Income Splitting Using a Family Trust
As discussed and referenced in previous blog posts, a successful corporation with surplus retained earnings can reap large tax-saving benefits from income splitting when done with spouse and children. When the owner/shareholder of a business wishes to take advantage of income splitting opportunities as his children reach adult age, the easiest and most economical way to accomplish this is by restructuring the existing share classes and holdings. Ideally, after a successful corporate reorganization, the adult children would hold new classes of shares that are dividend participating so that dividends can be declared on those shares, which results in income splitting opportunities with the spouse and/or adult children owning the dividend entitled shares of the corporation.
Corporate Reorganization Opportunities
An adult child must be over eighteen to receive dividends from a corporation without triggering the kiddie tax. This is also the typical age children start attending university and need to pay for tuition and boarding, which emphasizes the need for income splitting. Ideally, a corporate reorganization is completed before the oldest child is eighteen so that when they reach eighteen and begin attending university, their education and boarding costs are funded through dividends. This way, these dividends are taxed progressively to the child, as opposed to the parents, who are likely already taxed at high marginal tax rates. The child’s progressive tax rate combined with the child’s personal, tuition and education tax credits could result in little to no taxes paid on those dividends.
However, with larger and extremely successful businesses, the use of a family trust should be included in the reorganization plan as the trust could mitigate other problems that may arise from the reorganization.
Significant Tax Benefits From Income Splitting
In general, with the inclusion of a family trust in the new tax structure, the trust would hold a separate class of shares and the trustee would have legal control of the shares. In this case, the children are the beneficiaries of the trust and would not have direct legal control of the shares. With a family trust, the corporation would issue dividends to the class of shares held in the trust and the trust would issue these dividends to the various beneficiaries (i.e. the children) at the discretion of the trustee. Therefore, the trust has no income to report, as all dividends received would be distributed to beneficiaries. Each child would then report the dividends received from the trust as income on his/her tax return. As each child likely has no income from other sources while attending university, these dividends would be taxed starting at the lowest tax bracket available to each beneficiary – in other words, reaping significant tax benefits from income splitting.
The most common reason to integrate a family trust into a corporate tax structure is so that the beneficiaries do not have legal ownership of the shares as the trustee of the family trust has the legal control. It is also good tax planning to try to multiply the capital gains exemption by issuing voting shares to the trust.
Corporate reorganizations and the use of family trusts are complex tax planning tools so professional advice is recommended from the onset. If they are not initially set up correctly, costly problems can eventually emerge.