The 2 Best Strategies to Optimize Your Family Trust’s Taxes
DISCLAIMER
This information is intended for business owners in Canada and serves as general guidance only. Always consult with a qualified advisor before making any legal decision.
IN THIS ARTICLE, WE’LL COVER THE FOLLOWING TOPICS:
Family trust tax planning strategies
Strategy 1: Multiplication of lifetime capital gains exemption
Strategy 2: The prescribed rate loan strategy
Let’s start by acknowledging that family trusts are a very complex subject. As such, this article is not meant to be comprehensive and there are many nuances that require expert legal and tax advice. To determine whether or not a family trust is right for you, it’s best to speak with your tax advisor and lawyer.
That said, there are two important tax planning strategies to keep in mind when considering a family trust.
Tax Strategy 1: Multiplication of lifetime capital gains exemption.
The lifetime capital gains exemption, or LCGE, applies to the sale of certain types of shares and property. In most cases, the shares and property in question are held by corporations; in some instances, they are also applied to farm property and the principal residence exemption. In this example, we’re going to focus on the sale of shares in privately-held corporations.
If your family trust is structured so that it owns the shares of a privately-held corporation controlled by you, then upon the sale of the corporation, you and the other beneficiaries named in the family trust can make use of your lifetime capital gains exemption.
In 2022 each person’s LCGE is $913,630. So, if you, your spouse, and two children were all named as beneficiaries of a family trust, and the four of you decided to make use of your LCGE upon the sale of a company owned by the family trust, then the total exemption could be over $3.6 million dollars.
Note that in order for this tax planning strategy to work, the shares in your company would need to be considered qualified small business corporation shares. To meet that qualification, 90 percent of the assets held by your company need to be actively used in the business. This means that if there’s a stockpile of cash somewhere or other residual assets not being actively used, those assets will need to be pulled out of the corporation and funneled into a separate entity, whether it’s a holding company or some other investment vehicle. This process of purging non-active assets from your company is called purification, and it’s a process that can greatly benefit from the use of a family trust, especially when paired with a holding company.
Tax Strategy 2: Prescribed Rate Loan Strategy
In 2018, the Canadian government eliminated a lot of the income-splitting tax strategies typically used in family trusts. However, through the tax and split income of the TOSI rules, the prescribed rate loan strategy provides a variation of this type of income-splitting strategy.
How it works is that investment income held within the family can be split with a low-income spouse or other low-income beneficiaries, such as young children. The high-income earner will loan funds to the family trust, which, in turn, will use those funds to invest in publicly held securities. The yields from those public securities can then be re-invested by the family trust, thereby continuing to grow. And, you can take advantage of the fact that the beneficiaries of the trust don’t need to be paid out immediately each year (because low-income earners have a much lower marginal tax rate than high-income earners), meaning significant tax savings over time.
As of writing, the prescribed rate is 2%, however it is set to rise to 3% by the end of September 2022. This rate is locked in at the time of the loan’s creation, so locking in this strategy prior to Fall 2022 is advisable.
All that said, there are a few caveats to the prescribed rate loan strategy, the most important of which is that interest on the loan must be paid to the high-income earner on January 30th every year, and that if it’s not paid on time, the tax attribution rules will take effect and all income will be taxed at the rate that would have been applied to the high income earner. In other words, if you miss the January 30th deadline, you’re basically giving up all the benefits that this tax planning strategy would have granted you in the first place.
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