would have been taxable on the amount had you received the payment or transfer of property.
In situations where these conditions are met, subsection 56(2) will cause the amount to be taxed in your hands rather than the hands of the other person who received the amount. If subsection 56(2) applies, the amount in question will need to be added to your income; CRA will however reduce the income of the person who initially received the amount, in order to prevent double taxation.
The examples
Clear as mud so far? Let me share a few examples where 56(2) might apply.
* Sale of an asset. If you sell an asset but direct the sale proceeds to be paid to your spouse or a family member with the hope that they’ll pay the tax instead, 56(2) could apply to cause you to pay the tax anyway.
* Business income. Perhaps you own a business, provide goods and/or services to a customer, and then direct the customer to make payment to your spouse or family member and not you. Beware of 56(2).
* Rental income. If you own a rental property, or part thereof, and you instruct a tenant to make payment to your spouse, child, a charity, or some other party, subsection 56(2) could apply.
* Employment income. As an employee you could be subject to 56(2) if your employer makes a payment to one of your family members for services provided by you.
* Gifts by a corporation. Perhaps you’re a shareholder and the corporation makes a gift of cash or property to one of your family members. Subsection 56(2) could apply to tax you on the value of the gift because the gift would likely have been taxable to you as a shareholder benefit had it been made to you.
* Property sold to family. If you’re a shareholder and your corporation sells an asset to a family member at an amount below fair market value subsection, 56(2) could apply.
* Dividends paid to shareholders. Consider a situation where dividends are paid to a shareholder who is not entitled to receive dividends and/or you had a pre-existing right to dividends. Or where you might waive your dividend entitlement for the purpose of transferring income to other shareholders. Subsection 56(2) could apply to tax you on those amounts.
Now you get the drift. Subsection 56(2) is not to be confused with the other attribution rules in our tax law that can cause investment income to be taxed in your hands when you give or lend investment assets to a family member. This provision is broader. It can even apply to tax you on payments made to unrelated third parties.
The solutions
You should note that there’s often a way to accomplish the same tax savings without triggering 56(2).
This might mean receiving a payment yourself and then paying a deductible amount to a family member, properly transferring an asset to your spouse or child to allow them to pay tax on a sale later, restructuring your employment contract to allow payments to an assistant who might be a family member, or revising the terms of your company’s share classes to allow a more flexible sprinkling of dividends, among other ideas.
It’s also worth noting that there’s an exception for the splitting of CPP benefits, which is specifically allowed under our tax law.
Sunday, August 15, 2010
Business Owners: Did you ever use some income splitting techniques?
below is a great article written by BDO Canada, Chartered Accountants.
Family income splitting
The following opportunities exist to split income with other members of your family:
Make an interest-free loan to your spouse or children for investment purposes.
Under the attribution rules, income earned by your spouse or child on the funds will be taxed in your hands, just as it would have been had you not made the loan. However, that income becomes their property and can be reinvested without further attribution. Over time, family members can build up a large pool of funds which earn income taxed in their hands. Be sure to deposit the income in a separate bank account so that it can be properly tracked and separated from the funds advanced as a loan. Also, you may want to consider setting up a trust to manage the funds if minor children are involved.
The attribution rules do not apply to loans that bear interest at the prescribed rate—an interest rate set quarterly by the Canada Revenue Agency (CRA) that approximates short-term Treasury Bill rates. If you loan funds to your spouse or child and the funds are invested so that the rate of return is higher than the prescribed rate, the excess income will be taxed in their hands. Note that interest on the loan must be paid no later than 30 days after the end of the year. Where the interest is not paid on time once, the loan will be subject to the attribution rules until repaid. The interest rate on the loan does not have to be adjusted each time the prescribed rate changes.
Loan funds to family members other than your spouse to invest in assets that produce capital gains.
Consider loaning funds interest-free to low-income family members other than your spouse. They can use the funds to purchase investments with low returns, but with the potential to produce capital gains. Capital gains arising on these investments will not be subject to attribution.
Many mutual funds invest in growth stocks with low dividend rates. Such investments are well-suited for this plan, as any distribution from these funds are often a distribution of capital gains.
If a child’s in-trust account or a trust for the child has investments with accrued gains, consider triggering these gains each year to the extent the child’s personal exemptions are not otherwise utilized. This will help ensure that the child won’t have a large gain that will be taxed at some point in the future.
Make gifts to adult family members.
If you support adult family members, such as children at university or elderly parents, consider giving them assets which they can invest to earn their own income. The income will be taxed in their hands, not yours, and they’ll have more after-tax funds than if you had earned the income and paid their expenses.
This situation can arise where an adult child needs money for his or her education, or where your parents are dependent on you for support. Bear in mind that a gift means you give up control of the asset. If making gifts to low-income parents, you may want to ensure that the assets will be left to you in their wills. Also, if you give property other than cash to any relative, you’re deemed to dispose of it at fair market value, which could result in a taxable capital gain.
Ensure the high-income spouse pays all family expenses, while the low-income spouse saves.
Often, both spouses contribute equally to household expenses, where each have a source of income. This may seem fair and reasonable, but it’s poor tax planning. To the maximum extent possible, the low-income spouse’s salary and other earnings should be saved for investment purposes, while the higher income spouse pays for expenses such as food, clothing, mortgage payments etc. You can even pay your spouse’s taxes. This ensures that the family’s total investment income is taxed at the lowest possible rate.
Loan or give funds to family members to purchase a principal residence.
If you support a child in residence at university or pay rent for elderly parents, consider loaning or giving them funds to purchase a separate residence. This will reduce your investment income subject to tax and, since the funds aren’t earning income, there’s no attribution. Also, if the property increases in value, the family member may be able to use the principal residence exemption.
Invest the Child Tax Benefit and the Universal Child Care Benefit in the name of your children.
The Child Tax Benefit is based on family income. Consequently, higher income families do not qualify for the benefit. The Universal Child Care Benefit is available to all parents for children under the age of six and is paid in instalments of $100 per month per child. To the extent that you receive these benefits, you should invest the funds in a separate account in trust for your children. Investment income on these funds will not be attributed to you.
Invest inheritances for the benefit of your children.
If your child inherits money, make sure that you segregate these funds and invest them in the name of the child. If you or your spouse will inherit funds from a relative you can split income from that inheritance as well, if your relative names your child as a beneficiary. Keep in mind that if a child’s inheritance from a relative, that is not their parent, includes shares of a private company, the dividends will likely be subject to the kiddie tax (which we discuss later in the section entitled “Income splitting through corporations”).
Treat educational support to your spouse as a loan.
If you’re supporting your spouse while he or she is in attendance at a school, college or university and the spouse is expected to eventually be the high-income earner, treat the amounts spent on his or her education as a loan. Later, when the individual earns income, the amount can be repaid to you for investment purposes. You should document the amounts spent and have a written loan agreement.
Shift assets between spouses.
The attribution rules don’t apply if you transfer assets to your spouse in return for assets of equal value. If your spouse has non-income-producing property (i.e. such as a cottage), consider purchasing these assets for cash (or other income-producing assets) at their fair market value. You and your spouse can continue to enjoy the assets, as your spouse earns income from the funds.
Usually, assets can be exchanged between spouses with no tax consequences. However, to avoid attribution, you and your spouse must elect to have the sale occur at fair market value. If the assets transferred have accrued gains, a capital gain will result. If the election is made, any future income or capital gains on the income-producing property would not be attributed back to the transferring spouse.
Contribute to a Registered Education Savings Plan (RESP).
An RESP is a vehicle through which you can defer taxes, split income with your children and save towards their post-secondary education all at the same time. Unlike a Registered Retirement Savings Plan (RRSP), contributions to the plan are not deductible. However, income earned in the plan is not taxed until distributed as educational assistance payments to someone named by you as a beneficiary under the plan. At such time, the income is taxable in the hands of the recipient, presumably at a lower rate, and the original contributions are returned tax-free.
Before the 2007 Federal budget, you were allowed to contribute up to $4,000 annually to an RESP – with a cumulative lifetime contribution limit of $42,000. Changes announced in the 2007 Federal budget eliminated the $4,000 annual RESP contribution limit and the lifetime RESP contribution limit was increased to $50,000. What this means is that you can contribute $50,000 immediately to an RESP. Note that if more than one plan has been set up for a particular beneficiary, you and the other contributors must share the contribution limit. The plan itself must be wound up after 25 years.
There are two types of plans—individual plans and group plans. In addition, there are two kinds of individual plans – non-family plans and family plans. A non-family plan is a plan you set up for just one beneficiary, and there are no restrictions on who can be a beneficiary of such plan. A family plan can have more than one beneficiary; however, each beneficiary must be connected by blood or adoption to each living subscriber under the plan or have been connected to a deceased original subscriber.
A group plan (also referred to as a pooled plan or a scholarship plan), is a set of individual non-family plans that are administered based on a specific age group. Individual plans are more flexible, as they give the contributor more control over the investments made and the timing and amount of educational assistance payments made to beneficiaries. It is important to review all plans carefully to fully understand the provisions of the plan in the event that beneficiaries do not attend college or university within the required time period.
An added benefit of using an RESP is the Canada Education Savings Grant (CESG). The CESG is a federal grant that is added to your eligible contributions. Changes in the 2007 Federal budget increased the maximum annual RESP contribution qualifying for the 20% CESG to $2,500 from $2,000, which increases the maximum annual CESG per beneficiary for 2007 and subsequent years to $500 from $400. Similarly, the maximum CESG for a year has been increased to $1,000 from $800 if there is unused grant room because of contributions of less than the maximum amount in previous years. It is worth noting that the $7,200 lifetime CESG limit is unaffected by these changes.
Despite these beneficial changes, it may still make sense to use both an RESP and an “in-trust” account when saving for a child’s education. For more information, see Are You Getting a Passing Grade on Education Savings? in the 2008-01 issue of The Tax Factor.
Pay your spouse’s interest-bearing debts.
If your spouse has incurred interest-bearing debts such as a car loan, consider paying off these debts on behalf of your spouse. The reduction in interest expense is not subject to attribution. Your spouse will then have more funds to invest in the future.
Note that this plan does not work if the debts were incurred to acquire income-producing properties. If you pay off these debts, any income from the properties will attribute to you.
Provide for a testamentary trust in your will.
Rather than leaving your estate directly to your spouse, children or other dependants, consider leaving some funds in a testamentary trust for the benefit of these individuals. A testamentary trust pays tax as though it were an individual. Income from the funds will be taxed in the trust and will thereby benefit from an additional set of lower marginal tax rates. It is even possible to set up multiple testamentary trusts under your will, one for each beneficiary, which can multiply the availability of lower marginal tax rates on the income earned by the assets in your estate. The capital and after-tax income can be distributed over time to your beneficiaries free of tax. Your BDO advisor can help you select the method which best suits your needs and can assist you in other areas of estate planning.
Business income splitting
If you carry on a business, other income splitting opportunities are available to you:
Make your spouse a partner of your unincorporated business.
If you operate an unincorporated business in which your spouse is active, you may be able to establish that he or she is your partner, eligible to share in the profits or losses of the business. To be considered a bona fide partner, your spouse must either devote a significant amount of his or her time, specified skills, or training to the business or must have invested his or her own property in the business. You must ensure that your spouse’s share of income is reasonable compared with the amount of work or capital put into the business. A partnership agreement is recommended.
Pay your spouse and children a salary.
If your spouse or children work in your business, consider paying them a salary. The salary must be reasonable given the services performed. A good rule of thumb is to pay them what you would have paid a third party for the same services. A record should be kept of the time actually spent and the services actually performed.
When you pay salaries to your spouse or children, you usually must make withholdings for income tax, Canada/Quebec Pension Plan (for individuals over 18 years of age) and any applicable provincial payroll taxes. There will generally be no liability for employment insurance on remuneration paid to members of your family.
Pay your spouse a director’s fee.
If your spouse is a director of your corporation, consider paying your spouse a director’s fee for services performed. A director’s services usually include attending directors’ meetings, directing the management and affairs of the business, approving financial statements, declaring dividends, approving changes to share capital and electing officers of the company. Note that your spouse will also be jointly liable with the other directors for the fulfillment of certain regulatory requirements, such as salary withholdings and GST collections.
Pay a guarantee fee to your spouse.
If your spouse is required to pledge assets or to otherwise guarantee a business loan, he or she can be paid a fee by the business.
Again, the amount paid must be reasonable in the circumstances. In determining reasonableness, one would look at the amount of the loan, subsequent ability of the business to repay the loan and the amount that would have otherwise been paid to an arm’s-length party to guarantee the loan. The fee will also help in establishing deductibility of the loan for your spouse, should the debt become bad and the guarantee ever be called.
Loan funds to your spouse to start-up a business.
Only income from property is subject to attribution. Income from a business is not. If your spouse has a promising business venture, you can provide interest-free financing without any attribution. If the venture is risky, you should consider that an interest-free loan would not qualify for capital loss treatment should the venture fail. If this is the case, you might want to make a capital contribution to the business as a partner and share in the start-up loss. When the business becomes profitable, you can make interest-free loans to the business for further expansion. A gift could also be used to finance a new venture. Your spouse’s share of profits from the venture can be invested by your spouse and would not be subject to income attribution.
Income splitting through corporations
In the past, income splitting was possible with all members of your family through your corporation by issuing shares to your spouse and children, as long as you were careful to overcome certain obstacles. Dividends paid by the corporation to the shareholders would be taxed in their hands, provided you did not give or loan them the funds interest-free to acquire the shares. However, with the introduction of the kiddie tax, the government created yet another obstacle when it comes to income splitting with minor children. In order to implement a corporate income splitting plan that is successful, you must be aware of all of the obstacles that prevent income splitting.
The first obstacle is a set of rules commonly referred to as the corporate attribution rules. Without these rules, you could avoid attribution by simply making interest-free loans to a corporation where your spouse and children are shareholders, instead of directly to them. The corporate attribution rules provide that, if you make a low-interest or interest-free loan or transfer any property to a corporation with the main purpose of reducing your income and benefiting your spouse or minor children, you are deemed to receive interest on the loan or the value of the property transferred at the CRA’s prescribed rate. This income inclusion to you is reduced by any interest, by 5/4ths of any ineligible dividends and 145% of any eligible dividends you actually receive from the corporation. This deemed interest arises even if no income is earned by the corporation and no dividends are paid to your spouse or children. Consequently, it is a penalty provision that should be avoided.
The rules do not apply during any period that the corporation is a small business corporation (SBC). An SBC is a Canadian-controlled private corporation (CCPC) in which at least 90% of the assets (on a fair market value basis) are used in operating an active business in Canada. Therefore, as long as your corporation carries on business and does not accumulate significant investment assets, your spouse and children, particularly those 18 years of age and older, can be a shareholder and receive dividends.
The second obstacle is the kiddie tax, which prevents the transfer of income from high-income individuals to their children under the age of 18. Rather than redirecting income and taxing it in the hands of the high-income family member, the rules provide for a tax on minors who receive income under an income splitting arrangement.
Beginning in the year 2000, minor children are taxed at the top federal personal tax rate on dividends or business income received from a family business.
Specifically, this tax will apply on the following sources of income:
Taxable dividends received directly by a minor, or indirectly through a trust or partnership. Dividends from publicly traded corporations are excluded.
Income inclusions required under the Income Tax Act, in respect of the ownership by any person of shares of the capital stock of a corporation. Shares of a class listed on a prescribed stock exchange are excluded.
Business income from a partnership or trust, where the income is from property (prior to 2003, this reference was to goods) or services provided to, or in support of, a business carried on by:
a person related to the minor, including a relative who is a partner of the partnership earning business income, a corporation where a relative of the minor owns 10% or more of the corporation’s shares, or a professional corporation where a relative of the minor is a shareholder.
The reference to business income earned in support of another business carried on by a relative appears to be designed to prevent you from having your management company or partnership bill third parties directly, rather than your own business, for services rendered. Generally effective for 2003 and subsequent years, the government has proposed to extend the income splitting tax to catch rental or interest income earned by a trust or partnership from a family business and received by minor children.
Personal tax credits cannot be claimed to reduce this tax. However, the minor will be allowed to claim the dividend tax credits and foreign tax credits, where applicable, to reduce the tax.
Although limited, there are some exceptions to the kiddie tax:
the tax will not apply where both of the minor’s parents are non-residents of Canada, the tax will not apply on income from property inherited from a parent, and
if the child is going to college or university, or is disabled, income from property inherited from others won’t be subject to the tax. With the tax on minor children, it is difficult to achieve business income splitting through a corporation with minor children. However, income splitting with your spouse and children who are 18 years of age and older is alive and well. In a typical corporate income splitting arrangement, shares with nominal value are issued to the spouse and children. Dividends are later paid on these shares as income is earned by the corporation. The dividends paid often exceed the amount paid for the shares. Since different classes of shares are usually issued to different family members, it’s possible to determine the dividend amount to each person to minimize tax. (Note that the dividends paid to minor children will now be subject to the income splitting tax.)
This process, called “dividend sprinkling”, was the subject of a 1990 Supreme Court case (The Queen v. McClurg). The following guidelines were drawn from the outcome of that case:
1.If you’re setting up multiple classes of shares, you should ensure each class is different in some respect from the others—for example, one class of shares can be voting while the others are not, some shares can share in growth while other shares are redeemable at a set price. By varying the attributes of the shares, it is possible to have several unique classes of shares.
2.Fair market value consideration must be paid by your family members in exchange for the shares issued. This may be difficult if the shares have high value and the family members have no independent source of funds. Income splitting arrangements are often accompanied by a “freeze” in the value of the company. This is accomplished by having the owner-manager exchange their common shares for preferred shares having a redemption amount equal to the value of the company. Provided the preferred shares have attributes that support this fair market value, any new common shares issued should then have only a nominal value.
3.Each shareholder should pay for the shares using his or her own funds and not funds provided by the owner-manager.
If you have an existing income splitting plan that involves minor children, the kiddie tax will generally now make the payment of dividends to these children unattractive. The best way to optimize your current income splitting plan is to reinvest as much money as possible, that was accumulated in the past under your plan, for the benefit of your child. Your BDO advisor also has other more sophisticated income splitting strategies that might make sense for you.
Corporate income splitting is still very much an option with your spouse and children who are 18 years of age and older. Remember to consider the corporate attribution rules where a spouse will be a shareholder. Great care is required when developing a corporate income splitting plan and your BDO tax advisor should be consulted prior to undertaking any arrangement.
Family income splitting
The following opportunities exist to split income with other members of your family:
Make an interest-free loan to your spouse or children for investment purposes.
Under the attribution rules, income earned by your spouse or child on the funds will be taxed in your hands, just as it would have been had you not made the loan. However, that income becomes their property and can be reinvested without further attribution. Over time, family members can build up a large pool of funds which earn income taxed in their hands. Be sure to deposit the income in a separate bank account so that it can be properly tracked and separated from the funds advanced as a loan. Also, you may want to consider setting up a trust to manage the funds if minor children are involved.
The attribution rules do not apply to loans that bear interest at the prescribed rate—an interest rate set quarterly by the Canada Revenue Agency (CRA) that approximates short-term Treasury Bill rates. If you loan funds to your spouse or child and the funds are invested so that the rate of return is higher than the prescribed rate, the excess income will be taxed in their hands. Note that interest on the loan must be paid no later than 30 days after the end of the year. Where the interest is not paid on time once, the loan will be subject to the attribution rules until repaid. The interest rate on the loan does not have to be adjusted each time the prescribed rate changes.
Loan funds to family members other than your spouse to invest in assets that produce capital gains.
Consider loaning funds interest-free to low-income family members other than your spouse. They can use the funds to purchase investments with low returns, but with the potential to produce capital gains. Capital gains arising on these investments will not be subject to attribution.
Many mutual funds invest in growth stocks with low dividend rates. Such investments are well-suited for this plan, as any distribution from these funds are often a distribution of capital gains.
If a child’s in-trust account or a trust for the child has investments with accrued gains, consider triggering these gains each year to the extent the child’s personal exemptions are not otherwise utilized. This will help ensure that the child won’t have a large gain that will be taxed at some point in the future.
Make gifts to adult family members.
If you support adult family members, such as children at university or elderly parents, consider giving them assets which they can invest to earn their own income. The income will be taxed in their hands, not yours, and they’ll have more after-tax funds than if you had earned the income and paid their expenses.
This situation can arise where an adult child needs money for his or her education, or where your parents are dependent on you for support. Bear in mind that a gift means you give up control of the asset. If making gifts to low-income parents, you may want to ensure that the assets will be left to you in their wills. Also, if you give property other than cash to any relative, you’re deemed to dispose of it at fair market value, which could result in a taxable capital gain.
Ensure the high-income spouse pays all family expenses, while the low-income spouse saves.
Often, both spouses contribute equally to household expenses, where each have a source of income. This may seem fair and reasonable, but it’s poor tax planning. To the maximum extent possible, the low-income spouse’s salary and other earnings should be saved for investment purposes, while the higher income spouse pays for expenses such as food, clothing, mortgage payments etc. You can even pay your spouse’s taxes. This ensures that the family’s total investment income is taxed at the lowest possible rate.
Loan or give funds to family members to purchase a principal residence.
If you support a child in residence at university or pay rent for elderly parents, consider loaning or giving them funds to purchase a separate residence. This will reduce your investment income subject to tax and, since the funds aren’t earning income, there’s no attribution. Also, if the property increases in value, the family member may be able to use the principal residence exemption.
Invest the Child Tax Benefit and the Universal Child Care Benefit in the name of your children.
The Child Tax Benefit is based on family income. Consequently, higher income families do not qualify for the benefit. The Universal Child Care Benefit is available to all parents for children under the age of six and is paid in instalments of $100 per month per child. To the extent that you receive these benefits, you should invest the funds in a separate account in trust for your children. Investment income on these funds will not be attributed to you.
Invest inheritances for the benefit of your children.
If your child inherits money, make sure that you segregate these funds and invest them in the name of the child. If you or your spouse will inherit funds from a relative you can split income from that inheritance as well, if your relative names your child as a beneficiary. Keep in mind that if a child’s inheritance from a relative, that is not their parent, includes shares of a private company, the dividends will likely be subject to the kiddie tax (which we discuss later in the section entitled “Income splitting through corporations”).
Treat educational support to your spouse as a loan.
If you’re supporting your spouse while he or she is in attendance at a school, college or university and the spouse is expected to eventually be the high-income earner, treat the amounts spent on his or her education as a loan. Later, when the individual earns income, the amount can be repaid to you for investment purposes. You should document the amounts spent and have a written loan agreement.
Shift assets between spouses.
The attribution rules don’t apply if you transfer assets to your spouse in return for assets of equal value. If your spouse has non-income-producing property (i.e. such as a cottage), consider purchasing these assets for cash (or other income-producing assets) at their fair market value. You and your spouse can continue to enjoy the assets, as your spouse earns income from the funds.
Usually, assets can be exchanged between spouses with no tax consequences. However, to avoid attribution, you and your spouse must elect to have the sale occur at fair market value. If the assets transferred have accrued gains, a capital gain will result. If the election is made, any future income or capital gains on the income-producing property would not be attributed back to the transferring spouse.
Contribute to a Registered Education Savings Plan (RESP).
An RESP is a vehicle through which you can defer taxes, split income with your children and save towards their post-secondary education all at the same time. Unlike a Registered Retirement Savings Plan (RRSP), contributions to the plan are not deductible. However, income earned in the plan is not taxed until distributed as educational assistance payments to someone named by you as a beneficiary under the plan. At such time, the income is taxable in the hands of the recipient, presumably at a lower rate, and the original contributions are returned tax-free.
Before the 2007 Federal budget, you were allowed to contribute up to $4,000 annually to an RESP – with a cumulative lifetime contribution limit of $42,000. Changes announced in the 2007 Federal budget eliminated the $4,000 annual RESP contribution limit and the lifetime RESP contribution limit was increased to $50,000. What this means is that you can contribute $50,000 immediately to an RESP. Note that if more than one plan has been set up for a particular beneficiary, you and the other contributors must share the contribution limit. The plan itself must be wound up after 25 years.
There are two types of plans—individual plans and group plans. In addition, there are two kinds of individual plans – non-family plans and family plans. A non-family plan is a plan you set up for just one beneficiary, and there are no restrictions on who can be a beneficiary of such plan. A family plan can have more than one beneficiary; however, each beneficiary must be connected by blood or adoption to each living subscriber under the plan or have been connected to a deceased original subscriber.
A group plan (also referred to as a pooled plan or a scholarship plan), is a set of individual non-family plans that are administered based on a specific age group. Individual plans are more flexible, as they give the contributor more control over the investments made and the timing and amount of educational assistance payments made to beneficiaries. It is important to review all plans carefully to fully understand the provisions of the plan in the event that beneficiaries do not attend college or university within the required time period.
An added benefit of using an RESP is the Canada Education Savings Grant (CESG). The CESG is a federal grant that is added to your eligible contributions. Changes in the 2007 Federal budget increased the maximum annual RESP contribution qualifying for the 20% CESG to $2,500 from $2,000, which increases the maximum annual CESG per beneficiary for 2007 and subsequent years to $500 from $400. Similarly, the maximum CESG for a year has been increased to $1,000 from $800 if there is unused grant room because of contributions of less than the maximum amount in previous years. It is worth noting that the $7,200 lifetime CESG limit is unaffected by these changes.
Despite these beneficial changes, it may still make sense to use both an RESP and an “in-trust” account when saving for a child’s education. For more information, see Are You Getting a Passing Grade on Education Savings? in the 2008-01 issue of The Tax Factor.
Pay your spouse’s interest-bearing debts.
If your spouse has incurred interest-bearing debts such as a car loan, consider paying off these debts on behalf of your spouse. The reduction in interest expense is not subject to attribution. Your spouse will then have more funds to invest in the future.
Note that this plan does not work if the debts were incurred to acquire income-producing properties. If you pay off these debts, any income from the properties will attribute to you.
Provide for a testamentary trust in your will.
Rather than leaving your estate directly to your spouse, children or other dependants, consider leaving some funds in a testamentary trust for the benefit of these individuals. A testamentary trust pays tax as though it were an individual. Income from the funds will be taxed in the trust and will thereby benefit from an additional set of lower marginal tax rates. It is even possible to set up multiple testamentary trusts under your will, one for each beneficiary, which can multiply the availability of lower marginal tax rates on the income earned by the assets in your estate. The capital and after-tax income can be distributed over time to your beneficiaries free of tax. Your BDO advisor can help you select the method which best suits your needs and can assist you in other areas of estate planning.
Business income splitting
If you carry on a business, other income splitting opportunities are available to you:
Make your spouse a partner of your unincorporated business.
If you operate an unincorporated business in which your spouse is active, you may be able to establish that he or she is your partner, eligible to share in the profits or losses of the business. To be considered a bona fide partner, your spouse must either devote a significant amount of his or her time, specified skills, or training to the business or must have invested his or her own property in the business. You must ensure that your spouse’s share of income is reasonable compared with the amount of work or capital put into the business. A partnership agreement is recommended.
Pay your spouse and children a salary.
If your spouse or children work in your business, consider paying them a salary. The salary must be reasonable given the services performed. A good rule of thumb is to pay them what you would have paid a third party for the same services. A record should be kept of the time actually spent and the services actually performed.
When you pay salaries to your spouse or children, you usually must make withholdings for income tax, Canada/Quebec Pension Plan (for individuals over 18 years of age) and any applicable provincial payroll taxes. There will generally be no liability for employment insurance on remuneration paid to members of your family.
Pay your spouse a director’s fee.
If your spouse is a director of your corporation, consider paying your spouse a director’s fee for services performed. A director’s services usually include attending directors’ meetings, directing the management and affairs of the business, approving financial statements, declaring dividends, approving changes to share capital and electing officers of the company. Note that your spouse will also be jointly liable with the other directors for the fulfillment of certain regulatory requirements, such as salary withholdings and GST collections.
Pay a guarantee fee to your spouse.
If your spouse is required to pledge assets or to otherwise guarantee a business loan, he or she can be paid a fee by the business.
Again, the amount paid must be reasonable in the circumstances. In determining reasonableness, one would look at the amount of the loan, subsequent ability of the business to repay the loan and the amount that would have otherwise been paid to an arm’s-length party to guarantee the loan. The fee will also help in establishing deductibility of the loan for your spouse, should the debt become bad and the guarantee ever be called.
Loan funds to your spouse to start-up a business.
Only income from property is subject to attribution. Income from a business is not. If your spouse has a promising business venture, you can provide interest-free financing without any attribution. If the venture is risky, you should consider that an interest-free loan would not qualify for capital loss treatment should the venture fail. If this is the case, you might want to make a capital contribution to the business as a partner and share in the start-up loss. When the business becomes profitable, you can make interest-free loans to the business for further expansion. A gift could also be used to finance a new venture. Your spouse’s share of profits from the venture can be invested by your spouse and would not be subject to income attribution.
Income splitting through corporations
In the past, income splitting was possible with all members of your family through your corporation by issuing shares to your spouse and children, as long as you were careful to overcome certain obstacles. Dividends paid by the corporation to the shareholders would be taxed in their hands, provided you did not give or loan them the funds interest-free to acquire the shares. However, with the introduction of the kiddie tax, the government created yet another obstacle when it comes to income splitting with minor children. In order to implement a corporate income splitting plan that is successful, you must be aware of all of the obstacles that prevent income splitting.
The first obstacle is a set of rules commonly referred to as the corporate attribution rules. Without these rules, you could avoid attribution by simply making interest-free loans to a corporation where your spouse and children are shareholders, instead of directly to them. The corporate attribution rules provide that, if you make a low-interest or interest-free loan or transfer any property to a corporation with the main purpose of reducing your income and benefiting your spouse or minor children, you are deemed to receive interest on the loan or the value of the property transferred at the CRA’s prescribed rate. This income inclusion to you is reduced by any interest, by 5/4ths of any ineligible dividends and 145% of any eligible dividends you actually receive from the corporation. This deemed interest arises even if no income is earned by the corporation and no dividends are paid to your spouse or children. Consequently, it is a penalty provision that should be avoided.
The rules do not apply during any period that the corporation is a small business corporation (SBC). An SBC is a Canadian-controlled private corporation (CCPC) in which at least 90% of the assets (on a fair market value basis) are used in operating an active business in Canada. Therefore, as long as your corporation carries on business and does not accumulate significant investment assets, your spouse and children, particularly those 18 years of age and older, can be a shareholder and receive dividends.
The second obstacle is the kiddie tax, which prevents the transfer of income from high-income individuals to their children under the age of 18. Rather than redirecting income and taxing it in the hands of the high-income family member, the rules provide for a tax on minors who receive income under an income splitting arrangement.
Beginning in the year 2000, minor children are taxed at the top federal personal tax rate on dividends or business income received from a family business.
Specifically, this tax will apply on the following sources of income:
Taxable dividends received directly by a minor, or indirectly through a trust or partnership. Dividends from publicly traded corporations are excluded.
Income inclusions required under the Income Tax Act, in respect of the ownership by any person of shares of the capital stock of a corporation. Shares of a class listed on a prescribed stock exchange are excluded.
Business income from a partnership or trust, where the income is from property (prior to 2003, this reference was to goods) or services provided to, or in support of, a business carried on by:
a person related to the minor, including a relative who is a partner of the partnership earning business income, a corporation where a relative of the minor owns 10% or more of the corporation’s shares, or a professional corporation where a relative of the minor is a shareholder.
The reference to business income earned in support of another business carried on by a relative appears to be designed to prevent you from having your management company or partnership bill third parties directly, rather than your own business, for services rendered. Generally effective for 2003 and subsequent years, the government has proposed to extend the income splitting tax to catch rental or interest income earned by a trust or partnership from a family business and received by minor children.
Personal tax credits cannot be claimed to reduce this tax. However, the minor will be allowed to claim the dividend tax credits and foreign tax credits, where applicable, to reduce the tax.
Although limited, there are some exceptions to the kiddie tax:
the tax will not apply where both of the minor’s parents are non-residents of Canada, the tax will not apply on income from property inherited from a parent, and
if the child is going to college or university, or is disabled, income from property inherited from others won’t be subject to the tax. With the tax on minor children, it is difficult to achieve business income splitting through a corporation with minor children. However, income splitting with your spouse and children who are 18 years of age and older is alive and well. In a typical corporate income splitting arrangement, shares with nominal value are issued to the spouse and children. Dividends are later paid on these shares as income is earned by the corporation. The dividends paid often exceed the amount paid for the shares. Since different classes of shares are usually issued to different family members, it’s possible to determine the dividend amount to each person to minimize tax. (Note that the dividends paid to minor children will now be subject to the income splitting tax.)
This process, called “dividend sprinkling”, was the subject of a 1990 Supreme Court case (The Queen v. McClurg). The following guidelines were drawn from the outcome of that case:
1.If you’re setting up multiple classes of shares, you should ensure each class is different in some respect from the others—for example, one class of shares can be voting while the others are not, some shares can share in growth while other shares are redeemable at a set price. By varying the attributes of the shares, it is possible to have several unique classes of shares.
2.Fair market value consideration must be paid by your family members in exchange for the shares issued. This may be difficult if the shares have high value and the family members have no independent source of funds. Income splitting arrangements are often accompanied by a “freeze” in the value of the company. This is accomplished by having the owner-manager exchange their common shares for preferred shares having a redemption amount equal to the value of the company. Provided the preferred shares have attributes that support this fair market value, any new common shares issued should then have only a nominal value.
3.Each shareholder should pay for the shares using his or her own funds and not funds provided by the owner-manager.
If you have an existing income splitting plan that involves minor children, the kiddie tax will generally now make the payment of dividends to these children unattractive. The best way to optimize your current income splitting plan is to reinvest as much money as possible, that was accumulated in the past under your plan, for the benefit of your child. Your BDO advisor also has other more sophisticated income splitting strategies that might make sense for you.
Corporate income splitting is still very much an option with your spouse and children who are 18 years of age and older. Remember to consider the corporate attribution rules where a spouse will be a shareholder. Great care is required when developing a corporate income splitting plan and your BDO tax advisor should be consulted prior to undertaking any arrangement.
Tuesday, August 10, 2010
Holding companies have their benefits - Tax-free dividends, creditor protection among them
Today I would like to share an excellent article written by Tim Cesnick published in the Globe and Mail.
When you understand the rules of the game, you can make them work to your advantage.
I think of Roger Neilson, former National Hockey League coach, who also coached the Peterborough Petes when my brother-in-law played for the team years ago. Mr. Neilson knew the rules of the game better than anyone. On one occasion, when the opposition was awarded a penalty shot, he pulled his goalie and put a defenceman in net. When the opposing player picked up the puck at centre ice, the defenceman came rushing out of the net and hit the confused shooter. No goal. Hey, there was nothing in the rules to stop this type of tactic. Well, not at that time. The rulebook has since been changed. Mr. Neilson was probably responsible for more changes to the rulebook than any single coach.
Things are no different in tax planning. If you know the rules, you can use them to your advantage. For those who are business owners, taking advantage of tax law will mean setting up a holding company in most cases. Today, I want to talk about the benefits of a holding company.
The story
Gord is a business owner who established a holding company (Holdco) several years ago. Holdco, in turn, owns all the shares of Gord's operating company (Opco), which carries on an active business - he distributes light fixtures.
Gord pays part of the earnings of Opco to Holdco as a dividend each year. This is generally a tax-free, intercorporate dividend. Gord then uses that money to invest in other things, such as real estate, marketable securities, and other private businesses. If Opco needs more cash for any reason, Gord can arrange for Holdco to lend the money to Opco.
Gord also pays income out of Holdco to himself, and other family members, each year.
The benefits
Gord enjoys a number of benefits:
Tax-free dividends. Dividends paid by an operating subsidiary (Opco) to the parent holding company (Holdco) in Canada are generally tax-free dividends to Holdco. Tax free is always good.
Creditor protection. Because Gord has excess earnings in Opco each year, he pays the excess to Holdco as a tax-free dividend, which protects those earnings from creditors of Opco. If necessary, he can lend that money back to Opco on a secured basis to retain that protection from creditors.
Efficient reinvestment. Gord has been reinvesting some of Opco's excess earnings in other assets to diversify his holdings. He does this by paying tax-free dividends from Opco to Holdco and then having Holdco make those other investments. If he paid the excess earnings from Opco to himself, personally, to make those investments, he would pay tax first, leaving less to reinvest. As it stands, Holdco filters out that layer of tax, making reinvestment tax efficient.
Income splitting. Gord is able to pay income to his wife and children each year so that some of the earnings are taxed in their hands, not his. The income can be in the form of salary (if the relative is doing work of some kind), or dividends, among other things. Because Gord's children have very little other income, they'll pay no tax at all on the income he pays to them. You do have to be aware that dividends paid to minors (perhaps through a trust) will be taxed at the highest marginal tax rate. But once the kids reach age 18, they can receive up to about $40,000 (it varies by province) each year in Canadian dividends virtually tax free.
Timing income. Think of Holdco as a private pension in many ways. Gord can draw money out of Holdco when he wants it. He chooses to pay himself dividends every second year rather than every year, which allows him to avoid personal tax instalments each quarter, because it's possible to base instalments on either the previous year's tax owing, or the current year's expected liability. If Gord has little or no tax liability every second year, he can base his instalments annually on the year he expects to have little income.
Avoid U.S. estate tax. Canadian residents could be subject to U.S. estate tax if they own "U.S. situs property," which includes shares in U.S. corporations, among other things. If you're otherwise subject to U.S. estate tax on those securities, you can hold those investments in a Canadian holding company to avoid the estate tax.
The addition of a holding company required professional help; hence, contact me to talk about all the pros and cons.
When you understand the rules of the game, you can make them work to your advantage.
I think of Roger Neilson, former National Hockey League coach, who also coached the Peterborough Petes when my brother-in-law played for the team years ago. Mr. Neilson knew the rules of the game better than anyone. On one occasion, when the opposition was awarded a penalty shot, he pulled his goalie and put a defenceman in net. When the opposing player picked up the puck at centre ice, the defenceman came rushing out of the net and hit the confused shooter. No goal. Hey, there was nothing in the rules to stop this type of tactic. Well, not at that time. The rulebook has since been changed. Mr. Neilson was probably responsible for more changes to the rulebook than any single coach.
Things are no different in tax planning. If you know the rules, you can use them to your advantage. For those who are business owners, taking advantage of tax law will mean setting up a holding company in most cases. Today, I want to talk about the benefits of a holding company.
The story
Gord is a business owner who established a holding company (Holdco) several years ago. Holdco, in turn, owns all the shares of Gord's operating company (Opco), which carries on an active business - he distributes light fixtures.
Gord pays part of the earnings of Opco to Holdco as a dividend each year. This is generally a tax-free, intercorporate dividend. Gord then uses that money to invest in other things, such as real estate, marketable securities, and other private businesses. If Opco needs more cash for any reason, Gord can arrange for Holdco to lend the money to Opco.
Gord also pays income out of Holdco to himself, and other family members, each year.
The benefits
Gord enjoys a number of benefits:
Tax-free dividends. Dividends paid by an operating subsidiary (Opco) to the parent holding company (Holdco) in Canada are generally tax-free dividends to Holdco. Tax free is always good.
Creditor protection. Because Gord has excess earnings in Opco each year, he pays the excess to Holdco as a tax-free dividend, which protects those earnings from creditors of Opco. If necessary, he can lend that money back to Opco on a secured basis to retain that protection from creditors.
Efficient reinvestment. Gord has been reinvesting some of Opco's excess earnings in other assets to diversify his holdings. He does this by paying tax-free dividends from Opco to Holdco and then having Holdco make those other investments. If he paid the excess earnings from Opco to himself, personally, to make those investments, he would pay tax first, leaving less to reinvest. As it stands, Holdco filters out that layer of tax, making reinvestment tax efficient.
Income splitting. Gord is able to pay income to his wife and children each year so that some of the earnings are taxed in their hands, not his. The income can be in the form of salary (if the relative is doing work of some kind), or dividends, among other things. Because Gord's children have very little other income, they'll pay no tax at all on the income he pays to them. You do have to be aware that dividends paid to minors (perhaps through a trust) will be taxed at the highest marginal tax rate. But once the kids reach age 18, they can receive up to about $40,000 (it varies by province) each year in Canadian dividends virtually tax free.
Timing income. Think of Holdco as a private pension in many ways. Gord can draw money out of Holdco when he wants it. He chooses to pay himself dividends every second year rather than every year, which allows him to avoid personal tax instalments each quarter, because it's possible to base instalments on either the previous year's tax owing, or the current year's expected liability. If Gord has little or no tax liability every second year, he can base his instalments annually on the year he expects to have little income.
Avoid U.S. estate tax. Canadian residents could be subject to U.S. estate tax if they own "U.S. situs property," which includes shares in U.S. corporations, among other things. If you're otherwise subject to U.S. estate tax on those securities, you can hold those investments in a Canadian holding company to avoid the estate tax.
The addition of a holding company required professional help; hence, contact me to talk about all the pros and cons.
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