Income Splitting
Prosperity belongs to those who learn new things the fastest.
~Paul Zane Pilzer~
Income Splitting Strategies Save You Money! We specialize in assisting clients with income tax savings via income splitting, tax deferral and tax minimization, employing numerous strategies including the creation of Family Trusts and utilizing its structure for key tax and financial benefits.
Scenario 1: Income Splitting
Mr. Johnson establishes a Trust for the benefit of himself, his wife, and their four children. His oldest two children are over 17 years of age and attending university. The youngest children are minors living at home.
The participating shares of Mr. Johnson’s active business corporation are owned 100% by the Trust.
After salaries are paid to Mr. Johnson, his corporation earns approximately $125,000 before tax and $105,000 after tax. Based on current tax rates, if Mr. Johnson wishes to pay out the net after corporate tax income of $105,000 to himself to enable him to use it personally, he could pay additional taxes of $33,000 if he were the sole shareholder of the company.
Using the Family Trust structure and paying the income earned by the Trust equally to the adult children and Mrs. Johnson, the tax liability on the dividends would be taxed as follows:
- Wife – Dividend of $35,000
- Child 1 – Dividend of $35,000
- Child 2 - Dividend of $35,000
- Tax liability - nil
By using this Family Trust structure, the family saves approximately $33,000 in tax.
Note: Assumes that Mrs. Johnson and the children attending university have no other income.
Scenario 2: Capital Gains Splitting
Mr. Johnson has received an offer to sell the shares of his corporation (which is a 'qualified small business”') for $4,500,000. The shares were acquired for a nominal amount ($100). If Mr. Johnson were to receive the sale proceeds as the sole shareholder of the business, his tax liability might be computed as follows:
- Proceeds $4,500,000
- Cost ($100)
- Capital Gain $4,499,900
- Capital Gains Exemption ($750,000)
- Capital Gains Subject to Tax $3,749,900
- Taxable Capital Gain $1,874,950
- Tax $870,000
Under the Family Trust arrangement, the Trust could receive the total $4,500,000 proceeds. The capital gain could then be distributed to the Beneficiaries and they could each shelter the gain with their own $750,000 capital gains exemption. Accordingly, the entire $870,000 in tax could potentially be saved.
Family Trust
A Trust is a relationship whereby an obligation is imposed upon a person or persons (the 'Trustee') to hold property for the benefit of another person or persons (the 'Beneficiary'). Any kind of property can be transferred to a Trust. The obligations imposed on the Trustee are defined and described in a legal document called the 'Trust Deed'.The person who creates or settles the Trust is called the 'Settlor'.
Once the Trust has been settled, the Trustee will hold the Trust property, in Trust for the Beneficiary. The Trustee has a fiduciary duty to act in the best interests of the Beneficiary and to act in accordance with the terms of the Trust Deed. In all cases, it is imperative that a Trust have the following three certainties to be legally effective:
- certainty of the Settlor’s intention to create the Trust
- certainty of the subject matter or property being settled on the Trust
- certainty of the Beneficiary.
These three certainties must be reflected in the Trust Deed.
There are many different types of Trusts, including Trusts that automatically result on death. However, one of the most useful types of Trusts for succession planning is the Family Trust. In technical terms, a Family Trust is usually an inter vivos discretionary Trust. An inter vivos Trust is a Trust that is settled during the lifetime of the Settlor, as distinguished from a Trust created by a will.
When a Trust is discretionary, the Trustee has the discretion to determine how, when, and in what amount income distributions and capital distributions are made to the Beneficiary. The Trustee will exercise his or her discretion based on the changing circumstances, as guided by the terms of the Trust Deed.
Sharing Growth Without Losing Control
A Family Trust is an arrangement whereby an individual may allow family members to share in the growth and value of an incorporated active business without that individual losing control over the operations of the business. In the typical situation, an individual (the 'Trustee' of the family Trust), will hold property (shares of the active corporation) 'in Trust' for the benefit of family members (the beneficiaries of the Trust).
Although title to the property is in the Trusts’ name and the property (the active corporation’s shares) are under the Trustee’s control, the income and capital growth attributable to the shares accrues to the beneficiaries. To the extent that income earned by the Trust is paid to its beneficiaries, the income is taxed in the beneficiaries’ hands. Where these beneficiaries earn little of no other income, they may pay little or no income tax on those distributions.
Note, that a typical Family Trust agreement is drafted so the Trustee may pay that income out to, or for the benefit of, any or all beneficiaries at his discretion as he sees fit.
Establishing a Family Trust
A Family Trust is established when a person referred to as the Settlor (usually a relative) gives a gift to the Trust for the benefit of (usually) other family members. At the same time, a written agreement is drafted which sets out the terms whereby the Trustee will hold and manage the property on behalf of the beneficiaries. As it is this agreement which gives the Trustee the power to distribute funds from the Trust at his discretion, the Trust agreement is a critical part of any Family Trust arrangement.
A Family Trust is established when a person referred to as the Settlor (usually a relative) gives a gift to the Trust for the benefit of (usually) other family members. At the same time, a written agreement is drafted which sets out the terms whereby the Trustee will hold and manage the property on behalf of the beneficiaries. As it is this agreement which gives the Trustee the power to distribute funds from the Trust at his discretion, the Trust agreement is a critical part of any Family Trust arrangement.
Why use a Family Trust?
A Family Trust can offer the owner/manager a great deal of flexibility in the context of a business succession. For example, a Family Trust can allow the owner/manager to retain a certain amount of control over the business and delay decisions as to the appropriate distribution of the income and capital from the business until a later point in time.
A Family Trust can offer the owner/manager a great deal of flexibility in the context of a business succession. For example, a Family Trust can allow the owner/manager to retain a certain amount of control over the business and delay decisions as to the appropriate distribution of the income and capital from the business until a later point in time.
For example, this can be accomplished by establishing a discretionary Trust whereby the Trustee will hold the voting shares of the Corporation, for the benefit of the Beneficiary. The Trustee can also decide upon appropriate distributions to the Beneficiary in the future. In this way, a Family Trust can be invaluable in circumstances when it would be inappropriate to give control of the business to a minor child, or to a person who may not be capable of making decisions respecting the business at the present time.
In addition, a Family Trust is a useful tool to avoid the payment of probate fees and can aid in estate planning because property that is transmitted through a Trust will likely not be subject to a wills variation challenge.
How Does a Family Trust Work?
A Family Trust is very flexible and can be used for estate planning purposes in many different contexts. One of the more common estate plans will have the owner/manager create the Family Trust, after which time the Trust will subscribe for shares of the Corporation. It must be remembered that at all times the Trustees must act in the best interests of the Beneficiaries and in accordance with the Trust Deed.
As the controlling shareholder, the Trust will control distributions from the Corporation by deciding the timing and the classes for which dividends will be distributed. In addition, when the distributions have reached the shareholder (Trust) level, the Trustees will determine how and when dividends from the Corporation will be distributed to the Beneficiaries, as typically, the Trust Deed provides that income should be distributed at the discretion of the Trustees.
For income tax purposes, the Trust is regarded as an individual taxpayer. The Trust will be required to compute its income in the same manner as any other individual, except that an inter vivos Trust will be taxed at the highest marginal rate. However, if the Trustee has paid any of the Trust income to a Beneficiary during a year, that income will usually be deductible by the Trust and included in the Beneficiary’s income for tax purposes. For the purposes of the Income Tax Act, a Trust is deemed to sell certain property on the 21st anniversary of its creation, at fair market value.
As another benefit to establishing a Family Trust, it can often be used to spread income among family members. In this way, income will be taxed in the hands of the Beneficiary, who is usually at a lower marginal tax rate than the owner/manager. In addition, the use of the $750,000 lifetime capital gains exemption may sometimes be multiplied on the sale of the shares of the Corporation, as each Beneficiary may be able to utilize his or her $750,000 lifetime capital gains exemption to offset any gain. Of course, the shares would first need to meet the conditions necessary to fall within the definition of qualified small business corporation shares in order to be eligible for the lifetime capital gains exemption.
Family Trusts are not complicated and are fairly inexpensive to implement, especially in relation to the potential benefits. Accordingly, they are commonly used in small business tax efficient ownership structures. A Family Trust offers a great deal of flexibility and tax planning opportunities when used properly.
Income Splitting for Physicians & Dentists
The importance of incorporating is especially significant for those in the medical and dental professions. Currently, the spouses of doctors and dentists can subscribe to the shares of the professional corporation which would enable the successful application of income splitting.
As there is no limit on the amount of income that can be distributed through dividends, this income splitting is extremely advantageous as the medical and dental professionals can now split their income with their spouses resulting in less tax, thus increasing overall net cash flow. For example, as a result of incorporating and income splitting through dividends, the tax savings are approximately $32,000 on $250,000 of income, based on the dividends being split 50/50 between the spouses.