Family trusts – contrarian view Part I

Family Trust Pitfalls

*The Canadian government announced in July of 2017 that it is considering important changes to the Income Tax Act. The ability to multiply the LCGE will most likely be eliminated. Read my blog post here for more information*

I set out to write an article on the advantages and disadvantages of establishing a family trust and why I feel this option may be over-prescribed. However, as the exercise of writing this article has so starkly reminded me, this topic is difficult to explain clearly. So rather than cramming all of these concepts in one article, I have decided to break it down into more manageable chunks. In Part I, I will explain the method professionals recommend and some Income Tax Act provisions that drive this strategy. Later, I will cover the advantages and disadvantages. Hint: in theory, it works wonderfully; however, this strategy can cost a ton of money without providing any real benefit in practical terms.

Part I

Family trusts: If you own a business and start succession planning, your lawyer or accountant will undoubtedly discuss ‘freezing’ the corporation’s value and establishing a family trust. While in certain situations, this may be suitable, In my experience, professionals seem to recommend it more often than needed. Why are they becoming so prevalent? What are other options? Before I review the advantages and disadvantages, we should start by defining and explaining trusts. What are they exactly?

Definition

Merriam-Webster defines it as:

 “a property interest held by one person for the benefit of another”

Trusts are a creature of common law. They first came into being in the 12th century in England. While they seem mysterious, they are commonly used today. For example, when someone dies leaving a will, the deceased’s property is held in trust by the executor until it is distributed to the beneficiaries.

Use in Corporate Restructuring

Business owners establish family trusts to plan for succession. The main motivation is to bring in a new generation while planning to pay taxes on death.

Income Tax Act

When you sell shares of a company, you must pay tax on your Capital Gains. Capital Gains are essentially the growth in value of your shares and are calculated by subtracting the price you paid from the price you sell. Other adjustments are also included, but for the sake of keeping it simple, I omitted them. For example, a share sold for $50 minus bought for $10 = $40 in Capital Gains. When you die, the Income Tax Act creates a “deemed disposition.” This means from Revenue Canada’s point of view, on the day you die, you ‘sell’ all of your assets at fair market value, even if, in reality, you gift them to your children through the will. Revenue Canada then expects your estate to pay tax on the Capital Gains from the “deemed” sale. However, the Income Tax Act provides some relief. Every person can benefit from a Lifetime Capital Gains Exemption (LCGE) which is currently (2017) $835 716.00 (it is indexed to inflation and increases every year). For example, shares sold for $1 million minus shares bought for $10 = $999 990.00 in Capital Gains minus LCGE of $835 716.00 = $164 274.00 in taxable capital gains.

Family Trust Restructuring Example

You and your spouse, being the only owners, own 50 common shares each in your corporation. You have been in business for 20 years and now your employee children want to take an ownership stake. Let’s say the corporation is worth $1 million. You would freeze that value and convert your 100 common shares into preference shares. You will receive shares with a fixed value, often being one preference share for each 1$ of value. So, in this case, you would each receive 500 000 preference shares. The corporation would then issue new common shares to a family trust. As the company grows in value, the growth would be attributed to those new common shares instead of your shares which have been frozen in value.

Disposition of Shares

If you die or sell your shares, the value of your shares are fixed. In this case, the value is less than the LCGE of $835 716.00, so you would not have to pay taxes on the sale. If you die, your estate will not face a tax bill on your assets’ “deemed disposition”.The company’s future growth will go to a family trust, which then decides how the money will flow out of the trust to the beneficiaries, who are presumably you, your spouse and your children. If you sell the corporation later, each beneficiary can apply their LCGE to reduce the amount of tax payable.

Multiplying Capital Gain Exemption

For example, if the company grows in value to $5 million, you and your spouse would apply for your exemption on the sale of your frozen preference shares ($500,000 each). The remaining four beneficiaries would apply their LCGE to the remaining $4 million (4 x $835 716.00 = $3 342 864.00), which leaves a taxable gain of $657 136.00. However, you and your spouse still have $335 716.00 of unused LCGE each. As you and your spouse are also beneficiaries under the family trust, you could apply that residue to the remaining taxable capital gain. (LCGE of $335 716.00 x 2 = $671 432.00 of LCGE, which more than covers the leftover capital gains of $657 136.00). In this case, the combined LCGE would cover all the capital gains and no capital gains tax would be payable. Sounds great, doesn’t it? As alluded to above, while this works in theory, the practical reality doesn’t always pan out. I will cover those realities in Part II. Stay tuned.

Disclaimer – Legalese

This article is presented for informational purposes only. The content does not constitute legal advice or solicitation and does not create a solicitor-client relationship (this means that I am not your lawyer until we both agree that I am). If you are seeking advice on specific matters, please contact Philippe Richer at 204.925.1900. We cannot consider any unsolicited information sent to the author as solicitor-client privileged (this means confidential).

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