How Family Trusts Can Multiply Your Lifetime Capital Gains Exemption
Family trusts are valuable for tax and financial planning, providing a means to multiply the lifetime capital gains exemption. Family trusts can also help to separate control of assets from ownership and allow a trustee to control the assets on behalf of beneficiaries. A family trust allows for creating and preserving a financial legacy, all while keeping the assets safe for the family.
Let’s dive into what a trust is and the tax benefits of using family trusts.
What is a trust?
A trust can be thought of as a virtual "safe" or "vault" for your assets, similar to how a physical safe protects valuable possessions. Just as you would store important items in a safe for safekeeping and to control who has access to them, you can store assets in a family trust to manage and protect them for future generations. A trust is different from a corporation in that it represents a relationship between the trustee(s) and the beneficiaries, rather than being a separate legal entity.
What are the main types of trusts?
There are two main types of trusts - inter-vivos trusts and testamentary trusts.
Inter-vivos trusts are set-up during an individual’s lifetime. These can be either discretionary or non-discretionary.
A discretionary trust grants the trustee(s) the power to choose who gets what from the trust property. This is super handy for families because it lets the kids or other family members benefit from family wealth without having control or ownership of the property.
On the other hand, a non-discretionary trust is like following a strict recipe - the trustee(s) have to follow the trust agreement when it comes to distributing the trust property. A trust can also be both discretionary and non-discretionary. Think of it as a hybrid between the two - the trustee(s) get to choose who gets the income, but the capital distributions are set in stone.
Testamentary trusts are trusts that are established on the death of an individual.
The focus of this article is on inter-vivos trusts and a detailed discussion of testamentary trusts will be covered in a separate article. You can also contact us at Tax Heroes to learn more about the different types of trusts.
What are the tax benefits of having a family trust?
In Canada, one of the primary purposes of having a family trust is to benefit greatly when you sell your business.
Family Trust Capital Gains Exemption & Multiplication
The lifetime capital gains exemption (LCGE) is a tax benefit that lets individuals sell their shares in a qualifying small business corporation (QSBC) or a qualified farm or fishing property (QFFP) without paying regular income tax on the capital gain, up to a set limit. In 2023, the limit was $971,190 for QSBC and $1,000,000 for QFFP dispositions.
But wait, there's more! While a trust cannot claim the LCGE, the trust beneficiaries can if the trust allocates the capital gain to them and meets the requirements set by the Income Tax Act. That's right, the capital gains from selling a qualifying asset held in a family trust can be taxed in the beneficiary's hands as if they had sold it themselves, and with careful planning, the LCGE can be multiplied and the family's overall tax burden can be minimized.
To illustrate how the LCGE works, let’s consider an example of Jim, a savy entrepreneur, who has a family trust with four beneficiaries (Jim, Jim’s spouse, two adult children). The family trust sells shares of XYZ Inc. (a QSBC) in 2023 for $5,000,000. The family trust had originally purchased the shares of the XYZ Inc. five years ago for $116,000 and none of the beneficiaries have ever used their LCGE before and have no history of net investment losses. So, how will this sale impact the after-tax proceeds? Let's take a look at the calculations, with and without the LCGE magic:
| With LCGE ($) | Formula | Individual | Family Trust |
|---|---|---|---|
| Proceeds of disposition | "A" | 5,000,000 | 5,000,000 |
| Adjusted cost base | "B" | 116,000 | 116,000 |
| Capital gain | "C = A - B" | 4,884,000 | 4,884,000 |
| Inclusion rate | "D" | 50% | 50% |
| Taxable capital gain | "E = C * D" | 2,442,000 | 2,442,000 |
| Less: LCGE available (4x for trust) | "F" | 485,595 | 1,942,380 |
| Taxable income | "G = E - F" | 1,956,405 | 499,620 |
| Marginal tax rate (highest) | "H" | 53.53% | 53.53% |
| Taxes payable | "I = G - H" | 1,047,264 | 267,447 |
| After-tax proceeds | "J = A - I" | 3,952,736 | 4,732,553 |
| Tax savings using the LCGE | $259,939 | $1,039,756 |
Based on the above example, by using a family trust, Jim is able to multiply the LCGE by four times which results in tax savings of $1,039,756. If only Jim’s LCGE had been used, the tax savings would be only $259,939. Jim saves an additional $779,817 in tax by multiplying the lifetime capital gains exemption through his family trust and gets to keep that.
One important consideration is that gains allocated to trust beneficiaries are legally theirs. Therefore, if a family wants to take advantage of this tax technique, they'll need to be comfortable with letting the trust beneficiaries have the gains allocated to them. However, caution must be exercised when allocating the capital gain to minor beneficiaries.
LCGE is a very important tool to reduce taxes on the sale of a business, but the rules around it are quite complex. Contact your Tax Heroes to determine if your business is eligible for LCGE and if family trusts can be used to multiply the LCGE.
What are other benefits of a family trust?
Family trusts can also be used for succession planning and implementing a prescribed rate loan.
Succession Planning
For Canadian tax purposes, when an individual dies, they are deemed to have disposed of all their assets at fair market value (FMV). This may result in taxes if the FMV of these assets are greater than their cost base. If the assets are transferred to a surviving spouse, the taxes will be deferred until the death of that spouse. However, if the assets are held by a family trust, the individual's death does not trigger a tax liability as the assets are held in the family trust, reducing the estate's final tax burden.
It's important to note that a trust is considered to have sold all its capital property on the 21st anniversary of its creation to prevent tax deferral on gains in the trust indefinitely.
Consult your advisors at Tax Heroes to determine if a family trust can be used to reduce or defer the taxes arising on death or on the 21st anniversary.
The Prescribed Rate Loan “Strategy”
A family trust can also be used for another income-splitting strategy involving a prescribed rate loan.
A prescribed rate loan is created when investment capital is loaned by a high-income family member (the lender) to a family trust (the borrower) at a rate at least equal to the CRA’s prescribed interest rate. If the loan can be invested to generate income that exceeds the interest paid, there will be a significant advantage in making the loan and having the investment income taxed in the hands of the trust beneficiaries, assuming their tax rate is lower than the lender's.
If the trust is structured properly, another benefit of this strategy is that there is no attribution on any investment income (interest, dividends) or capital gains distributed from the trust to the beneficiaries. The trust will pay the lender annual interest on the loan, but when executed correctly, the beneficiaries will be reaping more tax savings from the distributed investment income, making it all worth it!
If you’re interested in setting up a trust and have questions regarding how a trust can benefit you, contact us at Tax Heroes, we’re happy to offer a free consultation.
