In what was considered in many ways an economically quiet budget, on February 11th, 2014 the Federal government proposed little more than targeted changes to existing programs and policies. This included an expansion of the “kiddie tax”, or taxation at the top marginal rate, of income allocated to minor children through corporate structures to also include partnership and trust income generated by third parties, where the rules only applied to non-arm’s length relationships previously. This was a further extension of the “kiddie tax” rules introduced in 2000 and expanded since to prevent the use of arrangements for splitting income with minor children.
The popular method of legal income splitting entailed issuing a specific class of shares of a private corporation directly to children or to a family trust of which the children are named beneficiaries. The company would then declare dividends on these shares to take advantage of each child’s basic personal tax credits and the dividend tax credit, resulting in the children paying little to no tax on the income.
The “kiddie tax” eliminated the use of personal tax credits and taxed the income at the top marginal tax rate; the dividend credits and foreign tax credits remained available for reducing the tax payable by the child. This tax was initially on taxable dividends and shareholder benefits received from a private corporation, and income from a partnership or trust whose income is derived from business carried on by a relative or non-arm’s length person. The Income Tax Act holds parents jointly and severally liable for their child’s “kiddie taxes”, giving the Canada Revenue Agency more power to collect on tax debts owed by the children.
As tax strategies shifted to adjust to these rules the “kiddie tax” was extended in response. In 2011 the tax was expanded to include capital gains on the sale of private corporation shares to a non-arm’s length person. These gains are now treated like a dividend on the child’s return for tax purposes, but without the benefit of a dividend refund for the corporation.
The 2014 budget further expanded the reach of the “kiddie tax” to include income derived from trusts and partnerships where the income comes from third parties, citing the example of a partnership’s adult partner providing services to a third party and then allocating a disproportionate amount of partnership income to a minor partner. The rule also includes third party rental income generated by the partnership or trust.
For the time being, these tax rules will not apply to capital gains realized by minor children from sale of publically traded stocks, or gains realized from the sale of private corporation shares to an arm’s length person. Paying a market rate wage to a child that works in your family business remains an option as well. The government will continue to monitor the effectiveness of the “kiddie tax” rule as a method to minimize income splitting, and can be expected to continue proposing rule changes as necessary where avoidance of the tax is found.
The use of corporations, trusts and partnerships remains valid for purposes outside of tax minimization. These structures may still provide protection of assets from creditors and division under matrimonial property rules. Use of corporations to create an estate freeze remains a viable way to shift the tax on future appreciation of corporate assets into the hands of children. Flexibility of dividend distributions among varying classes of shares is also a valuable benefit of corporations. Trusts permit control of how assets are managed and distributed, bypass the risk of court challenge to your Will, the cost of probate, and the public disclosure of assets due to probate being a public court record.
These structures should not be entirely discounted due to recent changes, but should be examined within the context of your personal financial plan and your estate plan. Regular review and update of your personal plans with an eye to changes in legislation and its interpretation by the courts is a key benefit of a wealth management engagement with a certified tax planning professional. We welcome the opportunity to meet with you and discuss whether a comprehensive examination of your personal circumstances and existing arrangements is warranted.
VR Business Brokers will like to thank Nicholas J. Miazek CFP for his contribution as a Guest Blogger on our site. Nick is a Vice President and Financial Planner with Fiera Capital Private Wealth in Calgary, Alberta, where he provides customized wealth management solutions and implementation services. Nicholas can be reached at firstname.lastname@example.org or (403) 699-9000.