Kiddie Tax

An old friend of mine, Louise Hunt, is the human resource director of a medium-sized engineering firm. “A couple of years ago, we instituted an income splitting plan for our partners,” she told me last week. “We set up a partnership that provided administrative services to the professional business. The partnership was owned by family trusts …”

“… and the children and spouses of your engineers are the beneficiaries of the family trusts?” I asked.

“Exactly. After our people adjusted to its complexity, the plan became very popular. At a time when the income of the firm was under pressure, we were able to give some tax relief to our people. The typical trust earned about $30,000. Where that money was used to fund the children’s expenses, we could realize significant savings.”

“That would be especially true for families with young children,” I said. “Summer camp can cost $6,000 per child and usually families have to earn $12,000 to retain $6,000 after tax. But if you could flow $6,000 directly to the child through a trust, you could save a full $6,000 in taxes.”

“That’s right. Last year we conducted a survey on the benefits derived from the plan. Families saved about $12,000 in tax as a result of using the trusts. But now I understand the federal budget has put a kink in our program.”

“You’re referring to the new kiddie tax. As you may recall, the Income Tax Act has a set of rules, called the Attribution Rules, which are aimed at stopping income splitting. Until now, those rules targeted investment income — that is, income from property. Provisions in the Income Tax Act deal with property income that is shifted from one taxpayer to another by loan or gift in order to lower taxes and benefit family members. The Attribution Rules attribute the shifted income back to the transferor of the property, so it can be taxed at a high tax rate.”

“You mean if I give my child a gift of $10,000, the income on that money is attributed back to me?”

“Yes, although when you are dealing in sums like that it doesn’t matter that much. The income on $10,000 of capital would only be $400 at current interest rates. In today’s economy, the people who most want to shift income are people like the partners in your firm — high income earners who own their own businesses. Their goal is to transfer business income to their children.

“A new series of tax provisions will broaden the reach of the Attribution Rules,” I continued. “The new rules will apply the highest marginal tax rate to certain types of income earned by minors. The targeted income includes taxable dividends and benefits paid by private companies to minors (either directly or through a trust or partnership). That approach is similar to the old focus on property income. But the kiddie tax also applies to business income earned by trusts or partnerships derived from providing goods or services to an entity involving a relative of the minor.”

“That’s pretty far reaching isn’t it?” Louise asked.

“It certainly is. You should note, however, that it doesn’t affect the ability of your trust to allocate income to spouses.”

“That doesn’t matter so much any more,” Louise said. “In many families, both spouses work and both are in high tax brackets.”

“That’s probably why the rules ignore adults. Also, there are exceptions to the rules for income earned by children. For example, the high tax rate will not apply to income actually earned by the minor for services provided, dividends received from public companies, and income from property inherited from a parent.”

“Do you think our present program can continue by using the exceptions?”

“No. The new provisions have really been designed to thwart just the kind of plan that your firm instituted. The partnership-trust income splitting program for minor children is pretty well consigned to the scrap heap of history.”

“You mentioned that income earned on inherited property is exempt …”

“Not all property,” I replied. “Just property inherited from the child’s parents.”

“What if a minor inherits property from someone other than a parent — a grandparent for example? My parents are planning on leaving some property to my children.”

“Based on the budget, income from targeted property would be taxed at the high rate.”

“That seems really unfair,” Louise said. “After all, people don’t die to shift income to their heirs.”

“The Department of Finance has stated that it is open to consultation on the provisions before they come into effect in the year 2000. It’s possible that the proposals will be softened before they are made law.

HANK T. BULMASH, C.A.

BULLMASH CULLEMORE

CHARTERED ACCOUNTANTS, TORONTO.