How to Reduce Your Taxes
“Every man is entitled, if he can, to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be”
Lord Tomlin in IRC v. Duke of Westminster, 1936.
Tax is a significant expense. Wherever we can reduce or defer your taxes, we have the opportunity to put more monies to work in order to grow and meet your needs and for providing a larger legacy to your children.
Reducing or deferring taxes is generally not something that’s done at the last minute. Your most significant tax savings typically will involve structural changes so that income gets generated and taxed at the lowest tax rates.
The Five Principles of Tax Planning
While it would be impossible to summarize all of the opportunities to reduce or defer taxes, we’ll talk about the general principles of tax planning and provide some examples of these techniques.
- Income Splitting
Income splitting involves taking an income and spreading it among several taxpayers; or having the income taxed in the hands of a lower income taxpayer.
For example, due to our graduated tax rates, it is better to have two people (say a husband and wife) pay tax on incomes of $55,000 each rather than having one person pay tax on an income of $110,000.
Similarly, it might make better sense to arrange for your inheritance to be received by a Testamentary (Will) Trust with multiple beneficiaries, than for you to receive your inheritance personally. That’s because the Trust might be able to spread its income among lower taxed beneficiaries (and also have some income taxed in its hands at its low tax rate), resulting in a lower level of family tax.
For professionals or business people earning more money than they spend, it might make sense to incorporate and subject that income to the small business company tax rate. In addition, there’s an opportunity to income split and pay reasonable salaries and/or dividends to family members based on their duties, responsibilities and share ownership.
Other opportunities to split income among family members include:
- granting a fair market interest investment loan to a lower income spouse who in turn invests in a portfolio to generate a high level of income (loans would be made the Prescribed Interest Rate and all income and gains from the invested loan proceeds would be taxed in the lower income spouse’s hands – just the interest on the loan would be taxed in the lender’s hands);
- giving a business loan to a lower income spouse to generate business income; and
- contributing to a spousal RRSP.
Unfortunately, you cannot arbitrarily decide who’s going to claim what amounts for income; otherwise everyone would try and split their income. So strategies to split income must be structured and used with great care.
- Income Shifting
Income shifting involves strategies that result in income that would otherwise be taxed in a high tax rate year to be taxed in a low tax rate year. Income may be shifted by changing the timing of deductions or choosing the timing of income realization.
For example, let’s say you plan on selling a rental property in a year or two with a large gain that would be taxed at a high tax rate. Rather than making your full RRSP contributions when you’re in a lower tax bracket, you may defer making contributions until the year of the sale. Or, where cash is not needed right away, you might be able to create a capital gains reserve in order to spread the gain at the time of sale over a five year period (this involves the receipt of a Promissory Note instead of cash).
Income shifting also includes deciding how to raise cash to meet your immediate needs while trying to minimize the family’s long-term taxes payable.
For example, if you have money in your holding company, this might involve remuneration planning (deciding on the mix of salary and dividends) to withdraw monies from your corporation. Or it might involve deciding whether to take early RRSP withdrawals. (Caution: One should not normally take income early without having done some future income projections.)
- Investment Selection
Investment selection involves choosing different types of investments that are eligible for full or partial tax exemption. Examples include:
- Investing through your Tax Free Savings Account where all growth and income in the plan are tax free and can all be withdrawn without tax;
- boosting returns on your bonds by buying a tax-preferred Prescribed Annuity;
- holding bonds in your RRSP/RRIF and holding equities personally;
- exempt insurance policies;
- $750,000 Small Business Capital Gains Exemption; and
- owning real estate that qualifies for the Principal Residence Exemption.
Investment selection might also include putting in place a Buy-Sell strategy for your private corporation funded with exempt life insurance in order to minimize taxes on your death. Here some of your corporate owned assets are converted to an insurance asset that can be paid out of the company tax-free on your death.
- Tax Deferral
A tax deferral strategy attempts to delay when tax will be paid. Deferring tax means you might eliminate the tax this year, but you may have to pay eventually. Generally tax deferral has two advantages:
- It’s better to pay a dollar of tax tomorrow than it is to pay a dollar of tax today
– that’s because you can invest those monies today to grow to meet your needs; and
- tax deferral typically puts the control of when to pay the tax in your hands. As a result you may be able to choose to take the income in a year when you are in a low tax bracket.
Examples include the use of RRSPs/RRIFs, Registered Education Savings Plans, Individual Pension Plans, and Deferred Profit Sharing Plans.
- Tax Shelter Investments
Here one invests in specific types of investments that generate substantial deductions or credits to minimize taxes.
In some cases, these investments have little investment merit but simply provide a mechanism to defer tax. The idea is that the generated tax savings is treated like an interest free loan providing cash for investing.
- Film and software shelters;
- Oil and gas and mining flow-through shares;
- Venture capital corporations;
- Leveraged real estate and real estate limited partnerships.
Don’t Overlook Tax Deduction Opportunities
Whenever you’re contemplating a major change to your financial affairs, it’s a good idea to discuss this with your tax accountant to ensure that your plans are done tax effectively.
For example, let’s say you’re planning to buy a home. If you borrow to buy the home, then the resulting interest expense is not generally deductible as the borrowing was for a personal purpose.
If however, you liquidate your investment portfolio, buy the home with cash, and then borrow money to replace your investment portfolio, then you’re borrowing for investment purposes. As such, the interest expense or a portion thereof may be deductible.
Where we fit in
Our training, education and dealing with affluent families may assist us in spotting opportunities to help you reduce tax.
Should we see an opportunity, we would look to discuss the situation with you and your tax accountant. This is the advantage of working with a financial planner who looks at your overall situation and can work together as part of a team (without being seen as a competitor or threat) with your tax accountant.
Where you don’t have a tax accountant or need tax advice, I can provide you with referrals to tax professionals that our clients have had satisfactory experiences with. I also provide tax planning services to my clients at no extra charge. Please call me at (604) 288-2083 (x1) or email me at email@example.com.
Written by Steve Nyvik, BBA, MBA ,CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.