Canada is home to many small business owners. A family that works together stays together. But as a business owner, some estate questions haunt you; what will happen to your assets and business after you? Is there a way to reduce tax liability when you transfer assets to your loved ones? There is one answer, family trust.
What is a Family Trust?
A family trust is a legal entity created by a settlor to hold the family assets (like shares of your business, real estate, and investments) and administer them for the benefit of family members. The trustee is the decision maker that determines what to do with the assets and how to allocate capital gains and income to beneficiaries. The trustee can be a family member or a third party, and beneficiaries are family members or a family member’s business corporation.
A family trust is essential for estate planning if you have sizeable assets and several beneficiaries. There is a misconception that a family trust is only for the wealthy because setting up and maintaining trust is expensive. But they are also beneficial for small business owners. Here’s why:
Small Business Owners Can Transfer Assets With Minimal Estate Tax Liability
Your family will face a significant estate tax liability (up to 40%) on the future growth of your estate when you pass away. But if you transfer your assets to a trust, the trust becomes the legal owner freeing your family members from the estate tax. If your business is growing rapidly, you can transfer your shares into the trust and freeze your estate at the current value, thereby removing the capital gain tax on the future growth of the business.
For instance, Bob transfers his company’s shares worth $10 million into the ABC family trust, and the value of the shares becomes $15 million in 5 years. As the trust owns the business, family members are not subject to estate tax. If you freeze your assets at $10 million, you need not pay any tax on the appreciated value, making trusts affordable even to small business owners.
Other Tax Benefits of a Family Trust
While family trust minimizes estate tax, it is not exempt from taxes. For federal income tax purposes, a family trust is the owner and pays the top marginal tax rates on gains and income. However, the trust can reduce its tax liability by allocating income and capital gains to beneficiaries. Along with income, it transfers the tax liability to beneficiaries, who pay marginal tax rates that apply to them.
The income can be in the form of interests, dividends and capital gain from the sale of assets.
- When the trusts disburse dividends/interests to beneficiaries, it is called income splitting. For instance, Mary and Sarah are ABC family trust’s beneficiaries and receive $40,000 in dividend income. Mary has an annual taxable income of $80,000, and Sarah’s only source of income is from the trust. As a result, Mary will pay $8,200 income tax (marginal tax rate of 20.5%) on her $40,000, while Sarah will pay little to no federal tax on her $40,000.
- When the trust sells shares of the company, it can use the lifetime capital gains exemption (LCGE) of beneficiaries to reduce its CGT liability. The LCGE for qualified small business corporation shares is $913,630 in 2022. From our above example, the ABC trust gets a $5 million capital gain by selling the company’s shares. It distributes this $5 million to six beneficiaries, including Bob, Mary, and Sarah, thereby accessing their LCGE. This way, neither the trust nor the beneficiary pays capital gain tax on the $5 million.
- If the beneficiary is a corporate, the trust can accumulate its dividends, interest, and capital gains tax-free and defer these payments, thereby deferring tax liability.
A Family Trust Protects Assets from Credit Risk of Individual Beneficiary
Remember, the family trust is the legal owner of assets, which means beneficiaries need not disclose these assets in their balance sheets. As a result, it protects the assets from litigation disputes and future creditors of beneficiaries.
For instance, Mary is in a divorce lawsuit. So she transferred her vacation home to ABC trust, protecting it from the lawsuit. This feature is particularly beneficial to small business owners as it helps them keep their assets safe from business risk.
Small Business Owners Can Use Family Trust for Succession Planning
Many small business owners want to continue the legacy of their business and hand over the management to the right person. The passing of business operations to a CEO who can continue running the company is called succession planning. If business owners have no heir fit to run the business, they pass on the ownership to the trust, appoint a CEO, and ensure the family keeps getting regular income.
The business owner can also maintain an appropriate amount of business control by talking to their wealth advisor. A family trust has various structures, and your wealth advisor can help you set up a family trust best suited to your requirement.
Contact Edelkoort Smethurst CPAs LLP in Burlington to Help You Set Up Your Family Trust
Talk to a wealth advisor to understand your tax implications and estate planning options and evaluate a trust structure that aligns with your business objectives. At Edelkoort Smethurst CPAs LLP, our wealth and estate planning advisors can provide services like trust planning and consulting. To learn more about how Edelkoort Smethurst CPAs LLP can provide you with the best estate planning solutions, contact us online or by telephone at 905-517-2297.