In our October 18, 2012 blog “Trusts – It’s Not All About the Tax”, I discussed a few non-tax reasons to consider in setting up a trust as part of estate and wealth planning. However, sometimes the goal is to minimize tax through income-splitting. Two methods of minimizing tax exposure are using a family trust and a spousal loan.
Under Canadian tax legislation, the income of an inter-vivos trust is taxed at the highest marginal rate of tax. However, if an income-producing asset is held by an inter-vivos trust, and provided the trust is properly structured from a tax perspective, the trust’s income and capital gains may be flowed-through to the beneficiaries of the trust, and taxed in their hands at their own marginal rates. If the beneficiaries have lower tax rates, tax savings will result. Provided certain rules are followed and certain restrictions are put in place when the trust is created, the trust’s income should not be attributed back to the person who contributed the property to the trust.
If funds are loaned instead of gifted, the trust’s income should not be attributed back as long as interest on the loan is charged at least at the prescribed interest rate and paid each year on or before January 30th. The prescribed rate of interest, currently at a historical low of 1%, is a rate set by the Government of Canada and is relevant to certain tax matters and Canada Revenue Agency calculations, one of these being loans between non-arms’ length parties (such as a person who contributes property to a trust and the trust itself).
Using a loan to fund a trust with minor children or grandchildren beneficiaries who usually have a significantly lower marginal income tax rate than the person loaning the funds to the trust may be advantageous. The trust income can be flowed out to these minor beneficiaries, and used for such expenses as school tuition, education expenses, and camp fees. Each minor beneficiary will be taxed on the income used for their benefit at their lower marginal tax rate, while the income will not be attributed back to the person who loaned the funds to the trust provided the rules noted above are followed. Effectively, many expenses can be paid using before-tax dollars, not after-tax dollars.
Loans to a spouse at the prescribed interest rate can also be used to split income with a lower-earning spouse (married or common law). As long as the loan is interest-bearing at least at the prescribed interest rate, and interest is paid on the loan on or before January 30th each year, the income including capital gains earned on the loaned funds will be taxed in the hands of the lower-earning spouse, allowing for tax savings based on the difference in marginal tax rates between the spouses. This is a very attractive option to anyone with investment funds earning more than 1% whose spouse is in a lower income tax bracket than themselves.
Peace of mind comes from many places. As part of an overall plan, family trusts and spousal loans, and other available tax planning tools, can work tax-efficiently as part of your estate plan.
Look for our next blog on expatriation from U.S. citizenship – why you may want to consider it and what are the potential pitfalls.
– Susannah Roth
The comments offered in this article are meant to be general in nature, are limited to the law of Ontario, Canada, and are not intended to provide legal advice on any individual situation. Before taking any action involving your individual situation, you should seek legal advice to ensure it is appropriate to your personal circumstances.