We’ve all heard about income-splitting with a spouse as a way to redirect income and reduce taxes. But many financial advisors are unaware of the methods that can be used to help high net-worth clients split income with their children or grandchildren, even those under 18.
The strategy involves the creation of a family trust and careful selection of investments. In these situations, says Armando Minicucci, principal, tax services, with Grant Thornton LLP in Toronto, the financial advisor and the accountant work together to ensure the income tax rules are followed.
Income-splitting with minor children became more difficult after 1999, when the federal government introduced the so-called “kiddie tax” rule, which, along with other attribution rules, made the practice less appealing.
The “kiddie tax” was brought in to stop income-splitting strategies between parents and children, Minicucci says, specifically, income from dividends from a private company.
So, in Ontario, for example, adults can earn up to $48,850 in eligible dividend income tax-free — if they have no other sources of income. However, this exemption doesn’t apply to a minor child, Minicucci says, negating the tax advantage.
“The ‘kiddie tax’ essentially puts the child in the same tax situation — or worse — as the parent would have been in, had the parent earned that income.”
However, there are some ways in which income can be split with a minor.
Current attribution rules state that income — either dividend or interest — from the transfer of property or a loan to a minor child is attributed back to the adult. That includes someone related to the minor by birth or adoption, including an uncle or aunt. However, Minicucci says, the rules do not apply to income in the form of capital gains.
So, take the case of a parent or grandparent who wants to ensure a method of paying for costs for the child, such as private schooling or a sports program. With the help of an advisor, the money is put into a family trust, which invests in a portfolio in which capital gains are generated.
At this point, the advisor and the accountant work together, says Minicucci: “They must be able to find investments that produce capital gains and that do not produce income or dividends, [which] would be attributable back to the parents or grandparents. That would not accomplish income-splitting.
“If [the investment] earns capital gains,” Minicucci continues, “then those capital gains are taxed in the hands of the children. The children have graduated rates, and they will pay little or no taxes on that income.”
Even more popular is the strategy in which the parent or grandparent sets up a trust for the child and gives a loan to the trust, with most of the returns generated from the portfolio going to the child. The rules for this strategy state that if the money is indeed a loan, there must be some interest paid to the parent or grandparent.
Since the second half of 2009, the Income Tax Act has set that interest rate at 1%. This idea works well for both sides: the lending parent retains control of the money and gets 1% per year in interest; the child earns any other kind of income; and overall taxes are minimized, assuming the child has little or no other income.
Minicucci gives the example of a parent loaning $100,000 to a child’s trust, and that $100,000 makes a 5% return on the year. The trust pays out $1,000 in interest to the parent. (According to the rules, this interest must be paid by Jan. 30 of the following year, and the parent would report the $1,000 on his or her income tax return.) The remaining $4,000 generated goes to the child, who, assuming the child has little other income, will pay little or no taxes.
“You have accomplished income-splitting,” Minicucci says. “And the parents still retain [control of] the original capital.”
When it comes time to dissolve the loan, the parent gets back the original $100,000.
Had that $4,000 for the child’s expenses come directly from the parents, it would have had to come from after-tax dollars. A parent living in Ontario in the 46.4% tax bracket would have had to make $7,462 before taxes to have that money to begin with. This tax bracket for 2013 in Ontario begins at $135,054 (ignoring the new Ontario 2% surtax for income earned over $509,000).
If you could take $135,054 of your income and have it taxed in your child’s hands, Minicucci says, “that could save you over $20,000 a year.”
After the child turns 18, Minicucci says, the door is open for even more lucrative income-splitting, because the kiddie tax no longer applies and parents now can pay dividends to their adult children, who are likely to pay less tax than their top tax-bracket parents.