This discussion will focus on succession and tax planning by using a Trust to own shares (“Shares”) in a Canadian controlled private business corporation (the “Corporation”). It presumes that the Corporation will be a qualified small business corporation for purposes of the use of the lifetime capital gains exemption.
A Trust is not a legal entity, like a person or corporation, but is a taxable entity. If a Trust is to contract or sue, it is the Trustees who do so on behalf of the Trust. To sue a Trust, the Trustees must be sued. A Trust authorizes its Trustees to hold and manage the assets of the Trust on behalf of and for the benefit of the Beneficiaries of the Trust.
The Settlor establishes the Trust by settling an asset on it. The Trustees enter into an Agreement or Deed of Trust with the Settlor and agree to manage the assets of the Trust for the Beneficiaries. The Beneficiaries are named in the Trust Deed or Agreement, are entitled to the ongoing benefits arising from the ownership and investment of the Trust assets and are the ultimate beneficial owners of the assets in the Trust.
The Trustees control the assets in the Trust during its lifetime. The Trustees are given complete discretion to allocate the benefits from the Trust assets and, ultimately, the assets themselves among the Beneficiaries disproportionately, and to some to the exclusion of others. By allocating benefits and assets judiciously, Trustees can protect them from creditors or other claimants.
Canadian residency is ensured for tax purposes by Canadian residents being a majority of the Trustees.
For ownership of Shares, the Trust can be put in place on day one of the Corporation, and therefore can buy Shares for nominal value. If the Trust becomes a shareholder later in the life of the Corporation, the Trust will pay fair market value for the Shares, or, more commonly, a freeze of the value of the existing issued Shares in the hands of the shareholders who own them will be required. Because all of the fair value of the Corporation will then be in the frozen Shares, the Trust and the existing shareholder, if desired, can then buy new Shares for nominal value.
The Settlor starts the Trust by settling an asset on it and entering into a Trust Agreement or Deed with the Trustees. The asset settled will not be used by the Trustees to buy Shares or other assets on behalf of the Trust. Often the asset settled is a commemorative coin or keepsake that will never be used to buy assets, but will be kept by the Trustees on behalf of the Beneficiaries as long as the Trust exists.
The choice of Settlor is critical. Ideally it should be a family friend or non-linear relative. If the Settlor is, say, the parent or spouse of Beneficiaries, and the settled asset is cash and is used by the Trustees to buy Shares, all of the benefits associated with those Shares, including dividends and capital gains, will be attributed back to the Settlor for tax purposes. This result defeats the purpose of using a Trust.
The Trustees can be anyone willing to manage the Trust’s assets for the benefit of the Beneficiaries. Often when a Trust is used to own Shares, the Trustees will be the principal of the Corporation, his or her spouse and a third arm’s length trustee such as a friend or professional advisor. Trustees have a high fiduciary duty or duty of care in carrying out their responsibilities on behalf of the Beneficiaries.
The Beneficiaries are named in the Trust Deed or Agreement. They can include the principal of the business, the spouse, their children, their grand-children, their parents or other relatives and anyone else to receive the benefit of the assets in the Trust. Often, children and grand-children are included as a group rather than by individual names, so that children born after the date of establishment of the Trust are also included.
The Trustees control the Shares during the life of the Trust. The Beneficiaries have no say in how the assets of the Trust are managed and cannot demand to receive any benefit other than what the Trustees decide on.
If the Trust receives dividends on the Shares, the payment of the dividends to Beneficiaries is totally discretionary to the Trustees. They can be paid disproportionately to the Beneficiaries and to some to the exclusion of others.
There is no advantage to paying dividends to a Beneficiary under the age of 18 because of the “Kiddie Tax” introduced in 1999. Those dividends would be taxed at the top rate. But in the year in which a Beneficiary turns 18, and after, the payment of a dividend to him or her can be quite advantageous.
The Trust itself is a taxpayer and its income can be taxed within it. Generally, this is not desirable because the Trust is taxed at the highest marginal tax rate without the benefit of personal exemptions. But there may be some circumstances when it is desirable to keep the money within the Trust and taxed there. Ordinarily, however, dividends or other income received by the Trust will be flowed through to the Beneficiaries and taxed in their hands. This can be done by paying to the Beneficiaries directly, or by paying certain expenses on their behalf such as tuition fees or medical expenses. Those payments are treated as income to the Beneficiaries.
A distinction can be made between income Beneficiaries and capital Beneficiaries.
If a Beneficiary is disabled, the Trustees can use the preferred beneficiary election to elect that the dividend be taxed in the hands of the Beneficiary, but not actually paid to him or her. It is then retained by the Trust and invested and administered on behalf of that disabled Beneficiary.
The Trust allows the capital gains on the sale of the Shares to be spread around among the Beneficiaries. This allows for the multiplication of the use of the $800,000 lifetime capital gains exemption. The allocation of Shares for this purpose is, again, totally discretionary to the Trustees.
Generally, the assets in the Trust must be distributed to the Beneficiaries within 21 years after the establishment of the Trust. This is because, under the Income Tax Act, all of the assets in the Trust are deemed to be disposed of every 21 years, so that capital gains do not accrue indefinitely. The deemed disposition is avoided by distributing the Shares and any other assets to the Beneficiaries before the expiry of the 21 year period; there is no deemed disposition because the Beneficiaries are deemed to have owned the Shares all along.
The Trust serves succession planning purposes by fully utilizing available capital gains exemptions on the sale of the Corporation, by spreading the taxable portion of non-exempt capital gains around, and/or by keeping the Shares under the control of the Trustees until their distribution to the Beneficiaries. This latter scenario is particularly appropriate if it is anticipated or hoped that some of the Beneficiaries will grow into management and ownership of the Corporation.
Income cannot be accumulated within a Trust for longer than 21 years.
Income kept within the Trust is taxed at the high rate.
Investments by Trustees are limited by the Trustees Act, unless broadened by the Trust Agreement.
Avoiding attribution can be tricky.
Deemed disposition every 21 years. Someone has to keep track of this time period and ensure that the Trust assets are distributed to the Beneficiaries before the 21 years expire. Ordinarily, the Trust is then wound up.
Trustees’ fiduciary duties. No-one wants to be sued by ungrateful Beneficiaries. Trustees should have regular meetings to ensure that they are meeting their standard of care. Minutes should be kept of the meetings and any decisions made by the Trustees.
The Trust is a taxpayer and must file annual tax returns, even if it has allocated all of its income, including dividend income on the Shares, to the Beneficiaries.
In summary, the flexibility, control and other advantages which a Trust gives to the owners of a business Corporation make the use of a Trust a valuable option to consider in business and succession planning.