With recent changes to Canadian tax laws, many tax payers may be wondering whether the use of trusts continues to make sense despite the Department of Finance’s efforts to restrict income splitting.
While the benefits associated with the use of trusts may now be curtailed under the new rules surrounding tax on split income (“TOSI”), the use of trusts for tax and estate planning purposes continues to have merit. Keep in mind that the benefit of this approach will depend on each taxpayer’s specific situation and the financial goals they are looking to achieve.
1. Sale of a Business
Trusts continue to be effective tools in planning for the eventual sale of a business. Where an individual sells shares of a “qualified small business corporation”, he or she may be entitled to a lifetime capital gains deduction that may effectively shelter up to $848,000 of capital gains (this lifetime exemption limit is indexed annually). The use of a trust as part of the ownership structure may allow for family members to claim this deduction, thereby reducing the family’s overall tax liability arising from the sale.
2. Income Splitting Through “Prescribed Rate Loan” Structures
While the new TOSI rules have significantly restricted taxpayers’ ability to split income with family members through the use of corporations, trusts may still provide income splitting opportunities through “prescribed rate loan” structures. Using a prescribed rate loan for income splitting is a simple and effective strategy that involves a high tax bracket individual lending to a family trust established for the benefit of the lender and family members. The trust is required to pay the lender interest equal to at least the prescribed rate of interest at the time the loan was made (currently 1%, but set to increase to 2% beginning April 1, 2018). The net income remaining after interest is paid to the lender may be allocated among the beneficiaries of the trust in any proportion the trustees may determine. Provided the interest is paid to the lender annually, the prescribed rate of interest in effect at the time the loan is made continues to be locked in. While this planning can be done by loaning funds directly to family members, using a trust provides greater flexibility in the income splitting process.
3. Estate Planning
Trusts also continue to be an effective tool for estate planning. A common estate planning strategy may involve new Common Shares of a corporation issued to a trust after the parents have frozen the value of their shares in the corporation. Holding the new Common Shares in a trust may provide parents with an added measure of control over the shares. This planning may also provide parents with more time to decide on how the Common Shares will be distributed to their children or grandchildren. While the need to implement an estate freeze may be clear at the time, the decision surrounding the division of assets among the next generation may not be clear until years down the road. The ability to disburse dividend income amongst family members may be restricted under these structures as a result of the proposed TOSI rules, so this should be weighed against the benefits of the estate freeze. Other specific types of trusts can be used for probate fee planning purposes.
For those with an existing trust as part of their financial structure, consideration should be given to whether your current structure continues to be effective, or whether restructuring is required. For those considering creating a new trust, it is important to clearly identify your financial goals in order to determine whether the use of a trust may helpful in achieving them. In either case, seeking professional advice and guidance will be important as well as beneficial to you, your family, and your business as you navigate the planning process.