Canada: Canadian Income Tax – Using Family Trusts For Small Business Tax Planning – Toronto Tax Lawyer Analysis

Last Updated: July 12 2016
Article by David Rotfleisch

Introduction

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.

Trusts Explained

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.

Conclusion

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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
Collins Barrow National Incorporated
Minden Gross LLP
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Collins Barrow National Incorporated
Minden Gross LLP
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions