No matter where you are in your small business journey, it’s obvious that you need profit to survive. So, it’s crucial that your business be structured in a way that maximizes after-tax profits. In this article, we explore the advantages of using a family trust for small business tax planning.
Why a Family Trust?
Most successful small businesses are operated through corporations, as they benefit from income tax deferrals and liability protection. Adding a family trust as a shareholder allows you, as the business owner, to maximize the after-tax cash available. Discretionary family trusts are a handy tool for structuring a corporation.
A discretionary family trust is a relationship between the Settlor, the Trustees, and the Beneficiaries. A trust is settled when a person (the “Settlor”), transfers property to another person (the “Trustee”) to hold for the benefit of one or more persons (the “Beneficiaries”). The trust agreement defines what the Trustees may do with the property and outlines the interests of the beneficiaries.
The most common use of a family trust is to introduce the trust as a shareholder of your corporation. Here are four notable benefits you can achieve through this approach:
1. Income Splitting
The trustees can allocate any income the trust receives to any beneficiaries. This is a popular way of splitting income with other family members, such as your children, who may be in lower tax brackets.
It’s a great tool for funding educational expenses, down payments on homes, or other personal needs. If the beneficiary has no other income, they could receive annual dividends up to $35,000 without significant personal income tax, provided they are over 18 years of age.
2. Capital Gains Exemption
Each beneficiary of a trust can use their Capital Gains Exemption on the sale of the corporation’s shares. So, if you establish a trust with multiple beneficiaries, the number of available exemptions can be multiplied.
In BC, the tax savings from claiming one Capital Gains Exemption is approximately $180,000. It’s not uncommon to utilize them for five or six beneficiaries on the sale of a corporation’s shares. Keep in mind that multiple requirements must be met for the corporation’s shares to qualify for the exemption, but savings can be significant if they do.
3. Business Succession
A trust can hold a corporation’s shares for up to 21 years. On or before the 21st anniversary of the trust, the shares will be transferred to one or more of the beneficiaries on a tax-deferred basis. The distribution of shares is at the trustees’ discretion.
Using a family trust allows trustees to set aside property for the benefit of family members today, without giving up control of the property for up to 21 years. This provides a great deal of flexibility in how and when you transition the ownership, as well as management of the business for the next generation.
4. Estate Planning
The individual beneficiaries of a trust do not hold the shares directly. As a result, you can avoid estate taxes so long as the shares remain in the trust. This allows the individual shareholders in the business to cap the value of their shareholdings subject to estate taxes. As a result, they maximize the wealth that may be passed on to the next generation.
For income tax purposes, a trust is deemed to sell all its property for fair value every 21 years. However, if the trust is structured correctly, the trust property may be transferred to the beneficiaries on a tax-deferred basis before the 21st anniversary, eliminating income taxes.
Corporations that don’t have a trust as a shareholder can be restructured to do so, although you need to be cautious to avoid traps found in the Income Tax Act. Also, there are specific technical, legal, and taxation issues related to the settlement of trusts. Obtaining professional legal and tax advice before any work is done to introduce a family trust as a corporation shareholder is critical.
Final Thoughts
As you can see, a family trust can have numerous advantages for income tax and estate planning purposes. To take advantage of its benefits, the trust must be set up correctly from a tax and legal perspective.
Note: This article deals with complex matters that have not been addressed in full and may not apply to your particular circumstances. The matters presented and the references in the article also reflect laws and practices that are subject to change. Please consult a tax advisor for advice on the above information.
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