Update: The prescribed interest rate for family loans, discussed in this article, increased to 2% from 1% in March 2018.)

The new income sprinkling rules mean it no longer makes sense for incorporated professionals and many business owners to income split with their families. That’s because dividends paid to a spouse or child will now be taxed at the top marginal rate unless the shareholder receiving the dividend can show specific labour or capital contributions to the business’s operations.

Taxpayers will be responsible for demonstrating in their tax returns that a family member meaningfully contributes to the business. It’s up to CRA to decide if the compensation is reasonable.

If only one shareholder is considered the legitimate owner of the business, he or she is only allowed to income split with:

  • a spouse, once the owner turns 65;
  • adults aged 25 or older who hold a 10% voting share in a non-professional corporation that earns less than 90% of its income from services; and
  • adults aged 18 or older who have averaged 20 hours of work in the business per week during the year, or any of the five previous years.

Shareholders who do not fit perfectly into one of these categories won’t know whether their 2018 dividend compensation will be taxed at the highest marginal rate (53.53% in Ontario) until mid-2019 when they receive their Notices of Assessment.

This is an unacceptable risk for most small business owners.

Read: Why IPPs can help more business owners than you’d expect

Consider a prescribed rate loan…

An alternative to paying dividends is to lend tax-paid personal capital to a spouse, child, or trust using a prescribed rate loan. This allows the passive income earned on the assets to provide an income for the borrower that avoids the tax on split income (TOSI) and kiddie tax rules that result in dividends being taxed at the top marginal rate.

For example, a $1.5-million loan to a trust at the current prescribed rate of 1% could earn a 4% cash yield after fees, equaling $60,000 of income. Out of that income, $15,000 would have to be paid back to the lender and would need to be declared as interest income. The remaining $45,000, however, could be distributed to the trust’s beneficiaries at the trustees’ discretion.

…but do it quickly

The loan option is attractive because, assuming interest is paid 30 days after year’s end, the interest rate will always be the prescribed rate in effect when the loan was made, which is currently only 1%. This rate is set quarterly and will be announced again on March 15. Based on our analysis, the rate is likely to increase. Here’s why.

The Income Tax Act contains a formula for determining the prescribed rate, which can be summarized as:

The average 90 Day T-Bill rate in the first 30 days of a quarter rounded up to the next whole percent and applicable the next quarter

In Q4 2017, the rate was 93 basis points, keeping the rate at 1% in Q1 2018. However, the T-Bill rate is already 1.17% as of January 15, 2018. If it stays there, the Q2 rate will be 2%, or double the current rate.

Such a doubling would decrease the income-splitting potential of our above example by $15,000 (or 33%). Further, the 2018 federal budget will be released in March along with new passive investment rules for CCPCs. These new rules could easily limit trust loans or change the prescribed rate model.

Read: What an interest rate rise would mean for prescribed loans

Benefits of prescribed loans

Individuals can loan tax-paid capital to a trust at the prescribed rate. The trust can then distribute taxable income earned above that rate to the beneficiaries of the trust including a spouse, children or grandchildren.

Business owners can withdraw that tax-paid capital from their corporations (e.g., from their Capital Dividend Account or using shareholder loans) to achieve the above-noted strategy. The most obvious reason is to allow business owners to continue income splitting with their spouse before age 65 (the age at which income splitting is allowed).

Read: How the prescribed interest rate interacts with employee loans

Trust loans could also work for business owners who have been saving for their children’s post-secondary education in their private corporations and were planning to pay their children dividends when they turned 18, but after these proposals are unable to do so. The disbursements that result from loaning money to a trust also avoid the kiddie tax, so the income could also be used to pay expenses for children and grandchildren under 18.

Ultimately, one family could use the trust for several purposes over time, as a trust is fully discretionary and has the longevity benefit of not requiring to be wound up upon the lender’s death (note that unrealized gains on trust assets are subject to capital gains tax unless distributed every 21 years).

Read: The benefits of family trusts

Next steps

Advisors should review if this type of planning might apply to their clients and ensure they have discussed the options with them. The client must have tax-paid capital via shareholder loans, the Capital Dividend Account or personal non-registered assets in order for this strategy to work. There are also other factors to consider, including a person’s comfort level with making loans and any family law implications. It is important that wealth management advisors work closely with their client’s accountant and lawyer on implementation to consider details such as the trust structure, promissory note, and ongoing administration.

Kyle Westhaver, CIM, is a financial advisor at Nicola Wealth Management, and John Nicola, CFP, CLU, CHFC, is chair and CEO of Nicola Wealth Management.