Income splitting is a term used to describe tax strategies that are intended to shift income from an individual who is in a high tax bracket to a family member who may be in a lower tax bracket, and to have that income taxed in the hands of the lower-income family member. Effective income splitting can result in a reduction to a family’s overall tax burden, and an increase to their overall after-tax income.
As tax legislation has evolved over the years, effective income splitting has become very difficult to achieve. One income splitting strategy that remains available involves making loans to family members at a prescribed rate of interest. In fact, this strategy is one of the very few opportunities to split income with minor children and grandchildren.
Where an individual gifts or lends money to a spouse or minor child/grandchild at no interest, various income attribution rules will apply to tax any investment income earned in the hands of the lender/transferor. However, where funds are instead loaned at an interest rate at least equal to the prescribed rate of interest in effect when the loan is made, these income attribution rules do not apply. The prescribed rate of interest is set on a quarterly basis and is currently 2%. However, the prescribed rate is set to drop to 1% for the third quarter of this year (beginning July 1, 2020). Once a loan is made at the prescribed rate of interest, that rate will remain in effect provided that the annual interest payments continue to be made to the lender. While the current 2% prescribed rate of interest is attractive, the reduction to 1% will provide an opportunity to lock in this income splitting strategy at the historically low rate and maximize income splitting opportunities for your family over the long term.
While a prescribed rate loan can be made directly to a family member, making a loan to a discretionary trust for the benefit of your family may provide a number of additional advantages, including:
- flexibility in optimizing your family’s income in any given year;
- allowing the lender to maintain control over the investments, thereby providing a mechanism to access the funds if necessary; and
- allows for income splitting with children or grandchildren that might be born in the future.
As an example of a common prescribed rate loan plan, assume an individual is in the highest personal tax bracket, has $1 million of cash to invest and could earn taxable income of $60,000 annually from the investments. Rather than investing the funds in his name, he might consider loaning the $1 million to a trust created for the benefit of his family. Assuming the prescribed rate of interest is 1% at the time of the loan, the trust would be required to pay $10,000 of interest to the lender, which would be taxable in his hands. The trust would then have $50,000 of net investment income remaining that could be allocated among the family in any proportion decided upon. Rather than this $50,000 of income being taxable at the highest personal tax rate, it would instead be subject to tax at the lower-income family members’ marginal tax rates. The allocation of income may vary year to year, such that the decision may take into account changes in each family member’s income in any given year.
Some families may have implemented prescribed rate loan structures at a time when the prescribed rate of interest was higher than 1%. A reduction in the prescribed rate may provide an opportunity to restructure the existing arrangement and take advantage of the new lower prescribed rate. Professional advice should be sought to ensure that the new loan is not simply a continuation of the original loan.
A key aspect of prescribed rate loan planning is the ability to access sufficient personal funds in order to make the structure worthwhile. Taxpayers should seek professional advice in considering their options for personally accessing the required funds.
We can help you determine whether these income splitting strategies are suitable for your situation, as well implementing an appropriate structure. While the prescribed rate could remain at 1% after the third quarter, implementing this planning by September 30, 2020 will ensure that you benefit from this historically low prescribed rate. Please consult your Welch LLP advisor to discuss how we can help.