If you’re a high-income earner, you may wish to:

• gift money to your kids
• maintain control over how this gifted money is used and invested, and
• have investment income taxed in your kids’ or grandkids’ hands

One option is to loan money to a trust for the benefit of your minor kids or grandkids and have the trust pay interest to you at the CRA prescribed rate at the time the loan is made. The prescribed rate in Quarter 1 of 2022 is 1%. Suppose the trust invests the money in an investment that generates an annual return of 10%. In this case, you will be able to have 9% of the investment earnings taxed in your kid’s hands – at lower tax rates – instead of yours.

Case Study

Here’s a quick example to explain how income splitting with children using a trust generally works.

Suppose John and Jane worked very hard in their business and are looking for ways to use their hard-earned wealth to benefit Kevin, their only son. Kevin is brilliant and ambitious. He wants to be an astronaut one day. Jane and John want to set up a tax-efficient way to set money aside to help Kevin’s dreams when he is ready to pursue higher education.

The Facts

• John and Jane have one child, Kevin, aged 10.
• Both John and Jane are in the highest marginal tax bracket in Ontario, such that their income gets taxed at the following tax rates:
  • Ordinary income: 53.53%
  • Eligible dividends (public company dividends): 39.34%
• John and Jane establish a trust for the benefit of Kevin.

The Steps

Jane and John work with their tax advisor (like LRK Tax) to set up a tax-efficient structure:

• Jane and Kevin set up the trust as an “Age 40 Trust”. This trust allows income and capital gains earned in the trust before Kevin turns 21 years of age to be retained in the trust until Kevin’s 40th birthday. (Note that there are very careful legal steps that need to be followed to set up a legally valid trust. A discussion of this is complex and beyond the scope of this article, but feel free to contact us if you have any questions.)
• John and Jane made a $500,000 loan to the trust in January 2022, at the prescribed interest rate of 1%.
• The Trust invests the $500,000 in various Canadian stocks that pay 10% dividends annually.
• In the first year, the trust earns $50,000 of eligible dividends. The trust will pay $5,000 to John and Jane as interest. The remaining $45,000, according to the trust deed, becomes vested in Kevin. This means that Kevin will pay tax on this amount while the amount sits in the trust.

The Results

• Here’s the result of setting up a trust for the benefit of Kevin:

	Tax Before Trust Set Up	Tax After Trust Set Up	Tax Savings
Jane/John	$20,000	$2,700	+17,300
Kevin	n/a	$600	-600
Total	$20,000	$3,300	+$16,700

• Kevin is taxed on $45,000 of dividend income and pays a $600 tax in Ontario.
• Jane and John pay tax on the $5,000 interest income and pay a tax of $2,700.
• The total tax is $2,700 + $600 = $3,300.
• Had Jane and John earned this income directly, they would’ve paid a tax of $20,000.
• As a family, Jane and John saved $16,700 in taxes.

This plan works well for grandparents who wish to gift money to their grandchildren during their lifetime. During their lifetime, they get to witness the benefits – such as their grandchildren using the money to achieve their life dreams.

Importance of Working with a Tax Specialist

The above is a good strategy. But the devil is in the detail. For these strategies to work, you need to implement these transactions properly from a tax and legal perspective. This is why you should hire tax specialists like LRK Tax who have experience implementing these types of structures.