Family trusts & prescribed rate loans
Income-splitting with minors may reduce tax & maximize cash flow
A prescribed rate loan arrangement can be used by couples (spouses or common-law partners) to split their income and take advantage of any differences between their marginal income tax rates. But what about taking this strategy further? With children (potentially) returning to school in the fall and expensive extracurricular activities resuming, additional income tax savings may be realized by extending this strategy to related minors (i.e., individuals under 18 years of age). Similar to spousal loans, loans to related minors are subject to the income tax attribution rules unless the loan bears interest at, or above, the Canada Revenue Agency’s prescribed rate at the time the loan was established (currently 1% through September 30, 2020).
A family trust overview
Consider establishing a trust, subject to certain requirements and recommendations, with personal non-registered funds loaned to the trust at the prescribed rate from the higher-income-earning spouse. The trust then invests these funds and “allocates” the net investment income after the payment of the prescribed rate interest to the minor beneficiaries. These allocated funds from the trust may be utilized to pay for expenses solely and exclusively for the benefit of these beneficiaries (e.g., private school tuition, sports memberships, activities, etc.).
Allocated funds are taxed in the hands of the beneficiaries, ideally at a lower marginal income tax rate. Depending on your individual circumstances and the amounts considered, the beneficiaries may have little to no income tax liability. If structured correctly, this reduces the after-tax cost of the expenses of your minor beneficiaries and maximizes the cash flow of your family unit.
In addition, to the extent that one of the spouses is in a lower marginal income tax bracket, they may also be a beneficiary of the trust, thereby achieving the same income tax benefit as a spousal loan strategy while also income splitting with your minor beneficiaries.
This strategy has requirements similar to a spousal loan arrangement (e.g., a loan agreement and the timely payment of annual interest) as well as requiring additional steps such as setting up a formal trust, record keeping of expenses and allocations, and annual income tax filing requirements for both the trust and its beneficiaries. As such, while the income tax savings may be substantial, a full cost-benefit analysis with your professional advisors should be undertaken prior to moving forward with such a strategy.
Restructuring Prescribed Rate Loans
If you have already set up a family trust with a prescribed rate loan for income-splitting purposes, it might be time to revisit this arrangement to the extent the loan was established when the prescribed rate was greater than 1%. Doing so may increase the income tax savings in your current situation. It is imperative that you obtain proper advice from your tax professional prior to restructuring any existing prescribed rate loan arrangements to ensure that a prudent approach is taken to abide by CRA rules.
Contact our team to discuss the potential income tax savings of setting up a family trust with a prescribed rate loan, and the suitability of this strategy for your family’s unique financial situation.