Introduction
The “kiddie tax,” detailed in Section 120.4 of the Canadian Income Tax Act, applies to income earned by children under 18 from private corporations that are designed for income splitting. While primarily targeting dividends or shareholder appropriations, this tax does not apply to capital gains.
Introduced to address tax avoidance strategies involving income splitting, the kiddie tax effectively ensures that such income is taxed at the parent’s higher tax rate.
The Evolution of Kiddie Tax
Income Splitting Before Kiddie Tax
Prior to the kiddie tax rules, it was common for parents to split income with their children by distributing dividends through private corporations. Minors, often having little to no other income, could use tax credits to reduce or eliminate the tax liability on these dividends. This strategy significantly lowered the overall family tax burden.
Impact of Kiddie Tax Rules
With the introduction of the kiddie tax, such dividends became fully taxable at the highest marginal rate applicable to the parents, effectively nullifying the benefits of income splitting for minors. In essence, the kiddie tax ensures that certain unearned income of minors is taxed as if it were earned by their parents.
Expansion of Kiddie Tax Scope
Capital Gains and Kiddie Tax
Initially, tax planners responded to the kiddie tax by converting dividends into capital gains, as the kiddie tax did not apply to capital gains. However, amendments to the Income Tax Act on June 6, 2011, closed this loophole. Now, capital gains realized by minors from the sale of private corporation shares are taxed similarly to dividends if taxable dividends on those shares would have been subject to the kiddie tax.
Additionally:
- Shareholder Loans: Loans made to minors by private corporations are immediately taxed at the higher rate.
- Excluded Scenarios: The new provisions do not apply to certain cases, such as:
- Sales of shares listed on designated exchanges.
- Shares of mutual fund corporations.
- Income deemed as "excluded amounts."
Taxpayers should consult with a professional to confirm whether specific income or capital gains qualify for exclusions under these rules.
Trusts: A Legal and Effective Alternative
Trusts remain a robust planning tool for minimizing the impact of the kiddie tax. Income earned within a trust and distributed to a minor may still be taxed at the minor's lower tax rate, provided the minor is in a lower tax bracket than their parents.
Establishing a Family Trust
- Asset Transfer:
- Parents can transfer income-generating assets to a family trust. However, this transfer is treated as a sale at fair market value, making any gains between the asset's cost and sale price taxable to the transferor in the year of transfer. For minimal tax impact, assets with little to no appreciation are ideal candidates for transfer.
- Capital Gains in Trusts:
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- Capital gains earned within the trust are taxed at the trust's capital gains rate. Since the kiddie tax does not yet apply to capital gains earned through trusts, this remains a viable strategy for minimizing tax liabilities.
- Trust-generated income can be distributed to beneficiaries, including minors, without incurring additional tax.
Tax Planning Considerations
When implementing tax planning strategies involving minors, careful consideration is crucial to avoid adverse tax consequences:
- Ensure compliance with current kiddie tax provisions.
- Evaluate the tax implications of transferring assets to a trust or implementing a share freeze.
- Seek professional advice to optimize the benefits of any strategy while adhering to legal requirements.
Conclusion
The kiddie tax rules are designed to prevent tax avoidance through income splitting with minors, significantly impacting how dividends and certain capital gains are taxed. While the rules have closed many loopholes, opportunities remain through careful planning, such as utilizing trusts. By working with a tax professional, families can navigate these complex provisions to achieve effective tax minimization strategies. If you are considering income-splitting strategies or need clarity on your tax obligations, consult with a qualified tax advisor to explore your options.
This article is written for educational purposes.
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