Using a Family Trust for Tax Planning

There are many reasons to start, grow and maintain your small business, but no matter why you’ve started it, it’s undeniable that you need to profit to survive. That’s why it’s so important that your business be structured in an appropriate manner to maximize the amount of after-tax cash that remains in your hands.

Most successful small businesses are operated through a corporation to take advantage of income tax deferrals and liability protection. The addition of a family trust as a shareholder of a corporation will allow you, as the business owner, to maximize the after-tax cash available to you. Discretionary family trusts are an incredibly useful tool that have become popular when structuring a corporation.

A discretionary family trust is a relationship that exists between the Settlor, the Trustees and 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 trust 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 some of the notable benefits you can achieve through this approach:

Income Splitting

The trustees of the trust will have the power to allocate any income received by the trust to any of the beneficiaries, which may include children over the age of 18. This is a popular way of splitting income with other family members, such as your children, who may be in lower tax brackets. It is a great tool to fund educational expenses, down-payments for houses and other personal needs of your children. If the beneficiary has no other income, they could receive up to $35,000 of dividends annually without significant personal income tax, provided they are over 18 years of age.

Capital Gains Exemption

Each beneficiary of a trust has the ability to utilize their Capital Gains Exemption on the sale of the corporations’ shares. As such, if you establish a trust with multiple beneficiaries, the number of Capital Gains Exemptions that are available can be multiplied. In B.C., the tax savings from claiming one Capital Gains Exemption is approximately $180,000. It is not uncommon to utilize the Capital Gains Exemptions for five or six beneficiaries on the sale of a corporation’s shares. There are multiple tests that need to be met in order for the shares of the corporation to qualify for the exemption, but if they do, the savings can be significant.

Business Succession

Practically speaking, a trust has the ability to hold shares of a corporation 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 those shares from the trust is at the trustees’ discretion. Using a family trust allows the trustees to set aside property for 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 and management of the business to the next generation.

Estate Planning

The individual beneficiaries of a trust do not hold the shares directly. As a result, estate taxes can be avoided so long as the shares remain in the trust. This allows for the individual shareholders in the business to cap the value of their shareholdings that are subject to estate taxes, maximizing the amount of wealth that may be transferred to the next generation.

For income tax purposes, a trust is deemed to sell all the property that it owns 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 prior to the 21st anniversary, eliminating the income taxes.

Corporations that do not have a trust as a shareholder can be restructured to do so, although you need to be cautious to avoid the many traps found in the Income Tax Act. In addition, there are specific technical, legal and taxation issues related to the settlement of trusts so it is critical to obtain professional legal and tax advice before any work is done to introduce a family trust as a shareholder of a corporation.

Final Thoughts

As you can see, a family trust can have numerous advantages for income tax and estate planning purposes. In order to take advantage of its benefits, it is imperative that the trust is set up properly from a tax and legal perspective.

This article deals with complex matters which have not been addressed in full and may not apply to your particular facts and circumstances. As well, the matters presented and the references contained in the article reflect laws and practices that are subject to change. Please consult a tax advisor for advice on how the above information should be applied.

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