Tax Alpha

In investment parlance alpha is the risk-adjusted excess return, after fees, of a fund compared to a benchmark index.  It is very difficult to achieve a positive investment alpha over a long period.  Wise investors look to more than the fund manager for alpha.  It does not matter what you make or how you make it but it does matter what you keep.

Your overarching goal should be to optimize usable after tax income.  It is not, and should not be to minimize tax, nor should it be to create wealth that is not usable.  Tax minimizing schemes frequently cost as much or more than they save, so beware.

The fruitful areas of productive tax management include type changing income, using structures that have better tax characteristics, deferring income, splitting income and improving deductions.

Tax laws are technical, complex and boring.  You will not like dealing with them, but they are a fruitful source of alpha.  Here is a short course in tax strategy.

A dollar of tax deferred is a dollar of tax saved.  If you pay as you go, you end up losing far more of the potential income than if you paid at the end of the holding period.  See Einstein Was Wrong.  There are structures and investment forms that defer the tax on the increase in their value.  Owning vacant land, some stock, and life insurance are examples.

Income splitting is a time honored technique.  When you can choose, let the lowest tax rate person pay the taxes.  There are ways to do it that require a little preparation.  Among those, in Ontario Canada and perhaps elsewhere, are:

  • prescribed rate inter-spousal loans,
  • multiple testamentary trusts,
  • dividend paying, non-voting shares owned by adult but low tax rate persons.  – Students primarily but perhaps parents too.
  • Damming cash flow so the high rate tax payer pays all living expenses and the low rate taxpayer invests.  Life insurance works because the insurers pay a lower rate on investment income.

Change the structure.  Essentially you own something that owns your investment and the something has a better tax arrangement.  Again in Canada, tax free savings accounts and registered retirement savings plans are examples.  Sometimes owning the brown paper bag is better than directly owning the sandwich, cookie and apple that are inside it.

Change the income type.  If you personally have business income, you could incorporate the business and change the income type from business income to  some combination of salary, dividends, interest, rent and so on.  Sometimes there are advantages to one type over another.

In the same way some investments convert highly taxable interest into much lower taxed capital gains.

Change who pays after tax expenses. 

An Ontario corporation earning less than $500,000 of active business income has a tax rate of 15.5%.  It keeps 84.5% of its income.  Paying a non-deductible expense like life insurance or club fees here, is better than a person paying when they only keep 54% of the salary that their corporation paid them.

Think higher in the chain.  How much would the corporation need to earn to pay a non-deductible expense of $5,000?  $5917.  Alternatively the corporation could pay the owner $9,260 of salary so they could have the same $5,000.  There is a saving of $3,343 pretax dollars at the corporate level.  Most people make the mistake of not looking to how much pretax income is required to meet an obligation.

Create deductions.

Interest on non deductible debt is common.  Also expensive, albeit not so bad in today’s interest environment.  If you buy investments with borrowed money you can deduct the interest.  If you buy personal assets, you cannot.  Suppose you owe $250,000 on a home mortgage at 4% .  At the same time you own $250,000 in an investment portfolio.  The sell investments pay mortgage, remortgage and use the new loan proceeds to buy back the investments tactic will save the tax on the $10,000 you pay the bank.  If you earn $90,000 or so, the cash saving is $4,300 after taxes.  That is the equivalent of receiving a raise of $7,544.  Pretty easy too.

A Combo plan.  A combination of create deductions, pay non-deductibles from low taxed income and split income.

Pay your children fair value for what they do for your business.  It has to be reasonable but that is about it.  Do not make them work cheap as a learning experience or family duty.  The first $12,000 or so costs almost nothing in tax to them.  The corporation needs about $14,200 of income to pay them.  You will need upwards of $21,000 to have the same $12,000.  They can buy their own clothes, video games, magazines, lunches and pay their own way on vacation.   It is like finding $6,000 lying on the street and the children actually learn something about what money is worth.

As always, do not try this at home.  Structure and precision matter; often quite a lot.  Everyone has a set of circumstances that will edge towards or away from any tax tactic.  Acquire and use advice from professionals who are both familiar with your situation and familiar with the concept.  Some have costs, so factor that into the saving.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

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