Published: April 10, 2020
Last Updated: February 21, 2022
Canadian Income Tax – Using Family Trusts For Small Business Tax Planning – Toronto Tax Lawyer Analysis
Although trusts are not considered a separate legal entity like corporations, they are considered separate taxpayers for the purposes of the Canadian Income Tax Act, which allows for a variety of tax planning opportunities, especially in the case of small, privately-owned corporations and their shareholders. By settling a family trust that subscribes for common shares in the family business or SME, corporate retained earnings can potentially be paid out to the trust and divided amongst the beneficiaries in a tax-efficient manner, resulting in income splitting. In addition, proactive tax planning can be enacted to structure the family trust in such a way that allows for each beneficiary’s lifetime capital gains deduction to be utilized on the sale of the business, potentially shielding several hundred thousand dollars in tax payable on the disposition of shares in the corporation by the trust. The purpose of this Canadian tax lawyer tax analysis article is to provide a general overview of the Canadian tax planning opportunities presented by the effective implementation of family trusts into a small business structure. For a more in-depth examination of your specific circumstances, contact our experienced Toronto tax lawyers to discuss your particular situation in order to explore tax efficient strategies available to you and your SME business.
As mentioned above, trusts are not a separate legal entity. Rather, trusts are a well-recognized legal relationship created by the Courts of Equity in England between the trustees and beneficiaries of the trust, under which the trustees manage the assets of the trust for the benefit of the beneficiaries. In order for a trust instrument to be valid and enforceable, the trust must satisfy what legal experts refer to colloquially as the “three certainties”, namely, the trust as drafted must provide sufficient certainty of intention, certainty of objects and certainty of subject matter. Each of the three certainties has its own body of case law, a discussion of which is beyond the scope of this article. Trusts created during the lifetime of the “settlor”, called inter-vivos trusts, are taxable at the highest marginal rate on income earned by, and retained in, the trust. However, amounts “flowed out” to beneficiaries are taxed in the hands of the beneficiaries, except in the case of minor children, usually at their respective marginal rates, with payouts typically being fully deductible to the trust. For instance, if a trust with two adult beneficiaries earns $20,000 in interest income in a given taxation year and pays $10,000 to each of the two beneficiaries, the trust will have no taxable income for that year and each beneficiary will include $10,000 in their own income for the year. Establishing a trust requires careful planning and a well-drafted trust deed. If you are interested in settling a family trust, speak with one of our Toronto tax lawyers to ensure all of the requirements of a properly constituted trust are met and that all future occurrences are considered and planned for accordingly.
Reduce Income Taxes by Income Splitting Among Beneficiaries
Family trusts offer several options for small, closely held corporations and their shareholders to limit their income tax liability. To the extent a family trust holds common shares of the family business, retained earnings can be paid out to the family trust as a dividend, which can then sometimes be paid out to the beneficiaries in a tax reduced manner. For example, consider a family business corporation that is co-owned by a husband and wife who have two children, with all four family members named as beneficiaries under a trust, which owns all of the common shares of the corporation. If the business has $100,000 worth of retained earnings in a given year, the full $100,000 can be paid to the trust as a dividend. Assuming the trust is fully discretionary, the trustee can allocate the $100,000 to the beneficiaries in the most tax efficient way, with the goal being little or no taxes payable by any of the beneficiaries on account of the disbursement. However, when employing this income splitting strategy, taxpayers need to be careful not to trigger unintended tax consequences for children who are beneficiaries of the family trust. In certain circumstances the Kiddie Tax applies and the Tax Act taxes amounts paid to beneficiaries of the family trust who are 16 or under, at the beginning of the taxation year, at the highest marginal federal tax rate of 33%. Care must also be taken to avoid the imposition of the attribution rules, which are essentially punitive provisions designed to discourage transfers or loans of property between family members, either directly or indirectly, which includes the use of trusts. Speak with our Toronto tax lawyers to discuss the taxation of trusts and develop a plan that optimizes tax efficiency according to the terms of the Income Tax Act.
Multiply Lifetime Capital Gains Deduction
Under subsection 110.6(2.1) of the Income Tax Act, every individual taxpayer is entitled to the lifetime capital gains deduction for taxable capital gains realized on the disposition of shares in a qualified small business corporation. The deduction amount for each individual in 2016 is $412,088, which offsets an underlying capital gain of $824,176 earned on the disposition of qualified small business corporation shares. Because the deduction is available to every individual taxpayer, the structure of a trust can be used to access each beneficiary’s deduction to multiply the amount of taxable capital gains that can be sheltered from Canadian income tax. Specifically, the trust would dispose of the shares, realize the capital gain, and then distribute the proceeds to beneficiaries by way of an election under subsection 104(21.2) of the Income Tax Act to ensure that the capital gains retain their “character” as capital gains once in the hands of the beneficiaries. Each beneficiary would then be able to shelter up to $412,088 in taxable capital gains, assuming they are eligible for the full amount of the deduction. For example, if a trust with five beneficiaries realizes a $4 million dollar capital gain, of which $2 million is taxable, on the disposition of shares in a qualified small business, the gross proceeds can be flowed out to the five beneficiaries in equal amounts without any taxes being payable thereon, again assuming the proper election is made by the trust under subsection 104(21.2) of the Tax Act and that each beneficiary is fully entitled to the capital gains deduction in subsection 110.6(2.1) of the Canadian Tax Act. In some cases, it will be advisable to execute an estate freeze prior to the trust subscribing for shares in the family corporation in order to ensure that an optimal tax structure is in place. If you own a small business corporation that you feel is positioned for strong future growth, speak to one of our leading Calgary tax lawyers to discuss the possibility of settling a family trust to proactively reduce any future income tax owing on the sale of the business by exploiting each beneficiary’s lifetime capital gains deduction.
Trusts are an effective method to reduce taxes payable on income, especially income earned in a small business corporation. Corporate retained earnings can be paid out as a dividend to the shareholder family trust and split amongst all the beneficiaries of the trust, potentially reducing taxes payable on the dividend to nil. Further, capital gains realized by a trust on the sale of qualifying small business corporation shares can be flowed out to beneficiaries to take advantage of each beneficiary’s lifetime capital gains deduction, greatly reducing the amount of tax payable. Tax planning is by definition proactive and it is therefore imperative that all possible opportunities are explored and considered before a solution is required. Our team of Canadian Tax Lawyers are experts on income tax planning and income spliting and can structure your tax affairs in order to put an optimal strategy in place that limits your exposure for Canadian taxes.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."