“The avoidance of taxes is the only intellectual pursuit that carries any reward.” – John Maynard Keynes
Written by Steve Nyvik, BBA, MBA ,CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.
If you are a Canadian business owner or have a professional practice, consider establishing a Family Trust as the owner. The Trust might also include an investment holding company as a beneficiary. Together, this structure provides significant tax benefits and flexibility in operating to achieve your financial goals.
Keeping After-Tax Funds in your Company
For professionals or business people earning more money than they spend, it makes good sense to incorporate and subject that income to the small business company tax rate which can be as much as 30% less than the personal tax rate. By keeping funds within a company you have up to 30% more to invest to grow and help fund your future needs. Note that this is just a tax deferral rather than a tax savings since once you withdraw money from the company, the taxes become payable.
But if your personal marginal tax rate drops, like maybe in your retirement years, you may realize an absolute tax savings when funds are withdrawn compared to having earned the business / professional income personally.
The Use of a Holding Company
The tax deferral sounds great as this can make a huge difference to your assets to support your retirement. But what if there is any potential for business or professional liability? By leaving funds within your company, are we simply leaving them for future creditors?
Where the liability has not yet occurred (and not foreseeable), it may make sense to have the after-tax funds “distributed” to a “holding company”. This distribution puts your after-tax income out of reach of future creditors of your operating company and preserves the tax deferral. Should funds still be required by the operating company, the holding company can loan money back to the operating company.
1. The Traditional Structure
It has been common practice for a holding company to be incorporated that owns shares of the operating company. This may permit payment of dividends on a tax- free basis from the operating company to the holding company.
The problem with this is that this structure can cause problems with regard to full access to the Small Business Capital Gains Exemption (now at $813,600 [as of 2015] per person) as the exemption is only available to individuals on their disposition of Common shares of a qualifying small business corporation. In other words, the disposition of the shares by the holding company doesn’t qualify.
2. The Modern Day Solution
The modern day solution is to have a discretionary Trust created with possibly your children, you, your spouse and a holding company as beneficiaries. The Trust owns all shares of your operating company for which the operating company pays all after-tax income to the Trust as dividends.
For funds required for living needs, the amount needed may be distributed by the Trust amongst you, your spouse and adult children. Any remaining funds may then be distributed to the holding company as a tax-free dividend that preserves the tax deferral for the surplus amount received by the company.
To summarize, the modern day solution has maintains both key tax advantages:
1. Income Splitting
With the Trust owning the operating company, income splitting is preserved as the after-tax income is dividended by the operating company to the Trust. The Trust then distributes cash needed for living needs amongst you and your adult family members and doing so in such amounts to manage family member income levels and overall taxes payable.
Beneficiaries receive dividend distributions, when and if the Trustee decides. Those distributions can vary from one year to the next and can be substantial in amount. Dividend distributions are received by beneficiaries not in relation to any work that they perform.
2. Capital Gains Splitting and Multiplying the Lifetime Capital Gains Exemption
Should the business be sold, it may be possible to multiply the $813,600 Lifetime Capital Gains Exemption for “Qualified Small Business Corporation shares”.
On sale of the operating company Common shares by the Trust, it may be possible to split the capital gain amongst several adult beneficiaries where each individual may claim their lifetime capital gains exemption on the capital gain proceeds received. For example, a Family Trust with 4 adult beneficiaries can receive up to $3,254,400 tax‐free (= 4 x $813,600) on the sale of shares that qualify for this exemption.
The Next Step
There are a host of issues to be considered before structuring your business or professional practice. For a professional practice, one has to first consider the provincial statutes for your profession that have restrictions on company ownership.
If you are a U.S. citizen or U.S. resident, we then need to consider United States Income Tax and Estate Tax laws.
Even if you are only a Canadian, there are a number of potential Canadian tax issues to avoid like corporate income attribution and trust income attribution. And there are requirements to ensure the operating company and holding company are considered connected for tax purposes to avoid of Part IV tax on the payment of the dividend by the operating company. Finally, there is the “kiddie tax” for which we need to avoid income being received by minor children.
If you own a business or a professional practice, I would be happy to review your current situation, discuss how we might improve it, and quantify the potential tax savings, the costs of establishing a structure, and the annual costs. Should you decide this is something to pursue, I can refer you to a tax accountant that my clients have satisfactorily dealt with to help you put in place an effective structure. For clients of mine, financial planning is included as part of the service.