As family wealth increases, thoughts about tax reduction, wealth preservation and wealth transition also increase.
One way families can address all three concerns is by using a family trust. Family trusts can be testamentary (arising on death) or inter vivos (used while alive), but the case studies below focus on uses of inter vivos family trusts.
What roles should family members play?
A family trust, like any other trust, requires three main parties: a settlor, trustee(s) and beneficiary(ies). The settlor establishes the trust and contributes the first asset. The trustee manages and administers the assets on behalf of the beneficiary. The beneficiary benefits from the income and capital of the trust. These roles and the terms of the trust are found in the trust deed (Figure 1).
Case study: Wilkins family business
The Wilkins family owns a successful auctioneer business. Melanie and her husband, Daniel, would like to include their four adult children as shareholders in the company as part of their succession plan. Three of the four children (Daniel Jr., Edward and Isabel) are married, with Tanya the only sibling who’s single. While Tanya isn’t active in the business, the Wilkins would like to include her as a shareholder. Melanie and Daniel are concerned about:
- distributing the value of the business fairly to their children in the event of their deaths;
- income splitting by paying dividends to each of their children, as well as to themselves;
- maintaining control over the business until the children are ready to run it;
- protecting each child’s interest in the business from potential future spousal and creditor claims; and
- locking in the tax liability on the growth of the business to date and splitting the future growth with their children.
The Wilkins decide to proceed with an estate freeze that includes the operating company, Wilkins Auctioneers, that is now wholly owned by the holding company (a numbered company). All common shares of the holding company are owned by the Wilkins Family Trust. Melanie and Daniel own 100% of the holding company’s voting preferred shares, which allows them to retain control of the business, caps the growth of the business in their hands, and transfers the future growth to their children.
The children will be the beneficiaries of the family trust, with Melanie and Daniel acting as trustees. If the trust is fully discretionary, Melanie and Daniel can control when the income of the trust (in this case, dividends, but other types of income are possible) is retained by the trust or allocated to the trust’s beneficiaries (Figure 2).
Role of the family trust
While a family trust isn’t a mandatory component of an estate freeze, its presence helps the Wilkinses to meet their objectives. Through the trust structure, they can ensure a fair distribution of the business, split dividend income with the children, and protect the children’s interest from future spousal or creditor claims. If the trust is fully discretionary, protection from such claims is further improved.
As trustees, Melanie and Daniel enhance their control of the children’s interests. This complements their control as the voting preferred shareholders. Not only can they make decisions about the operations of the business and declare dividends, they can control the allocation and distribution of income from the trust to their children. If any of the children have no other income sources, dividends could be paid to them tax-free. These tax-free dividends could range from $14,360 (P.E.I.) to $33,305 (Ontario), assuming no other income or deductions other than the basic personal amount and dividend tax credit.
Finally, with future growth of the business being attributed to the common shares held by the family trust, the lifetime capital gains exemption of each beneficiary can be used to shelter future capital from taxation.
Case study: Sharing the wealth in the Gerard family
Peter Gerard is an executive vice-president with a large Canadian conglomerate. His wife, Mary, is raising their four minor children (Alex, Michael, Justin and Elizabeth). Peter has accumulated significant cash outside his registered investment accounts. He wants to:
- invest the cash in a diversified portfolio and split the income with Mary and the children;
- continue to contribute to the assets over time and use them to pay for expenses related to the children, such as sporting activities and private school; and
- use the assets to fund the children’s post-secondary educations, home purchases, weddings and so on.
The family establishes the Gerard Family Trust. Charlene Gerard, Peter’s mother, settles the trust with an initial $100 cash contribution. Peter is the trustee and his wife and children are equal beneficiaries. Next, Peter lends $1 million to the trust through a prescribed-rate loan. The trust takes the cash proceeds and invests in a diversified portfolio.
The trust must pay the annual interest on the loan to Peter no later than January 30 of the year following the year the interest accrued. Peter must claim the prescribed-rate loan interest as taxable income on his tax return. The interest payment can be deducted from the trust’s income, with the net income being allocated or paid to the beneficiaries. This allows the income to be taxed in the beneficiaries’ hands with presumably little or no taxes payable (Figure 3).
Role of the family trust
Since most beneficiaries are minors, the trust structure allows Peter to execute the prescribed- rate loan strategy and lend the money necessary for investment directly to the trust. Income and capital gains earned on the invested funds are not attributed back to him. This could provide significant tax savings for Peter.
While he will have interest income of $10,000 (1% of $1,000,000) and pay tax of $5,000 (assuming a 50% tax rate), the beneficiaries of the trust likely have taxes near zero on the taxable income of the portfolio.
Peter’s taxes would likely be higher on the portfolio’s earnings if he earned them directly, given his tax bracket and the probability that the portfolio would generate taxable earnings greater than 1%. Further, as trustee, he maintains control over the asset, including investment decisions, allocations and distributions to beneficiaries.
A family trust can be an invaluable tool for high-net-worth families to pool their wealth, to lower income taxes across the family unit and to meet estate planning objectives. Whether planning for business succession or investment wealth transfer, a family trust is a viable solution to keep more wealth in the family.
Budget 2017 update
Federal Budget 2017 promises to review tax planning strategies related to private corporations. Two items are of particular interest and relate to the first case study involving a small business family. The first is income sprinkling: specifically, the payment of dividends from a private corporation to shareholders who are family members of the original owners. The second is the holding of a passive investment portfolio within a private corporation. As you will see in the first case study, both strategies can provide business owners with either significant immediate tax savings (income sprinkling) or a large tax deferral opportunity (holding of a passive investment portfolio within a private corporation). Should the federal government review lead to legislative changes in these areas, the tax planning strategies outlined below would need to be revisited for continued applicability.
Frank Di Pietro, CFA, CFP, is assistant vice-president of tax and estate planning at Mackenzie Investments. He can be reached at firstname.lastname@example.org.