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Income Splitting and Employee Profit Sharing Plans


Background:

The Canadian government made legislative changes in February 1999 that effectively removed the family trust as a legitimate device for splitting business-generated income with minor children. The amendments to the Canadian Income Tax Act were introduced in order to tax all income received in the hands of minor children at the top marginal rate where the source of dividend income arising from shares of a private company or management fees (referred to in accounting circles as the “kiddie tax”).

Previously, dividend income passing through a family trust to a minor was taxed on a progressive basis after deduction for basic exemptions, resulting in a very little or no tax until approximately $23,000 of income per child was paid out (British Columbia tax rates).
 
Thousands of professionals and small business owners throughout Canada who have previously set up a family trust are affected by this change. Many will be seeking financial advice as to how income splitting with minor children may be legitimately achieved in the future.
 
The EPSP Trust
 
Employee Profit Sharing Plans (EPSP) have been around since the 1940’s, but have not been widely utilized in recent years due to the popularity of the family trust. With the rules changing, perhaps it’s now appropriate to dust off the old EPSP legislation and revisit the benefits of establishing an Employee Profit Sharing Plan trust. There is an approach to these EPSP trusts which make them attractive for an owner-managed corporation in which the family wants to reduce the total amount of tax paid by sharing the total business income with all family members.
 
An EPSP trust is an arrangement under which a corporation can pay part of its profits for the benefit of designated employees. The selected employees report the income and pay the appropriate income tax based on their own progressive tax rates. The “kiddie tax” rules do not apply to income received by a minor child from an allocation from an EPSP trust. The payout is deductible by the corporation as an expense.
 
An Example of EPSP Income Splitting

This example illustrates how an EPSP trust works and its benefits in financial planning for a typical small business owner with a wife and minor children. Jack Jones is a pharmacist married with a teenaged daughter and son. His business provides a total of $125,000 of net income. Mrs. Jones is a homemaker but is an employee of the pharmacy and provides part time management and accounting services. The two teenaged children also work part time after school and on weekends. Jack Jones would like to reduce his total payments and is considering income splitting with his wife and children.
 
Without the EPSP trust, Jack Jones earns $125,000 from the business and his wife
and children do not draw any income:

Taxable Income:  $125,000
Less: Tax (Approx.):  $53,000
After Tax Income:  $72,000
 
With an EPSP trust, Jack Jones establishes an EPSP trust and allocates $125,000 from the business’s profits. These allocations are not subject to source deductions such as income tax, EI and CPP contributions. The trustee (Jack Jones) allocates profits to each of the family members, and the family members all contribute to family expenses:

 

 
Jack Jones
Mrs. Jones
Daughter
Son
Taxable Income:
$75,000
$30,000
$10,000
$10,000
Less Tax (Approx.):
$26,000
$6,200
$900
$900
After Tax Income:
$49,000
$23,800
$9,100
$9,100

 

The total family after-tax income is now $91,000 ($49,000 + $23,800 + $9,100 + $9,100). Add the CPP and EI savings and the total family after tax-income increases to $96,800, a total increase of $24,700 per year!
 
EPSP Trust Requirements

The Income Tax Act sets out the requirements of an EPSP trust. It is essential that the payments from the business to the trust must be calculated by reference to the profits of the business. This means that the payments must be a percentage or share of part or all of the profits derived from the business. There must be an obligation on the business to make the payments in accordance with a formula in which profits are the principle variable. These payments must be made in any year where the business enjoys profits.
 
A trustee (can be the employer) is required and a bank account in the name of the trust must be established. While not strictly required to be registered with the Minister of National Revenue, it is advisable to file with the minister to ensure qualification as an EPSP.
 
EPSP Reporting Requirements

There is no requirement to file a trust return for an EPSP trust, unlike the family trust where an annual trust tax return is mandatory. All income is reported by the recipient employees and is taxable in their hands. Since no income is retained in the EPSP trust there is no income earned by the EPSP trust and, therefore, no tax liability in the trust. Allocations to employees are summarized by the trust and reported by the employer to Revenue Canada on T4 Summary Information slips.

Miscellaneous Features and Benefits

All amounts paid by the business to the trustee for the EPSP during a taxation year or within 120 days thereafter are deductible in computing the income of the business.
 
There is no requirement that all employees must be included or that those employees must be treated equally uner the EPSP trust. The decision to share profits and the selection of the employees with whom they are shared are entirely discretionary.
 
Allocated profits qualify as “earned income” for RRSP purposes and the RRSP carry-forward rules. Amounts paid by a business to an EPSP trust are not subject to source deductions for income tax, Canada Pension Plan or Employment Insurance contributions.
 
Closing Caution

Whether the establishment of an EPSP trust makes sense or not for a particular business is an individual decision that must be made after careful analysis and consultation with a lawyer (trust specialist) and a professional accountant. There are legal and accounting fees associated with the analysis and drafting of EPSP trust documents. Finally, the window of opportunity for this particular approach closes when Revenue Canada decides to shut down yet another currently legitimate tax strategy.

Based on an article by Randall B. Reynolds, MBA, CFP, CLU, CH.F.C of the Financial Advisors Brokerage Group

 



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