Avoid the (new) Kiddie Tax

Budget 2014 expanded the Kiddie Tax, making it more challenging to split business income with minor children. The new rules apply to the 2014 taxation year onward.

The background

Diverting income to relatives with lower or no income reduces the overall family tax burden. But the Income Tax Act limits when this is allowed through attribution rules, including the Kiddie Tax.

Also known as the tax on split income, these rules tax income at the highest federal tax rate (29%), even if a minor child or spouse in a lower bracket earned it.

Read: Help clients track income sources

The type of split income targeted includes:

• taxable dividends and shareholder benefits on unlisted shares of Canadian and foreign corporations (other than mutual fund corporations), received directly or indirectly;
• capital gains from selling these shares to non-arm’s length people (relatives or friends); and
• income from a partnership or trust that provides property or services to, or in support of, a business carried on by a minor’s relative; a corporation, where 10% or more of any share class is owned by a relative; or a professional corporation with share ownership by a relative.

Budget 2014 expanded the definition of split income to include business and rental income from third parties, paid to a minor. The rules apply if a minor’s relative regularly performs income-generating activities, or in the case of a partnership, where the relative has an interest.

Under the old rules, a trust or partnership could invest in property, rent it out to third parties, and allocate net income to minor partners or beneficiaries. Typically, a parent would manage these rental businesses.

Read: Tax filing for couples

If your client uses this strategy, she may be able to preserve the trust’s ability to spread income by hiring a third-party manager, because the third party is unrelated.

Budget 2014 also targets business trusts where third parties contract with other third parties for services performed by the parent, with an eye toward allocating the net income to minor children. Similar opportunities were available in partnership structures.

Are you transferring income to your kids to save tax?

Legitimate ways to split income with adult children

Hire them: CRA will only recognize a reasonable salary, usually equal to wages your client would pay a non-family member to do the same work. Clients must keep records of children’s employment activities and how long they worked for the company; and be sure to remit payroll taxes and CPP.

Lend them money to invest: Your client can lend children money at the prescribed rate (currently 1%), and they can invest it. Any excess income above the prescribed rate would be taxed in the children’s hands. Make sure the children pay interest owed no later than 30 days after the end of the year. If you don’t, excess income’s attributed back to the lender.

Give or lend money for their TFSAs: Income earned in a TFSA isn’t subject to attribution rules. A client can loan her children money intended for their TFSAs, or gift the money outright.

Lend or give money to buy property: If your client already helps a child with the rent, it may make sense, tax-wise, to loan or give that child money to buy a house instead. Since the house purchase doesn’t generate income, there’s no attribution. If the property’s value increases, the child may be able to use the principal residence exemption to shelter the gain.

Read: 7 ways to help clients save tax

Lend money to a trust: The client can lend money to a trust at the prescribed rate. Whatever the trust earns above the interest paid on the loan is allocated to one or more trust beneficiaries, who must pay tax on their personal returns, regardless of age.

Stella Gasparro, CPA, CA, is a partner at MNP in Toronto.