Succession Tax Counsel

A trust is a highly effective creditor proofing strategy. A trust is creditor proofed from  legal claims made against individuals. A trust is separate from the individual therefore claims made against the individual cannot be made against the trust.

Where a trust has family member beneficiaries it is called a family trust. A family trust can own a personal residence which can protect it against family law claims. A family trust can hold any type of asset including private company shares.

Purchasing growth shares

An effective strategy is to have a trust purchase small business growth shares after an estate freeze. Where growth shares are purchased by a trust there are six tax planning benefits:

1. non-voting growth shares with nominal current FMV can be purchased by the trust after a freeze;
2. small business shares are capital property so that if no dividends are paid then there is no annual taxation in the trust;
3. dividends can be allocated to adult beneficiaries and retain the character of dividends on the return of the beneficiary;
4. capital gains can be allocated to beneficiaries and retain the character of capital gains on the return of the beneficiary allowing the beneficiary to claim the capital gains exemption;
5. if the trust owns ‘connected shares’ (>10% votes and value) then small business dividends paid to the trust can retain the character of dividends and be paid to a Holdco beneficiary on a tax free basis;
6. small business shares can be rolled-out on a tax free basis to beneficiaries prior to the 21 year deemed disposition date.

Trust taxation

A family trust is taxed at the highest tax rates on all income received, this means these trusts are not taxed at marginal rates. The annual taxation of an inter vivos trust can be managed in two ways:

1. the trust can own capital property which does not generate annual income; and,
2. trust income can be allocated to beneficiaries thus taking advantages of lower tax rates if available. Dividends can be allocated as dividends; and capital gains can be allocated as capital gains.

The second tax consequence of an inter vivos trust is that all property in the trust is deemed to be disposed of every 21 years. This means capital gain must be paid regardless of whether the asset is sold or not. CRA allows the trust property to roll-out to a capital beneficiary prior to the 21 year deemed disposition. Where a holding company is a capital beneficiary the growth shares can be rolled out to the holding company rather than children.

A roll-out will be denied if s. 75(2) has ever applied to the trust.

Income Tax Act s. 75(2) 

Every trust must be designed carefully to avoid triggering s. 75(2). This section applies to property contributed to a trust by a settlor or a subsequent contributor.

A settlor is the person who settles the trust and contributes the initial property to the trust. After the trust is settled any family member can contribute to a trust. S. 75(2) is designed to catch any of these contributions. The term “contributor” includes the settlor and any other person who contributes property to a trust.

Where a contributor contributes property to a trust s. 75(2) applies two consequences:

1. all income and loss with respect to that particular property, or substituted property, is attributed to the contributor. Once the contributor pays the tax CRA accepts that the trust no longer has to pay it; however the contributor has no right to demand that the trust repay the amounts the contributor has paid.  Growth shares held over a long time can generate significant tax.
2. the trust loses the right to roll property out of the trust on a tax free basis prior to the 21 year deemed disposition date.

Attribution no longer applies where: the contributed property is returned to the contributor; or, the contributor dies. The right to roll property out of the trust is forever lost if s. 75(2) applies at any time.

CRA says s. 75(2) is triggered where a contributor has the right:

1. to receive the property back. The most common example is where the contributor is a capital beneficiary. It is not clear whether a contributor can be an income beneficiary.
2. to direct to whom the property should go.
3. to be the sole trustee, or demand a unanimous vote, or demand that no majority can be formed without the vote of the contributor.

Managing s. 75(2)

S. 75(2) does not apply where the trust enters into a bona fide loan arrangement on commercial terms; or, to fair market value purchase transactions.

The key to managing s. 75(2) is to ensure that none of the trustees or beneficiaries has made any contributions to the trust. This is done by ensuring the settlor is not a trustee or beneficiary; and, by ensuring that any property in the trust, other than the property contributed by the settlor, is either borrowed or purchased by the trust.

There two important steps to ensure that parents are not seen as ‘contributors’:

1. the preference shares that the parents take back in exchange for their common shares must represent the fair market value of the business so that there truly is nominal value in the growth shares to be purchased by the trust;
2. the trust has to get the money to buy the shares by way of a legitimate loan so that income will not be attributed back to a person who ‘contributes’ the money to buy the shares.

Why has the boomer wealth transfer lasted as a news story for the last fifteen years or so? In November 2012 CIBC reported that the boomer transfer will be $3.8 trillion. Sure it’s a big number but what would it really get you? one Iraq war? the IRS budget for a year or so? twice as much as was lost in the 2008 market crash? The stack of dollar bills would be from here to the moon; but in terms of macro economics it is just one more of many big number events. So why is the topic of business succession in the media so often?

Business succession itself is not news. Business succession has been around since the first business owner passed it on and has applied to every business owner since. The news is the volume ($3.8 trillion) and number of transactions (hundreds of thousands) that will occur and actual real people involved. This is not some war far away or the hissing of phantom derivative dollars as the monetary system deflates. The challenge is whether there will be wealth preservation or wide spread destruction of value occurring in family businesses all across the nation.

The solution begins with understanding the term ‘business succession’. What does it mean? Business succession describes: a process; a market; a transaction; and a demographic. It is difficult to be precise, so it is helpful to know what business succession isn’t. Continue Reading