My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Tuesday, March 1, 2011

Introducing a Family Trust as a Shareholder in a Private Corporation

Two weeks ago I discussed using a holding company as a simple method to creditor proof excess corporate funds or other assets in a private corporation. In this blog I will discuss a “fancier” and far more complex transaction that can not only achieve creditor proofing, but potentially provides a means to income split with family members, potentially provides multiple access to the $750,000 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.

For the purpose of this blog, I will  use the example of Starlet Yohansen who 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 (although given Starlet's past history, we may want to leave her spouse out of the trust), 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 (Starlet may have a trophy husband who does not have much income). The trust can also provide tax-effective income splitting on the sale of a business irregardless 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 $37,500 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 $750,000 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.

I am sure there are very few readers still awake or with eyes not glazed over; but believe it or not, this type of reorganization has been simplified greatly for discussion purposes. There are several pitfalls along the way and in the future that must be avoided in order to successfully achieve the objectives noted at the beginning of this blog. If you are contemplating undertaking such a transaction, you must consult your accountant and lawyer to ensure that the transaction makes sense given your personal situation and that no details are missed in carrying out the finer points of the reorganization.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the material is time sensitive and subject to changes in legislation or law.

34 comments:

  1. Hi Mark, using your example, would it make sense to first rollover the common shares to a Holdco at an ACB of $750,001 to "crystallize" the Capital Gains Exemption for Starlet?

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  2. Simon, congrats for making it through this detailed blog and asking a great question.

    The Holdco would be problematic for cost base and future sale reasons. However, if Starlet still has her capital gains exemption and wanted to crytalize and the common shares met certain criteria, she could crystalize with a tax election when exchanging her common shares for the special shares.

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  3. Hi Mark, thanks for this blog. What would be the value in considering Alberta as a jurisdiction for the Yohansen Family Trust?

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  4. I enjoy your writing.

    I'm guessing that one of the other complications of utilizing the $750k exemption is how to make those assets of MSL substantively all used in an active business...

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  5. Anon:

    Complex question.

    In order to utilize an Alberta trust if you are not actually resident in Alberta, the trust itself must be resident in Alberta and the majority of trustees must be resident in Alberta.

    However, in the past couple years there have been a couple cases on trusts (Garron and Garron, Trustees of the Garron Family Trust v The Queen, being the main one) that have cast some concern on whether Alberta trusts are still effective if the decision makers in regard to central management and control, Starlet, in this case are not resident in Alberta. Thus, you should tread carefully and obtain professional advice.

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  6. Sacha, thanks for the kind words.

    I felt the blog was complicated enough without getting into the complex criteria as to how to qualify for the $750,000 exemption, which includes a two year asset test and a time of disposition test. However, the beauty of using the holding company as a beneficiary of the trust is, you can use it to purify any excess cash not used in the active business to help keep MSL in this example eligible for the $750k exemption.

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  7. Hey Mark, Ryan Reynolds here, ha. My business is not at a stage where I have succession concerns. When should I consider a family trust for just tax planning purposes.

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  8. Hey Ryan, tough break about Starlet. I would suggest you consider the family trust when (a) you think you may have explosive growth in the value of your company and you may want to income split by multiplying the capital gains exemption (although as noted in the blog, the money legally belongs to your children or (b)just before your first child turns 18.

    If you allocate $37,500 in dividends to a child at least 18 years old, the tax savings could be as high as $12,000 per child or more if the dividend is even higher.

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    Replies
    1. If the child has some income, let's say from a part-time job of 10K a year, does that just reduce the amount of dividends to $27,500

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  9. Hey ryan
    we need draft of family trust required in such cases. shall be obliged if u could help us.our e mail id is dalip.adv@gmail.com

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  10. Malhotra-My clients pay signficant money for these documents. I do not provide templates or documents, only the ideas and concepts. I suggest you engage a lawyer to proeprly draft a family trust specific to your situation, if the trust makes sense, you will save a multiple of the lawyers fee in taxes.

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  11. Hi Mark,
    Wanted to become learn about trusts and just (Feb 2012)found your post. Informative. Thanks.
    The claw back of my Canada Pension is significant due dividend income in addition to my defined pension pay out. Would setting up a trust result in keeping more of this pay out?

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  12. Hi Frans:

    The type of trust discussed in this blog would not be helpful. However, if you have an accountant you should ask them whether using a holding company, alter ego trust or joint partner trust would be beneficial in your case.

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  13. Hi Mark,

    another great article.
    My company has started a similar re-org process to what you described here.
    However, there are a couple differences I would love to get your perspective on.
    1) Our lawyers/accountants suggested using a connected HoldCo. to own the shares from OpCo. through a section 85 rollover.
    2) The family trust owns special preferred shares to receive dividends from HoldCo.
    3) Optional use of InvestCo. as a beneficiary of the Trust for investment of excess funds. It also becomes a good substitute for RRSPs.

    What are the benefits/disadvantages of this model? I still don't understand why we eventually need two companies (HoldCo. and InvestCo.) and a Trust.

    Keep up with the great postings.
    Cheers,

    Eduardo.

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    Replies
    1. Hi Eduardo, I responded to the same or similar question on Sept 9th,in the should your corp s/h be a family trust blog, see that answer

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  14. Hi Mark,

    I am interested on your thoughts pertaining to tuition (or other expenses) to family trust beneficiaries. Would these be deductible within the trust as an expense or do they have to be attributed against the $37,500 "tax-free" dividend?

    Thanks

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    Replies
    1. Hi Doug

      The trust does not have "expenses" for tuition and other children benefits. What we try and have our clients do is pay a dividend to an account in the child's name. The child then pays for the tuition or other expense. Practically, the trust sometimes pays, however that is then considered as part of the dividend paid to the child. it is not a separate expense.

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  15. hi doug, i have a family trust in quebec and currently going thru a divorce. I invested/purchased say $200k, 5 yrs ago, for private company equity, in favour of the trust, which are currently valued at say $1m. Does the trust adequately protect from the division of assets in case of divorce (ie. 50% of $1m) and all I would owe is $50% of the initial investment??

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    Replies
    1. Sorry, I have no idea about Quebec tax or family law, ask your lawyer.

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  16. Hi,

    In your example would the family trust own shares in the HoldCo and also be a beneficiary of the trust?

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    Replies
    1. No, the family trust owns opco and a beneficiary of the family trust is a Holdco

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  17. Hi, I recently bought a house with my dad's money (loan) because he was undertaking heavy medical treatment and the deal on the house was right, we didn't want to loose it; what's the best way for me to return it? to transfer it under his name and him putting it into his will or transferring the house in the family trust(I'm in the process of making one)? The end result will be the same but what's better?

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    Replies
    1. Hi Anon

      Sorry, but I don't provide personal tax planning advice on this blog. Please engage an accountant.

      Delete
  18. Hi Mark,

    Love your blog! What is the benefit of redeeming the shares gradually? Is this so that we can gradually pay the taxes in a lower bracket as opposed to having a huge lump sum later on?

    Thanks!

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    Replies
    1. Yes, exactly. A slow redemption can save tax or even reduce OAS clawbacks etc

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  19. Are there any workable methods to delay capital gains in family trust at the 21 year. Transfer out at cost to another trust?

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    Replies
    1. Hi Unknown

      Typically you can transfer the property to the beneficiaries without negative tax consequences. Speak to your accountant.

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  20. Hello - Firstly, great job! I think your blogs are very helpful. I am a CA, CPA myself. I had a question that has got me thinking. Can a family trust (living trust) in Canada own a foreign corporation? I think yes, but wanted double assurance. Secondly, if a HoldCo. (which is incorporated in Canada) is assigned a beneficiary of that family trust. The OperatingCo (which is based abroad), pays excess earnings as dividend to the trust (the trust owns 100%of OperatingCo,). The trust now allocates some of the dividend income to HoldCo., does that dividend income flows tax-free? If yes, then what is the logic? I mean the HoldCo. does not own any shares in OperatingCo.

    Thanks for your input in advance.

    Best,
    Ali

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    Replies
    1. Hi Ali

      Sorry, I dont provide tax planning advice on this blog

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    2. Hey,

      I am not looking for any advice. I just wanted your thoughts. But thank you. Can you at least share your input on how the trust can allocate income to HoldCo. that flows tax-free?

      Best,
      Ali

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    3. Hi Ali

      Here is a very good article on how you can use a corporate beneficiary to flow funds tax free from the trust http://thetaxissue.com/the-corporate-beneficiary-2/

      Delete
  21. Hi Mark,

    Great post.

    Wanted to get clarification about your example. Who would be the settlor of the Yohansen Family Trust?

    If Starlet is the settlor and a beneficiary, would that trigger Section 75(2), where all income from the trust is attributed back to the person who contributed the property to the trust?

    Second question. If MSL already has retained earnings in the company (earned before and not after the Yohansen Family Trust subscribing for shares), can those earnings still be paid out as dividends to the Trust's beneficiaries (i.e. HoldCo tax free)?

    Thanks,

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    Replies
    1. Hi Anon

      I am not answering any question that is affected by the Liberals proposals, such as trusts. In any event your questions are too complicated to be answered on a blog, ask your accountant.

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