Splitting income with Kids
Kids are expensive. Whether it’s music lessons or soccer, summer camp or even private school, parents are constantly on the lookout for ways to lessen the financial burden associated with raising children.
But what if you could pay for your kids’ expenses with virtually tax-free investment income? Turns out you can, with some proper legal and tax advice, by taking advantage of a prescribed-rate income-splitting strategy.
The general rule is that if you give your kids money to invest, any income or dividends earned from the money so invested is attributed back to you, the parent, and taxed in your hands. This is known in tax parlance as the “attribution rules,” which are designed to prevent most attempts at income splitting among family members.
When it comes to income splitting with minor kids, however, there are two important exceptions to the rule. The first one is that capital gains earned on money gifted to minor kids are not attributed back and therefore can be taxed in the kids’ hands.
But what if you want to income split interest or dividend income with your minor kids? That’s where the prescribed-rate loan strategy can be useful.
It’s generally problematic to lend funds directly to minor children so generally a formal discretionary family trust, with the minor kids as beneficiaries, can be established. Mom or dad makes a loan to the family trust at the prescribed interest rate, currently set at a record historic low of 1%. The trust invests the funds in, say, GICs, bonds or dividend-paying securities and earns an annual yield. It pays mom or dad, the lender, 1% on the loan and anything above that can be distributed from the trust to the minor kids and taxed in their hands.
If the minor child has no other income, then he or she could receive up to $10,500 of income or nearly $50,000 in Canadian dividends flowed out to him or her from the family trust completely free of any personal federal tax.
The advantage of setting up this loan today is that the Income Tax Act only requires you to use to the prescribed rate at the time the loan was originally extended. So, if you make a 20-year demand loan to the family trust by June 30, 2011, which is the next date upon which the quarterly prescribed rate could increase, you can use the 1% rate for the entire 20 years, even if the quarterly rate eventually increases in the years ahead.
The only caveat is the trust must pay the 1% interest to mom or dad by Jan. 30 of the following calendar year, otherwise the strategy falls apart for the current and all future tax years.
Finally, don’t try this on your own. There are very specific rules around how the trust must be settled so be sure to speak to your tax advisor before implementing.