Income Splitting Strategies with Family Trusts
There are many types of income splitting strategies which are used in Canada. All of them are based on the fact that in Canada each person is taxed separately. As a result, you create anomalies where the total tax paid by a family is higher or lower depending on how much each family member earns.
Tax rates go up progressively as your income goes up. For example, in British Columbia in 2012, once your total taxable income is over $132,000 per year, you are in the top tax bracket of 43.7%. However, if your total income is less than $37,000 per year, you pay tax at the rate of only 20%. And depending on your personal exemptions, you may not pay any tax at all. So there are definitely significant tax savings if income is earned by a family member in a lower tax bracket.
For example, imagine a family of four: 2 parents and 2 children who are 18 years old or older. If one of the parents earned all the family income (say $200,000 per year), the family tax bill would be over $67,000. However, if each of the 4 family members earned $50,000 each ($200,000 in total), the family tax bill would only be around $35,000. That’s a significant difference and to many families in Canada, this seems unfair and creates a large incentive to try to split income amongst family members.
And if you add to this the ability of children who are full-time students to claim all of the available credits for education and tuition fees, the total tax paid by the family is even less.
The Canadian Government allows a certain amount of income splitting but to do it properly, it has to comply with all the tax rules and needs to be done very carefully with great attention to detail.
One of the best and most flexible income splitting strategies involves paying dividends through a discretionary family trust. It works best for families that carry on an active business, but can also work reasonably well for investment assets.
It is very popular for any type of business that can be carried on through a limited company. Many people who are self-employed or carry on a professional practice (e.g. doctors, dentists, lawyers, accountants, etc.) are able to carry on their business or practice through a limited company. That is the key.
By way of a general overview, the way it works is that a discretionary family trust is set up for the family and this family trust buys shares of the limited company. As the business earns profits, the limited company is required to pay corporate tax on its profit. However, in British Columbia, an active business pays tax at the low rate of 13.5% on its profits (up to $500,000 of profits per year). That’s a very low rate and then allows the remaining 86.5% of profits remaining (profits after tax) to be paid out by way of dividends to the family trust.
Typically the family trust “flows through” these dividends to family members who are the lowest tax bracket so that they pay the least amount of tax. As long as the family trust flows through the dividends and doesn’t keep them, the family trust pays no tax.
If there are family members who earn no other income (e.g. full-time students), the tax on these dividends can be very low or even zero. In fact, it may be possible to earn $30,000 per year in dividends from the family trust and pay no tax at all. As a result of these tax rates, this strategy can be a very effective way to pay for a child’s post-secondary education using tax free dollars.
This strategy was challenged by the Canada Revenue Agency on numerous occasions in the past. Finally, the Supreme Court of Canada ruled in 1998 in Neuman that this form of income splitting using dividends was acceptable.
Today, the Canada Revenue Agency still reviews these kinds of income splitting strategies, but their audit focus is on ensuring that the arrangements have been properly implemented and documented so that they comply with all of the detailed rules contained in the Income Tax Act. So income splitting with a family trust is an excellent strategy, but make sure it is set up properly and you have dotted all your i’s and crossed all your t’s.