Income splitting is a term popularly used to describe tax plans which legitimately transfers taxable income from a person in a high tax bracket to one in a lower tax bracket (generally a spouse) resulting in overall permanent tax savings.
Over the last while the tax authorities have shut down many of the last “acceptable” income splitting plans.
One of the few remaining is perhaps the simplest, a loan from a spouse in a higher income tax bracket to his or her spouse who is in a lower income tax bracket. The lower income spouse invests the proceeds of the loan and pays tax on the income generated by the investments at his or her lower tax bracket, an immediate and permanent tax savings to the couple.
As an example, Joanne, a high rate taxpayer pays tax at 53%. Her husband, Robert has very little income and pays tax at a much lower rate. If Joanne invests $1,000,000 and earns a 5% return, she will keep $23,500 after tax. If, however, Joanne lends Robert $1,000,000, he invests it and earns the same 5% he will pay very little tax and the couple, as a unit, will be much better off.
We all know the old saying, “If It sounds too good to be true it probably is”. This isn’t a truism in this scenario but there are a few catches.
The loan must be set up and adhered to properly.
- Robert must pay Joanne interest every year at a prescribed rate in effect at the time the loan is made. We are at historically low interest rates and the prescribed rate is currently 1%. If the loan is made while the rate is still at 1%, the rate would be locked in for the duration of the loan thus making this plan an attractive option in today’s environment.
- Robert can deduct the interest paid but Joanne must declare the interest received.
- The interest must be actually paid in the calendar year or by the end of January of the following calendar year and it is preferable that the interest is not paid from a joint bank account. If even one interest payment is missed, the income earned form the loaned money will be taxable to Joanne in that year and all future years.
- The terms of the loan, including the interest rate and conditions of repayment should be put in writing and it may even be advisable to provide security in case of default.
The higher income spouse should have the funds available personally as opposed to in a corporation. If Joanne doesn’t have the funds personally and withdraws money from a corporation she owns in the form of a dividend, she would have to pay tax on the dividend prior to making the loan to Robert and much of the benefit would be lost. It is however, in some circumstances, possible to withdraw funds from a corporation with little or no tax.
Our Tax Team can help you determine if this is possible for you. Do not hesitate to contact us for any questions.