Owner-managers of companies who operate a business or who own investments such as real estate or a stock portfolio in a private corporation may now be reluctant to split income from their corporations by paying dividends to adult family members because such dividends may now be subject to the highest marginal tax rate under the “Tax On Split Income” or “TOSI” rules (unless certain exclusions are met, please refer to our Revised Income Sprinkling Rules article dated January 2nd, 2018).
One of the few ways to split income with adult family members is use a prescribed rate loan strategy with related family members who no longer can receive dividends from a family company without the TOSI rules applying.
The prescribed rate loan strategy generally works as follows:
Suppose Sarah owns a successful company which manufactures furniture. The shares of the company are owned by a family trust of which Sarah, her husband Jack and their two children, Megan 19 and Connor 22 are beneficiaries.
Dividends can no longer be paid on the shares held by the family trust and paid out to Megan and Connor because the dividends will be subject to the highest marginal tax rate to them under the TOSI rules.
Both Megan and Connor attend full-time university and each need approximately $30,000 per year to pay for their tuition, automobile expenses, cell phone and other personal expenses.
If Sarah is paid dividends from the family company, the company would need to pay her dividends of approximately $107,000 per year. Sarah would then pay taxes on the dividends received of approximately $47,000 per year leaving her with net after-tax income of $60,000 per year. She would then gift $30,000 each to Megan and Connor so they could pay for their expenses.
However, Sarah has accumulated a lot of money and investments personally from her business over the years and would be willing to lend $600,000 to each of Megan and Connor who will invest the funds in a conservative portfolio earning a return of 6% per year.
Sarah enters into a legally-binding loan agreement with both Megan and Connor (no later than March 31, 2018) to lend them $600,000 each and will charge them interest at the current prescribed interest rate of 1% per annum. Megan and Connor will pay interest on the loan no later than January 30th after the end of each calendar year.
Megan and Connor will invest the funds in a conservative portfolio and will report the 6% return on the investment portfolio and claim the 1% interest on the loan from Sarah as an interest deduction. Therefore they will earn and report a net return of 5% on the $600,000 investment portfolio or $30,000 per year. Because both Megan and Connor have minimal other income and tuition and personal credits, they will pay no or minimal taxes on the 5% net return on the investment portfolio; so will each have close to $30,000 of return on the investment portfolio after taxes to pay for their personal expenses.
Sarah will report the 1% interest on the $1.2 million of loans made to Megan and Connor of $12,000 per year and will pay tax on such interest at her marginal tax rate of close to 50%. If this strategy was not implemented, Sarah would have earned a 6% return on the $1.2 million investment portfolio of $72,000 per year and would have paid taxes on the investment returns of approximately $26,000 to $36,000 depending on the composition of the investment returns.
Because interest on the loans have been charged at or greater than the prescribed interest rate at the time the loan was entered into (1% or higher) and interest is paid on the loans within 30 days after each calendar year, Megan and Connor’s returns on their investment portfolios will not be attributed to Sarah for tax purposes.
Note: If there is a family trust, Sarah could lend the funds to the trust instead of directly to Megan and Connor. This may provide more control and flexibility on how the funds are invested and allocated to the trust’s beneficiaries including to Megan and Connor; depending on their school expenses and summer job income. The same or similar loan terms would apply as above (i.e. charge and pay 1% interest by January 30th after the end of each calendar year).
The prescribed interest rate is increasing to 2% per annum on April 1st, 2018 and thus, if you wish to lock in the interest rate on the loan to family members at the current 1% prescribed interest rate, you must make the loan to the related family member by no later than March 31st, 2018.
Please speak with your DMCL Advisor as soon as possible if you would like further information on this prescribed rate loan strategy and how it could apply in your particular circumstances.