- Introducing a Family Trust as a Shareholder in a Private Corporation [Derek King Newsletter]
- The Use of Family Trusts [link to Ginsberg Gluzman Fage & Levitz Newsletter]
Introducing a Family Trust as a Shareholder in a Private Corporation [Derek King Newsletter]
A complex transaction that can not only achieve creditor proofing, but potentially provide a means to income split with family members, potentially provides multiple access to the $800,000 capital gains exemption and finally, may provide a means to crystallize or “freeze” the income tax liability related to your company’s shares at death.
Example: Starlet Yohansen owns all the common shares of Movie Star Limited (“MSL”). The shares initially cost Starlet $1 and are now worth $3,000,000.
For Starlet to concurrently achieve all the objectives noted above, she would typically “freeze” the value of her common shares in MSL. At the date of the “freeze”, Starlet would exchange her common shares for special preferred shares with a value equal to the value of the common shares exchanged, that being $3,000,000. Thus, at this point in time, there are no common shares and Starlet owns special shares worth $3,000,000. These special shares cannot increase in value, hence the term “freeze”.
Any future growth in the value of MSL over the current value of $3,000,000 will accrue only to the new common shares that are issued as part of this reorganization. That growth will accrue directly, or indirectly through a family trust, to potentially Starlet’s family members and/or a Holding company by having them subscribe for the new common shares issued in MSL (Starlet can also maintain some of the future growth if she subscribes for the new common shares or is included in the family trust). Often we see this strategy being used in succession planning when the owner-manager wishes to transfer ownership of their operating company to the next generation, but this strategy can be used without succession being the objective.
The beauty of the freeze is that Starlet’s maximum income tax liability on her MSL shares has been established (unless she subscribes for more common shares). At Starlet’s death, her income tax liability on her MSL shares will be equal to $3,000,000 times the applicable income tax rate at that time, likely around 23%. As Starlet knows the maximum income tax liability on her special shares she can plan to pay this liability by putting aside funds or by purchasing life insurance.
In addition, we often further reduce Starlet’s income tax liability by redeeming her frozen shares over time, which typically creates a current taxable dividend to Starlet, but also serves to reduce the value of the frozen shares by essentially the value of the dividend reported [ie: if Starlet redeems 500,000 shares that have a paid up capital and adjusted cost base of $1, she will have a deemed dividend of approximately $500,000 to report on her personal income tax return and her special shares are now only worth $2,500,000 ($3,000,000-$500,000 redeemed)]. Thus, if Starlet lives long enough, much if not all of her income tax liability can be eliminated prior to her death by redeeming her shares slowly over time.
If Starlet uses the Yohansen Family Trust to subscribe for the new common shares of MSL, the beneficiaries of the family trust would typically include Starlet, her spouse, her children and a Holding company. The inclusion of these beneficiaries can provide tax-effective income splitting on dividends received from MSL when the children are 18 years of age or older or when a spouse is in a lower income tax bracket. The trust can also provide tax-effective income splitting on the sale of a business regardless of the beneficiary’s age.
Generally, a family trust is discretionary. The trustees can tax effectively allocate the income received by the trust (i.e. dividends from MSL) to any or all of the beneficiaries including Starlet, so long as they are 18 years of age or older. A beneficiary who is 18 years of age or older and has no other sources of income can receive up to $35,500 in dividends tax-free. This strategy is a great way to help fund a child’s post-secondary school education (in addition to an RESP) or other expenses, while also lessening the family’s overall income tax liability.
If the shares of MSL are sold in the future, any sale proceeds in excess of the value of Starlet’s original frozen special preferred shares ($3,000,000 maximum) can be allocated to the beneficiaries of the trust. This may permit the utilization of the $800,000 capital gains exemption by each of these beneficiaries. A word to the wise though, any sales proceeds allocated to a beneficiary of the trust, including a minor child, will result in the money legally belonging to the child.
Finally, back to the original creditor proofing issue. The inclusion of a Holdco as a beneficiary of the trust would provide a means to transfer any excess funds in MSL as a tax-free via a dividend from MSL to Holdco thus creditor proofing the excess cash in MSL by moving it to Holdco.
- The family trust “settlor” should not be a trustee or beneficiary.
- There should have 3 to 5 active trustees with a majority decision required. No trustee should have a veto. Minutes of meeting and complete banking records must be kept.
- The beneficiaries usually include all family members and may include future children or grandchildren. There are complications if non-residents are beneficiaries.
- A corporation (“Holdco”) can also be a beneficiary – excess operating cash can be flowed on a tax-deferred basis to this company.
- The existing common shareholders must receive fair market value for their shares – a formal business valuation is required.
- The agreement should include a price adjustment clause in the event CRA disagrees with the valuation.
- The “freeze” preference shares should be voting, redeemable and retractable. There should be a reasonable dividend (ie 5% to 10% annually) payable on these shares.
- The family trust subscribes for new common shares. The cash comes from a bank account with a small overdraft protection (or a loan via a promissory note with a prescribed interest rate). The loan will be repaid later when the trust receives a dividend.
- The assets of the trust are normally distributed to the beneficiaries before the 21st anniversary of the trust.