Keeping your business "all in the family" is what income splitting is all about. One of the best long-term tax planning opportunities available to entrepreneurs, it enables owners of small-to-midsized companies to structure their affairs so that current and future income can be shifted to family members in lower tax brackets. This will ease your current and future tax burden considerably, help to protect and creditor-proof your assets, and even reduce future probate fees. Best of all, when you decide to sell, income splitting can turn your personal one-time $500,000 capital gains exemption into a winning proposition by multiplying that amount by the number of your family members.
The most common way to split annual income is, of course, to pay salaries to individual family members for services rendered. While remuneration should be based on responsibilities assumed and services performed, you have reasonable latitude concerning the amounts paid. This is particularly true for spouses and children 18 years of age or older. You have less flexibility in the case of younger children because paying them large sums is more difficult to justify.
While paying salaries to your children offers some tax reductions, the best way to achieve long-term savings is by structuring your company’s ownership so that you pay dividends to them and your spouse. Shared ownership, moreover, provides a significant opportunity to dramatically reduce the tax payable on your company’s eventual sale. Since any income splitting of this nature is predicated on your company's future growth prospects, timing is everything. That's why the time to start thinking about structuring such an arrangement is sooner rather than later in your business' life cycle. If you are planning to start a business and want to maximize future income-splitting opportunities, you might consider involving your children, spouse or both as shareholders from the beginning.
Forming a discretionary Canadian trust to hold all or a portion of your company's shares will allow you to make your family its beneficiaries. If you have an existing business and believe it will grow fairly quickly, it's possible to structure a transaction whereby you, as the company's current owner, convert your common shares to preferred shares, which equal the present value of the company. All or a portion of the common shares, representing the company's future growth, would be held by the newly-created family trust.
Apart from the income-splitting possibilities mentioned here, family trusts also help to creditor-proof assets. Because the beneficiaries are discretionary, they have no right in law to any income or capital held by the trust until the trustees decide to allocate it to them.
Trusts, moreover, are extremely flexible. The trust document would allow the trustees -- and you, as the company's owner, would likely be one -- to decide the amount of capital or income, if any, payable to all, any or none of the beneficiaries. The trustees would then distribute the dividends paid from the operating company to the trust in whatever manner they choose.
An individual with no other income source in Canada is allowed to earn up to $23,500 in dividends before paying any tax. This arrangement works particularly well for spouses and majority-age children. However, as a result of the February 1999 budget, any dividends payable to children under the age of 19 will be taxable at the highest personal rate.
The good news is that all children, regardless of age, as well as spouses, are still eligible to claim the $500,000 capital gains exemption. Therefore, when your company's shares have grown substantially in value, say in 10 years' time, the trust can sell them -- along with the preferred shares -- provided you froze your existing shares previously. The capital gain realized can be allocated to your beneficiaries, each of whom is eligible to apply for the $500,000 exemption. Thus, a family of four would be eligible for a $2-million exemption.
To guard against the possibility of a future Finance Minister eliminating this opportunity by the stroke of a legislative pen, it's possible to "crystallize" the inherent gain in the common shares -- assuming they grow in future -- so the capital gains exemption will increase their cost base. That way, even if the exemption disappears in a future budget, you will be ready to reap the benefits on your company's eventual sale.
The $500,000 capital gains exemption on the sale of shares of qualifying Canadian small-business corporations, and the ability to multiply that exemption by family members, is one of the biggest inducements small and mid-sized entrepreneurs have to carry on business in this country.
As always, the key is to plan now to structure your affairs so that, from the outset, you can take full advantage of current and future income-splitting opportunities in the Canadian tax system.
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The foregoing article, prepared by Dean R. Levitt, FCA, was first published in The Globe & Mail’s "Report on Business".
Dean Levitt is the Toronto-based Leader of the PricewaterhouseCoopers LLP Personal Financial Services tax practice. E-mail: email@example.com
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