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.