You could be forgiven for thinking family trusts are only for the very rich. In fact, trusts can be an invaluable financial, estate and tax planning tool for many people.
In this article, I would like to focus on the potential benefits for owners of smaller businesses to reduce their tax bite and plan for succession. (You can learn more about the basics of family trusts by watching my video on the subject or reading the associated article.)
New federal tax rules came into effect last year that reduced one notable tax benefit for entrepreneurs. However, the new rules by no means killed family trusts as a useful vehicle.
Income splitting—One reason that entrepreneurs use family trusts is to save taxes by splitting income from the business among beneficiaries of the trust. Before the new rules, an operating company could distribute dividends through a trust to the owner’s spouse and adult children. These beneficiaries could then claim the income at their lower tax rate, reducing the family’s overall tax burden.
Under the new rules, dividends from the operating companies are now taxed at the top marginal rate—the tax on split income (TOSI)— in the hands of family members, unless they qualify for one of several exemptions. One key exemption depends on whether children who are 25 and older are involved in the business on “a regular, continuous and substantial basis.” This and other exemptions to TOSI are complex and require the advice of a tax expert.
What didn’t change?
Multiplication of the lifetime capital gains exemption—One of the main benefits of setting up a family trust if you’re an entrepreneur is to multiply the lifetime capital gains exemption (almost $850,000 in 2018) on the sale of a qualified small business corporation.
The business owner, his or her spouse and their adult children can each claim their unused capital gains exemption to reduce the capital gains tax owing on the sale. For a family of four that would add up to close to $3.4 million, a big advantage.
The benefits of family trusts can extend well beyond taxes for small business owners. They include protecting assets from creditors or in the case of marriage breakdown for one or more of the beneficiaries. They also offer flexibility in terms of control over a company and how income is distributed to beneficiaries. And trusts can facilitate estate planning through an estate freeze and the minimizing of probate fees.
As you can see, there are many potential benefits for entrepreneurs in setting up a family trust and the structure is well worth a look. However, there are many factors to consider. And that means you need an approach like the one we use at PWL where financial, tax and legal advice is brought together to make sure you make the best decisions for your family’s future.