The minimum interest rate for family loans rose from 1% to 2% in October 2013, and should fall back to 1% in January 2014.
But changes in the interest rate don’t take the lustre off this income-splitting strategy, say tax advisory and wealth management experts. Families can still benefit; the keys are understanding how the loans work and what makes them tax-efficient.
Nuts and bolts
The objective is “to transfer investment income that would otherwise be taxed at a higher rate to a family member in a lower marginal tax bracket,” says David Lloyd, managing director and chief wealth management officer at Toronto’s Newport Private Wealth.
Loans can be made between spouses or parents and both minor and adult children, but you’ll have to set up a trust for minor children.
Assume the lending spouse is a high-paid executive, and the borrowing spouse has little or no income. The lender transfers a lump sum of $1 million to the borrower and charges the prescribed rate of interest.
Dave Walsh, a tax services partner at EY in Ottawa, notes the prescribed rate’s tied to the 90-day government treasury bill rate. “It’s based on a 3-month average, rounded up. Since 2009, the average has been less than 1%, so rounding up gets you 1%. But recently the average slightly cracked 1%, forcing the prescribed rate up to 2%.”
This means annual interest payments on a $1 million loan would be $20,000 instead of $10,000, which is why many advisors pushed clients to lock down the lower rate before October 1. But Walsh insists prescribed rate loans are still a great deal because “rates could normalize to 4% or 5%.”
Adds Deborah MacPherson, national leader of KPMG’s enterprise tax practice, “Never in our wildest dreams did we think the rate would get as low as 1%. Going back up to 2% certainly doesn’t sound the death knell for this excellent strategy.”
For the loans to make sense, clients need a significant spread between the 2% prescribed rate and the rate of return on investments made with loaned funds. So a GIC paying 2.5% isn’t going to make the strategy worthwhile, says MacPherson. With a 5% yield, you’re in business.
But she notes a hefty loan can make a small spread look big. Jason Safar, a tax services partner at PwC, agrees: “If someone’s loaning $15 million, it doesn’t take that much for this strategy to work.”
MacPherson says the expected tax benefits must outweigh the cost of the loan.
The annual return on investments made with loaned funds, less the yearly interest paid to the lender, goes into the borrower’s pocket. He pays tax on this sum, while the loan interest appears as a deduction on his return. Interest payments received by the lender, meanwhile, are taxed as income, Walsh explains. It’s crucial the borrower be in a lower tax bracket than the lender, and savings are greatest when borrowers have little or no income.
But this still works when the borrowing spouse has regular income, says MacPherson. “If the borrower makes $50,000 a year, another $80,000 from returns on the borrowed funds would push him or her into the top bracket. Yet the strategy produces tax savings because they’re using some of the borrower’s lower brackets to reach that top bracket.”
Interest payments: Do or die
Interest payments for a given year are due no later than January 30 the following year, “and missing even one payment torpedoes the entire strategy,” says Lloyd.
A missed payment means attribution rules kick in, notes Mac- Pherson, and “investment income is thereafter taxed in the lender’s hands, as if a loan arrangement had never been made.”
She adds the first interest payment on a loan that begins October 1 is pro-rated. For a $2 million loan, the calculation for three months of interest (October through December) would be:
For any years thereafter, the entire 2% ($40,000) is due before January 30.
To avoid missing a payment, MacPherson suggests linking the transfer with another significant financial event on the family’s calendar. “For instance, if clients regularly make RRSP contributions in January, suggest they schedule family loan interest payments with that event.”
“The loan is typically established with a demand promissory note that states the amount loaned, to whom, and the rate of interest,” says MacPherson.
“It should make clear the rate charged is in effect for the life of the loan.” The document does not need to be notarized.
There’s no need to specify an end date, but Safar suggests avoiding open-ended arrangements in case relationships turn sour.
Taxpayers should document all interest payments, invested funds and returns, in case they’re audited. Safar advises setting up a separate account in the borrower’s name strictly for the loan and investment earnings. That way, “when interest payments are made to the lender, the transfer is clear and easy to track.”
Loans to children
Lending money to children can also accomplish a variety of planning objectives, Lloyd notes.
Loans can be used to cover education expenses. Suppose a family has three children attending private secondary school. “Since they would pay little or no tax on the investment income, a family loan would be able to meet education costs with pre-tax rather than aftertax dollars.”
Since the kids are minors, a trust would be established to receive the loan. “If there’s an existing inter vivos trust,” Lloyd notes, “the family can use that, provided the indenture allows borrowing.”
The same strategy also lets wealthy grandparents “see an inheritance in action,” he says. “Even though the parents are in the top bracket, they may be preoccupied with paying down mortgages and contributing to RRSPs. The grandparents can loan to a trust for the benefit of the grandchildren, earmarking the investment income for education costs.”
Safar also gives a non-tax reason to loan to an adult child. Say your client wants to help his daughter buy a first home, but doesn’t like her spouse. “If he simply gifts the money and the couple divorces, the house is part of their family property; whereas if the client loans the money, it’s still his capital, so his daughter’s spouse can’t make a claim on it.”
Also, as long as the daughter continues to pay interest, she wouldn’t have to pay back the loan. Lloyd notes prescribed loans are also an effective way for wealthy families to prepare the next generation so they responsibly manage inheritances.
“Many clients worry that their children […] need to learn the fundamentals of tax and investments, and a prescribed loan can be a perfect strategy for conveying these lessons.”
For example, a wealthy client might loan $250,000 to a university- aged adult child, who’s then responsible for its management. “It not only provides tax savings to the family; it also provides the next generation with a starter kit for developing strong financial skills.”
The logic behind lending such a large sum to university-aged children is that they’re not on their own. “We have several associate portfolio managers in their twenties and we pair them up with these clients,” Lloyd says. “Aligning demographics makes the relationship easier.”
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While there’s still some risk, he stresses how much greater it would be if these children were left to inherit millions with no prior money management experience. “Two years from now their parents could die in an auto accident, leaving completely inexperienced children with many millions. The value of teaching them fiscal responsibility as soon as possible outweighs the risk of handing a 23-year-old a quarter-million dollars.”
And make no mistake: the money is theirs to use, so it’s more than worthwhile for a son or daughter to give mom or dad a hand with their tax planning.
Jason Safar, a tax services partner at PwC, says prescribed loans are the best income-splitting strategy—unless your clients own a business.
“Wealthy business owners should consider a dividendsprinkling arrangement, where family members own shares of and receive dividends from a business organized as a corporation.”
He suggests a trust for holding the shares. “It receives the dividends and allocates them to the family members.” One benefit is that younger family members won’t have direct possession of the shares.
“A trust is a good buffer against a 20-year-old making a mess.” He adds the tax benefits of income splitting are also accomplished by having family members on the payroll. But don’t let compensation get out of hand.
“When CRA audits a business it will usually look at the payroll register. If your client is paying a 14-year-old $80,000 for answering the phone for three hours on a Saturday, it’ll raise red flags.”
CRA’s benchmark is whether a non-family member would get the same pay for the work in question.
Originally published in Advisor's Edge Report
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