Trusts for Small Business Owners

Courtesy of Invesco, Posted 29 Sep 2014

The trust has existed under common law for centuries and can be devoted to a wide variety of purposes. In essence, a trust structure separates legal ownership of property from beneficial ownership. In the hands of a business owner, a trust may likewise be applied for many purposes, but the focus is often on tax results.

For that business owner, the property in question consists of shares of a business corporation, with the trust beneficiaries being a combination of spouse, children and possibly extended family members. The business owner would generally be cast in the role of trustee – often with one or more other trustees – having the ability to legally manage the shares on an ongoing basis.

Though not exhaustive, summarized below are a number of key benefits of this arrangement. Circumstances will dictate whether and to what extent this may impact a particular individual or business, and therefore, consultation with qualified tax and legal professionals is a must before acting upon any of this information.

From an Income Perspective

Shares may be structured in such a way so dividends can be paid to the trust as a shareholder. In turn, the trustees will have the power to manage the distribution of dividends to the trust beneficiaries. As a flow-through from the trust, beneficiaries receiving dividends will generally be entitled to the dividend gross-up and tax credit.

The effective tax rate on Canadian dividends is less than it is for regular income (e.g., interest
and registered plan income), and can even be lower than the rate for capital gains, particularly for those individuals not in the top income tax bracket. There is actually a level where a taxpayer will pay no tax on the dividends if that person has no other income. For ineligible dividends (where the prior corporate income benefited from the small business deduction), the ‘tax-free’ dividend level ranges from a low of $7,000 to about $35,000, depending on the province.

Note that an anti-avoidance measure (known colloquially as the “kiddie tax”) effectively negates the preferential tax treatment of such dividends paid to minors related to the business owner, whether directly or via a trust. This measure may also apply to capital gains if dividend payments have been withheld on the shares.

From an Ownership Perspective

Generally, capital gains on business corporation shares will be realized on disposition at the business owner’s initiative, or possibly deemed so upon that person’s death. One or more trusts are often components of an estate-freezing exercise whereby eventual capital gains on these shares are sought to be pushed to younger generations. The freeze can be implemented by changes in beneficial ownership that may involve absolute transfers or may instead make use of intermediate vehicles, such as further corporations and/or trusts.

In addition to the capital-gains-freeze aspect, the concurrent purpose of this exercise is to multiply access to the lifetime capital gains exemption on qualifying small business corporation shares. The exemption (proposed to increase from $750,000 to $800,000 pursuant to the 2013 Federal Budget) is a per-person entitlement and can be structured using one or more trusts so the tax benefits can be achieved without the business owner losing control of the enterprise.

From a protection & control perspective

Subject to share provisions and/or a shareholders’ agreement, direct share owners generally have full ownership rights. Even when in a minority position, securities legislation may entitle a shareholder to require a corporation to take actions contrary to the controlling majority’s wishes. By separating beneficial from legal ownership, a trust can help the business owner achieve wealth- and estate-planning ends while muting business complications that might otherwise arise.

In addition to being subject to attack from others, property owned directly by an individual is exposed to the individual’s own frailties. A trust can provide a greater degree of insulation against present and future risks and uncertainties, such as creditor claims, matrimonial disputes, mental incapacity or the death of that individual.