11 Jun The Benefits of Family Trusts
Recent changes in legislation have left individuals questioning the benefits of a Family Trust (“FT”). In this article, we will explain some of the legislative changes and identify the benefits that still exist from using an FT.
While this article focuses on the tax benefits available through the use of an FT, trusts have retained many non-tax benefits, including:
- Confidentiality
- Control
- Reduction of probate fees
- Succession planning
Dividend Streaming / Income Splitting
Prior to the revised Tax on Split Income (“TOSI”) rules, it was common for private corporations owned by an FT to pay dividends to the FT and allocate the dividends to adult family members. In many cases, inactive family members were able to receive dividends, and therefore the family was able to shift income from higher income-earning family members to lower income-earning family members resulting in overall tax savings to the family unit. This strategy was commonly referred to as “income sprinkling”.
However, effective January 1, 2018 the TOSI rules were expanded to apply to individuals over the age of 18 and now limit the ability of private corporations to income split between family members who do not really contribute to the business or are not actively involved. While there are still some limited exemptions, the ability to income split has been significantly reduced. Any income taxed under the TOSI rules is subject to tax at the highest personal marginal tax rates, eliminating any advantage achieved from income sprinkling.
Multiplication of the Lifetime Capital Gains Exemptions (“LCGE”)
Effective January 1, 2019 the LCGE has increased to $866,912. This means that $866,912 of capital gains resulting from the sale of a qualifying small business corporation’s (“QSBC”) shares could flow tax-free to an individual. Each individual is entitled to their own LCGE.
Where QSBC shares are owned by an FT, and the FT sells said shares, the FT can allocate the capital gains that are realized on the sale to one or more beneficiaries of the FT. Each beneficiary would then be able to claim their own LCGE to the extent that they have not used it in the past.
Examples:
Scenario 1: Suppose an individual disposed of shares in A Co. (a QSBC), for proceeds of $1,800,000 (with a nominal cost base). Subject to certain limitations, the individual may apply the LCGE of $866,912 to reduce the capital gain from $1,800,000 to $933,088 ($1,800,000 – $866,912).
Scenario 2: Assume the same facts as above, but in this scenario, the shares of A Co. are held by an FT, of which individuals A and B are beneficiaries. When the FT sells its shares of A Co. for $1,800,000, the resulting capital gain may be distributed to the beneficiaries at the discretion of the trustee. Individuals A and B may each be allocated half of the capital gain (i.e., $900,000 each), and may apply their respective LCGEs to reduce this capital gain. As a result, the aggregate capital gain is reduced from $1,800,000 to $66,176 ($1,800,000 – $866,912 – $866,912).
Maintaining QSBC Status
In order to use the LCGE outlined above, one of the requirements is that the company be considered a QSBC. QSBC status is also important as taxable capital gains from the disposition of QBSC shares are exempt from the new TOSI rules.
A FT can also help a company to maintain and control an appropriate asset mix so it maintains its QSBC status in a tax efficient manner (a process referred to as “Purification”). A private corporation with excess cash may be able to pay a dividend to the FT which can then allocate the income to a corporate beneficiary. This can allow the private corporation to meet the QSBC criteria.
A dividend from a private corporation through the FT to a corporate beneficiary would be considered an inter-corporate dividend and flow tax-free.
Succession Planning
FTs are frequently used in succession planning as they can be used to transfer wealth to future generations in a tax efficient manner.
The use of a discretionary FT within the context of a private corporation allows for several benefits including the control of trust assets (i.e., shares of a private corporation), reduction of estate taxes upon death, and the distribution of trust assets to beneficiaries on a tax-deferred basis.
- Control: When a discretionary FT is settled, a trustee will be established to administer and manage the FT. As a result, the trustee will have control over the FT and its assets.
- Deemed disposition: When an individual passes away in Canada, they are deemed to have disposed of their assets at fair market value (“FMV”) for tax purposes. To the extent that the FMV of these assets exceeds their cost base, the “deemed disposition” will result in a capital gain on which the estate must pay tax. Assets held by an FT are not subject to this deemed disposition, which can result in a considerable reduction in an estate’s final tax liability.
- Transfer to beneficiaries: Capital property (which would generally include shares of a private corporation) may be distributed to an FT’s Canadian resident beneficiaries at cost (i.e., on a tax-deferred basis).
Used together, these tools allow for a tax-efficient transfer of wealth to future generations.
New Trust Reporting Requirements
Effective 2021, additional reporting will be required for trusts including:
- Reducing the exemptions for not having to file a trust tax (“T3”) return. This will mean that more trusts will be required to file a T3 return;
- Requiring additional information such as personal information for each trustee and beneficiary; and,
- New penalties for failing to file and comply with the requirements.
Interested in learning more about Family Trusts and if they are right for you? Contact us at we_are@clearlinecpa.ca.
