Today we’re talking about Family Trusts, a wonderful tax planning tool.
It used to be a popular strategy for income splitting amongst lower income family members, although recent tax changes have caused substantial changes to this.
However, there are still some valid reasons for a Family Trust to be part of your overall corporate structure. We’re going to tell you there are still some tax advantages to them and let’s cover them today.
Below you will find an example of what a typical structure for a family trust may look like.
Most of the time, you start with you Operating Company (OPCO), the company which is generating the active or passive business income. This company could be, for example, maybe a real estate development company or a plumbing company or something along those lines.
When you have the operating company, which is either increasing in value over time, or has surplus cash, a family trust and holding company (HOLDCO) can be beneficial.
One of the reasons a trust can be beneficial is the creation of an added layer of liability protection.
This helps shelter the shares of the operating company from personal creditors, division of family property and helps transition passive assets outside of your operating company to protect it from corporate creditors.
We often see all of the passive assets, such as surplus cash/investments etc, get funneled through the trust and end up in the HOLDCO. We like to call this your Piggy Bank!
Eventually if you sell the OPCO, the last thing you likely want is to sell all your hard-earned cash with the company. Most business owners will tend to utilize this “Piggy Bank” for funding their retirement, or perhaps investing in their next business venture.
Lifetime Capital Gains Exemption
Let’s take a look at another major advantage of the family trust, which of course is the ability to multiply the Lifetime Capital Gains Exemption (LCGE). This means that you have the ability to use the LCGE for anyone who is a beneficiary of the family trust.
All this results in more tax-free money that would result from the sale of your OPCO. Of course, there are many complexities as to what is takes for your company to qualify for this and that is a subject for another time.
That sounds all well and good, but how does it actually work?
Here’s an example – Mom and Dad own the OPCO, valued at $5,000,000 and all the shares are owned by the family trust ($0 ACB) and they sell the shares of the OPCO to a third party, they would need to pay capital gains taxation on the gain of $5,000,000.
Assuming a 50.40% marginal tax rate, that would result in a hefty tax bill of $1,260,000 for simple math.
However, you can limit your tax liability on the sale of your operating company through using LCGE for any beneficiaries on the trust.
Perhaps, Mom, Dad and their two children are on the trust as beneficiaries. This would mean they could potentially shelter $866,912 (2019 limit) of LCGE times four, or $3,467,648, which would reduce the tax bill for their sale to $386,152 using similar assumptions.
That’s a significant increase on their bottom line! Of course, they may even have more beneficiaries on their trust, thus allowing an even greater advantage.
Needless to say, the ability to multiply Lifetime Capital Gains Exemptions can be quite powerful!
Liability protection can be another advantage for some clients.
It’s unfortunate it could happen, any lawsuits that come to the OPCO would ideally remain in the OPCO.
Of course, we’re not giving you legal advice here, but many lawyers would likely say that adding a family trust is a great benefit in reducing any potential liability exposure to the corporation’s passive assets.
So, the theory is, you transition any passive assets/cash out of your OPCO and leave as little as possible in the OPCO so that the liability is significantly reduced, and you can only lose what’s owned by the OPCO.
Let’s take a quick look at an estate freeze.
First off, what is an Estate Freeze? It is the concept of freezing the value of your shares and transferring the future growth in the company to a new shareholder, such as a trust, a holding company or an individual.
By using a trust for an estate freeze, you can transfer all the growth in the company’s value to the next generation and use their capital gains exemption down the road.
In doing this, you can retain control. Then later you can decide if you want to give shares or not to the next generation, however it provides you with options. This leads to the conversation about timing and when is the best time to implement this strategy.
Trusts have a 21-year lifespan for tax sheltering any growth. That’s it! After 21 years, any gains in the value of the shares owned by the trust must be taxed, as the trust is considered to have a deemed disposition of all assets every 21 years.
When you’re considering a trust, make sure to talk to your tax planning expert about the length of time that you have and determine the most opportune time to start the trust. Often, we see the huge advantage for the estate freeze with business succession planning or high growth businesses.
Whether your goal is business succession, selling your company to a third party, legacy planning or multigenerational planning, it’s very important to know what that tax bill will be on death. If you could lock that in today, it’s a wonderful tool for tax planning.