Notwithstanding that financial markets and the economy continue to take a beating, there are significant tax planning opportunities that have not existed for quite some time.
In a typical estate freeze, the common shareholder of a private corporation, “Opco”, (Mr. A) exchanges his common shares for redeemable, retractable preferred shares. This reorganization of capital would generally be carried out on a tax deferred basis under section 86 of the Act (or other tax deferred methods). Alternatively, and if applicable, Mr. A may choose to crystallize his unused $750,000 capital gains deduction and exchange his common shares for preferred shares utilizing the provisions of section 85 of the Act.
The children of Mr. A, or a family trust, subsequently acquires new common shares of Opco for nominal consideration, as the current value of the corporation has been frozen in the preferred shares held by Mr. A. Therefore, all future growth or appreciation of Opco is attributable to the new common shareholders (the children of Mr. A or a family trust). The estate freeze may also satisfy the objective of income splitting amongst the common shareholders.
As discussed in our blog entry of December 5, 2008, consideration should be given to “thawing” previously implemented estate freezes during these uncertain times.
Spousal loan / loan to trust
With prescribed interest rates at 2% for the first calendar quarter of 2009 (and scheduled to be an unprecedented 1% for the second quarter of 2009!), spousal loans or loans to trusts may provide an attractive alternative to achieve income splitting where the spouses or beneficiaries of trusts are in different tax rates. The prescribed rate in effect when the loan is entered into is locked in or effective for the entire term of the loan, notwithstanding that the prescribed rate may increase in the future. Where an existing spousal or trust loan is in place from a prior taxation year bearing a prescribed interest rate in excess of 2%, consideration should be given to paying off the loan and entering into a new spousal loan at the 2% interest rate (or 1% commencing April 1, 2009).
The spousal/trust loan rules are fairly straightforward. The higher income spouse (the lender) loans money to the lower income spouse (or to a trust), who then utilizes the funds for investment purposes. In order to be onside of the attribution rules under the Act, the borrowing spouse or trust MUST pay the interest on the outstanding loan balance by January 30th of the following year. Failure to pay the interest by the January 30th due date will result in the application of the attribution rules whereby the investment income earned by the borrowing spouse or trust will be included in the investment income of the lender spouse.
Notwithstanding that the lending spouse must include the interest income earned on the loan in his or her income, the borrower spouse or trust should be able to deduct the interest expense. Therefore, provided that the borrowing spouse or trust can achieve a return on investment greater than the loan rate, and that spouse or beneficiaries of the trust are in a lower tax bracket than the lending spouse, a spousal/trust loan may provide a relatively simple strategy to split income.
We would be pleased to discuss freeze or thaw alternatives, or explore the spousal/trust loan rules with you.