DAVID WILKENFELD, CPA, CA, canadian tax CONSULTANT

Posts Tagged ‘Income Splitting’

The Corporate Beneficiary

In Canadian Income Tax, Estates and trusts on October 25, 2010 at 3:46 pm

The family trust is alive these days and thriving more than ever. More and more taxpayers are beginning to appreciate the tax saving possibilities of income-splitting. The trustee has the absolute power to allocate income or capital of the trust to any beneficiary of his choice with no restrictions.

In a simple structure, a trust is created, with children as beneficiaries. The trust owns shares of an operating company (“Opco”) which pays annual dividends to the trust. The dividends are then distributed to the beneficiaries and taxed at their graduating marginal rates.

One spin on the family trust is to add a corporation to the list of trust beneficiaries. This option provides even more flexibility and advantages to the common family trust.

In an income splitting situation, it may not be desirable to pay dividends to the trust over a certain amount – that is the amount that would yield the lowest rates of tax when distributed to beneficiaries. For example, a Quebec taxpayer with no other income may earn up to $12,500 in dividends before paying any tax. The trustee may not wish to distribute more than this amount to the beneficiaries annually. If Opco has high income, its directors may find such a limitation restraining.

Adding a holding company (“Holdco”) to the list of beneficiaries wipes out this limitation. Opco could pay a large dividend to the trust. The trustee would allocate a portion of the dividend to the individual beneficiaries, and the excess would be assigned to Holdco.

A dividend paid by one corporation to a connected company is non-taxable. However, since Holdco does not own any shares directly in Opco, care would have to be exercised to ensure that the two companies were technically connected for tax purposes. Generally, this could be accomplished if the trust controlled Opco, or Opco and Holdco were controlled by persons who do not deal at arm’s length with each other.

Where Opco generates high levels of cash, the ability to pay dividends in this manner provides certain advantages. First, it allows protection from creditors in that cash may easily be moved out through dividends and away from potential claims.

Where individual beneficiaries have not claimed their capital gains exemption, this structure provides an easy means of having the company qualify as a small business corporation by paying excess “non business” cash out as a dividend.

Sometimes, the implementation of a family trust involves an estate freeze. In such a case, corporate attribution rules may apply to assign deemed dividends to the value of preferred shares issued to a parent as part of the freeze. One exception to this rule is to ensure Opco remains a small business corporation throughout the year. The ability to pay unlimited dividends to the trust on an ongoing basis would allow Opco to retain its small business corporation status so the exception applies.

Finally, if the trust is wound up, it may be possible to distribute the Opco shares to Holdco free of tax, thereby eliminating the need to give up eventual ownership of the shares to children.

Before implementing any such complex structure, care should be taken to ensure that all legal requirements are met, and that the tax advantages are worth the added costs.