Prescribed Rate Loans – One Last Kick at the 1% Rate

I have discussed the use of prescribed rate loans several times over the years. In this post, I will review a couple of the best ways to use these loans. However, time is now of the essence, if you wish to implement one of these loans. The current prescribed rate of 1% will be rising to 2% effective April 1st as per this Advisor.ca article and many people only see the rate slowly rising from here over the next few years.

The two most common ways to use a prescribed rate loan are:

1. A loan to a spouse as detailed in this blog post.

2. A loan to minor children using a family trust as detailed in this blog post.

To recap (read the actual posts for all the details), the Income Tax Act contains income attribution rules that typically reallocate income to the higher income earner when he or she tries to income split with his or her spouse or children. However, there is an exception to the above attribution rules where an individual makes a loan to a spouse or minor child and interest is charged on the loan at a rate at least equal to the CRA’s prescribed interest rate at the time the loan was made. The benefit is as follows:

Where the loan carries interest at a rate no less than the prescribed interest rate, the attribution rules will not apply. For the loan to avoid the income attribution rules, the interest owing must be paid each year within 30 days after the end of the year (i.e. January 30th).

For example, say you make a $100,000 loan to a spouse with minimal income. Your spouse will be required to pay you $1,000 in interest by January 30th of each year. However, if they use the loan proceeds to invest in marketable securities and they make a 6% return, or $6,000, your family will have tax savings of up to $2,700 ($6,000-1,000 x 53.5% the highest tax rate in Ontario).

Income splitting with minors can be problematic because minors generally cannot enter into an enforceable contract. Thus, it is suggested that where you make a prescribed loan to a minor, a family trust be utilized to navigate the enforceability issues.

Tax Changes to Private Corporations

As I have discussed on this blog multiple times, the government has implemented changes to the taxation of private corporations. In December they released the legislation in relation to the revised tax on split income rules . We are still waiting (likely in the budget this week) for the rules on earning passive investment income in a corporation.

To date, it does not appear that these rules will impact prescribed rate loans, subject to this weeks budget. However, before you consider implementing a prescribed rate loan, you need to discuss this issue with your accountant to ensure they are onside with the idea and that you clearly understand the requirements and changes in legislation.

Finally, it would be prudent, based on what we know, that the proceeds of these loans only be invested in public marketable securities and not in private corporations or related corporations.

If you are interested in maximizing a prescribed rate loan, you only have a few weeks to get this loan in place to beat the increase to 2%.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Confessions of a Tax Accountant -2014- Week 4

This year I am going to end my confessions series a week early. I am doing this for two reasons. Firstly, to be honest, I have not found much to write about that I have not already discussed in prior income tax seasons (other than the T1135 fiasco). Secondly, I am a little burnt out from tax season (getting a mild case of food poisoning and having your back act up never helps). So I will see you again in a couple weeks, hopefully in a better state of mind, but until then, I have a couple tips for filing your tax returns this year and some tax planning tips you should consider implementing sooner rather than later.

A Couple Final Reminders

1. File your income tax return on time (May 5th this year) to avoid the 5% late filing penalty (in addition to the 5%  penalty, there is an additional penalty of 1% a month thereafter for each month you are late - that could total 17% in total).

2. If you have to file the T1135 Foreign Reporting Form, file it as soon as it is completed. With the July 31st deadline extension, you may either complete the form and not rush to file, or put it off. However, where the form is not filed as required, the CRA can levy a penalty equal to $25 a day to a maximum of $2,500.

Tax Planning for 2014

 

While taxes are on your mind, you may want to consider some tax planning you can undertake now or plan to undertake in 2014.

Prescribed Rate Loans

 

If you are lucky enough to have significant non-registered assets and your spouse is in a low marginal tax rate or does not earn any income, you may wish to consider a prescribed interest loan to your spouse before June 30, 2014. Essentially, you can make a loan at 1% until June 30, 2014 (at which time the prescribed rate may or may not change) and that rate of interest remains for the life of the loan. Thus, as long as your spouse can earn greater than 1% a year on those funds, you have benefited from income splitting. As discussed below, there are interest payment requirements that must be met. Here are three prior posts I have written on this topic:

1. 1% Prescribed Interest Rate Loan - A Great Income Splitting Opportunity - A good overview.

2. Paying for Private School With Tax-Free Money -  A discussion about using a prescribed loan to fund your child's education. You need to read this one in conjunction with the third post.

3. Prescribed Rate Loans Using a Family Trust - Again, you need some large coin to do this, probably at minimum a few hundred thousand in non-registered accounts, but very effective if you have the money.

Transferring Capital Losses Amongst Spouses

 

If you or your spouse have any unused capital losses after preparing your 2013 tax returns, and  the other spouse has unrealized capital gains, you may want to consider transferring the capital losses to the spouse who has the unrealized gains. If you are in this situation, you should start the planning for this now. As this type of planning is complicated, you should speak to your accountant (or engage an accountant for a short consultation) to ensure you do this properly.

I discussed this type of planning in this capital gains post, go to the 3rd paragraph from the bottom (Creating Capital Losses-Transferring Losses to a Spouse Who Has Gains).

Get Your Record Keeping In Order 

If you were scrambling this March and April to put together either your employment expenses, rental income or self-employment income, then make your life easier and either start using Quicken or create an excel spreadsheet to track these costs. If you update your expenses every month, not only will you reduce your stress next tax season, but you will have more accurate records and most likely capture more expenses.

In addition, get in the habit of downloading any donation receipts immediately. This will ensure you do not miss any donation credits next year and save you scrambling to recall which donations you made.

Make the Acronym Contributions Early

 

Don't wait to next December to make your RESP or TFSA contributions or February, 2015 in the case of RRSPs. Where possible, make these contributions throughout the year. It will ease your cash flow and these accounts will have additional time to grow tax-free.

That's it for now, I've got a bunch of tax returns to get out.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Tax Tweets of the Day for the Week Ending February 22, 2013

My Twitter tax tips for this week are listed below. My twitter handle is @bluntbeancountr. If you will be receiving a severance payment/retiring allowance in 2013, or are planning to withdraw funds from your RRSP in 2013, ensure you pay attention to the first tip.

Tips for Week of February 18 - February 22, 2013

Receiving a retiring allowance? Cashing an RRSP this year? Beware, taxes withheld are often less than the tax you will owe. #blunttaxtip.

Note: For a discussion of this issue, see this blog post.

US citizens must file a 1040 US return. If you are a Cdn resident earning #Rental Income in the US, you must file a 1040NR. #blunttaxtip

Do you own shares in any bankrupt #stocks? You can file an election to claim the capital loss this year. #blunttaxtip

When filing a deceased parent/grandparent’s return, ensure you report any deemed dispositions of stocks or real estate. #blunttaxtip

Note: Upon passing, if property is not transferred to a spouse, you are deemed to dispose of your capital property at death as if you actually sold the shares or real estate. The determination of the cost base of that property can often be problematic to say the least.

Interest rates are very low; consider a 1% prescribed #loan to your spouse. The 1% interest rate is locked in forever. #blunttaxtip

Note: For a discussion of this issue, see this blog post.

    

White Paper on Salary or Dividend for Small Corporate Business Owners

My recent three part series on whether small corporate business owners should take Salary or Dividends , The Numbers and The Issues to Consider has been made into a more readable white paper on my firms Cunningham LLP's website. You can download the paper by following this link. Note: Full disclosure; you will have to submit your personal information.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Prescribed Rate Loans Using a Family Trust

In July 2011, I wrote about the income tax savings that may be derived by using a 1% prescribed interest rate loan to income split with your spouse and children. As the world economies would have it, interest rates have not moved very much over the last eighteen months; consequently, the Canada Revenue Agency (“CRA”) prescribed interest rate is still 1% for this quarter. I would therefore suggest that the use of a prescribed interest rate loan is still an attractive tax planning alternative, however, today I will expand the use of these types of loans to include a loan to a family trust for purposes of income splitting.

To recap the above blog post. The Income Tax Act contains income attribution rules that typically reallocate income to the higher income earner when he or she tries to income split with his or her spouse or children. However, there is an exception to the above attribution rules where an individual makes a loan to a spouse or minor child and interest is charged on the loan at a rate at least equal to the CRA’s prescribed interest rate at the time the loan was made. Where the loan carries interest at a rate no less than the prescribed interest rate, the attribution rules will not apply. For the loan to avoid the income attribution rules, the interest owing must be paid each year within 30 days after the end of the year (i.e. January 30th).

As I noted at the end of the blog post, income splitting with minors can be problematic because minors generally cannot enter into an enforceable contract. Thus, I suggested the use of a family trust to navigate the enforceability issues. Today, I want to expand on the use of a family trust for these type loans.

Using a Family Trust

Where a family trust is a shareholder in your company, the kiddie tax rules make income splitting with beneficiaries problematic and typically the trusts are only beneficial for children once they turn 18 or where the company is sold and you can "sprinkle" the $750,000 capital gains exemption amongst your family members.

Shockingly, for once, individuals have a planning advantage over corporations. Where you do not have a corporation or the circumstances don’t allow for the introduction of a family trust as a shareholder of a corporation, a family trust can still be utilized to income split, by utilizing a prescribed interest rate loan to a family trust. The beauty of making a prescribed loan to a trust is that the kiddie tax will not be applicable and if structured properly, children under 18 who are beneficiaries of the trust can be used to income split. 

To prevent any confusion, let me clarify. A family trust is not an “in trust” account that some institutions allow. What I am talking about here is a formal discretionary family trust governed by a trust agreement or trust deed drafted by a lawyer and properly settled, often by a grandparent. The beneficiaries of a family trust in the case of a prescribed loan trust would include both minor children and children 18 years of age and over and the trustees would typically include at least mom or dad, if not both, and an arm’s length third party.

Once the family trust is settled, mom or dad makes a loan to the trust at the prescribed interest rate in effect at the time of the loan (i.e. 1% if the loan was made this quarter). It is very important to understand that the Income Tax Act requires that the loan carry an interest rate at least equal to the prescribed rate at the time of the loan and that this interest rate remains in effect the entire time the loan is outstanding. Thus, the 1% interest rate will not change as long as the loan is in existence, even if the CRA’s prescribed interest rate increases in the future. I cannot emphasize what a huge benefit the low permanent interest rate is in our current low rate environment. If rates begin to rise, the trust will continue to only pay 1% interest, yet the family trust can earn say 7% interest without the risk that would be required today to try and achieve a 7% return.  

Once the trust receives the loan proceeds, it will then invest the funds, but must  pay mom or dad the 1% interest by January 30th of the following year. Mom or dad must report the interest earned on the loan in their personal income tax return and the trust is entitled to an interest expense deduction for the interest paid.

The income earned by the trust less the interest expense paid is then allocated out to the children and is taxed in their hands, which in most cases will result in no income tax.

The trust can be used to pay the children’s school costs, camp costs, etc.

So why isn't there a proliferation of family trusts used for income splitting of investment income? Well, the legal and accounting costs of setting up the trust can range from $4,000 to $8,000 give or take and there are also annual T3 Trust filing costs charged by an accountant. In addition, as noted yesterday, in order to make this worthwhile, the parents would typically need to advance at least $500,000, but probably closer to $1,000,000 in this low rate environment to make the additional income tax filings and administration costs worthwhile. However, you could establish or settle a trust and loan it, say $100,000 today, to lock in the 1% rate, if you believe the compounding effect of the invested money will provide you with significant investment income down the road or you expect the stock market is going to go gangbusters in the near future. Remember though, any loans advanced to the trust in the future will need to carry an interest rate at least equal to the prescribed rate at that time, so if you loan the trust more money in the future and the prescribed rate increases to say 5%, the additional loan will be subject to the higher interest rate.

Where you have funds available for investing and have children with significant private school or university costs, then you should consider the creation of a family trust and the use of a prescribed interest rate loan for income splitting purposes. Alternatively, you can just use the trust to build up funds in your child's name to help them buy a car or a house.

Tax planning of this nature is very complicated as you must navigate several income tax and trust law provisions to ensure compliance. Before considering tax planning of this nature, you must consult with an accountant and/or lawyer.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.