There are a variety of ways in which business owners can use income splitting to reduce their tax bill. But one method in particular, family loans, will require owners to act quickly to maximize those savings. That is because the Canada Revenue Agency’s prescribed interest rate for these loans will increase on Oct. 1.
Income splitting involves shifting income from the hands of a family member in a higher tax bracket to those of a one in a lower bracket so that the same income is taxed at a lower rate — or not at all. The tax rules prevent many forms of income splitting but some opportunities remain.
For example, a business owner can lend his or her spouse money to invest so that any investment income is taxed at the spouse’s lower rate. You must have a written agreement specifying the terms of repayment and an interest rate at least equal to the CRA’s prescribed rate at the time. Your spouse must pay you interest on the loan each year by Jan. 30 of the following year. If the interest is not paid, the investment income resulting from the loan will be taxed in your hands.
You can lock in family loans at the CRA’s prescribed interest rate of 1% indefinitely if you finalize all arrangements before Oct. 1, when the rate increases to 2%.
Here’s how it works: You lend your spouse $100,000 before the rate change date. Under a written agreement, your spouse agrees to pay you interest at 1% a year. He or she then invests the money and earns a 3% return of $3,000 in 2013. Your spouse must pay you 1% interest on the loan, or $1,000, by Jan. 30, 2014, which will be taxed in your hands. The difference of $2,000 will be taxed in your spouse’s hands in 2013. If you are paying tax at a top marginal rate of about 45% and your spouse is paying about 25%, you’ll save 20% in tax; $400 in this example.
Investment loans can be made to other family members, including minor children by using a family trust, providing significant tax savings for your family over time.
Another way to split income is to have your company pay a salary to your spouse and children. The salary must be reasonable in light of the services they perform for the business, which might include bookkeeping, filing and other administrative work, business development planning or acting as a director for the corporation.
The CRA is flexible in interpreting what constitutes a reasonable salary, provided services are genuinely provided. You’ll need to weigh the cost of payroll taxes, Canada Pension Plan contributions and Employment Insurance premiums against the potential tax savings.
Having your spouse own shares of the corporation may also provide tax savings because he or she can receive dividends that will be taxed in his or her hands. If you eventually sell the shares and the company is a “qualified small business corporation,” both you and your spouse may be able to claim the lifetime capital gains exemption (increasing to $800,000 in 2014, from $750,000) to offset your capital gain on the sale. If your children also own shares, either directly or through a family trust, the number of exemptions available potentially increases. To be able to claim the exemption, however, the shareholder must own the qualifying shares for at least two years before the sale.
Other ways to help your lower-income spouse keep a larger portion of his or her income to invest include, you paying the household expenses such as groceries, mortgage and credit card bills; and giving your spouse up to $5,500 a year to invest in his or her Tax-Free Savings Account, provided contribution room is available in the account. (Investment income earned in the TFSA is tax-free.)
You can also directly pay your spouse’s income tax bill. Simply make sure the cheque is drawn on your own account. The funds your spouse would otherwise use to pay taxes can be invested and the income will be taxed in his or her hands.
For these ideas to work, you need to keep careful documentation. Separate bank accounts for spouses will allow you to trace each one’s funds properly. The effort it takes to keep your paperwork in order can be well worth the tax savings your family can achieve from income splitting.
Deb MacPherson is a partner with KPMG Enterprise in Calgary.