Financial checkup: Reducing capital gains with a trust

Hugh earns about $1 million a year. The capital gains on his shares in the PIM are expected to exceed his lifetime capital gains exemption of $800,000 in about five years. The capital gains should amount to about $5 million in 10 years.

Hugh and Sharon own a $5-million home, on which they have a $1-million mortgage. Hugh has $600,000 in his RRSP; Sharon, who plans to remain a “stay at home” mother, has $300,000 in a spousal RRSP. Hugh and Sharon have about $40,000 each in tax-free savings accounts (TFSAs). They also have $2 million in a joint, non-registered account and $50,000 in a family registered education savings plan (RESP).

The couple spend about $180,000 a year before taxes, mortgage payments, major house repairs and RRSP/TFSA contributions. That sum will rise to $240,000 a year when all three children are in private school.

The recommendations: Both Cheng and Moody recommend establishing an inter vivos trust, with Hugh, Sharon and the three children as beneficiaries. This trust will allow the capital gains tax liability on any realized disposition of property that is held by the trust to be split among the beneficiaries of the trust. The trust’s income also can be distributed among the beneficiaries in the most tax-efficient way.

Cheng suggests that Hugh lend the trust $1 million, using a prescribed loan (see below) with the interest rate equal to the rate set by the Canada Revenue Agency (CRA). The trust then would buy $1 million worth of Hugh’s shares in the PIM. While this sale to the trust would be a capital disposition for Hugh, the capital gains would be limited to $1 million minus the original cost base of Hugh’s shares.

Hugh could use any capital losses he has to offset the capital gains on this transaction. If he still has a capital gain, he could use part of his lifetime capital gains exemption – provided the shares in the PIM fit the Income Tax Act’s (ITA) definition of shares of a “qualified small-business corporation.”

When the PIM shares held by the trust reach about $5 million, they could be sold to a third, unrelated party, realizing a $4-million capital gains. This sum would be split among the beneficiaries. That would mean those gains would be tax-free for all beneficiaries who have not used up their lifetime capital gains exemption; Hugh could use the rest of his lifetime capital gains exemption to offset this sale.

This strategy assumes that at the time of the trust’s sale of the PIM shares, the PIM meets the ITA rules that will allow beneficiaries to use their lifetime capital gains exemptions, says Cheng. Specifically, the PIM must pass three tests: the small-business corporation test, the holding-period ownership test and the holding-period asset test.

The trust also could distribute dividends to Sharon, who currently is in a low tax bracket. This strategy effectively would create income-splitting between Sharon and Hugh, thus lowering the overall tax payable significantly.

Moody suggests a different approach, using the inter vivos trust, an “estate freeze” and a holding company – a strategy that could increase the tax savings.

In Moody’s two-tiered approach, the value of previously held shares are “frozen” in the owner’s hands. The future appreciation of the underlying corporate assets accrues to the new common shareholders of the holding company.

Under this strategy, Hugh first establishes a holding company, into which he transfers his PIM shares on a tax-deferred basis in exchange for preferred shares in the holding company – assuming that the PIM is willing to reorganize its shares in this way. The trust then purchases nominally valued preferred shares of the holding company.

Since the preferred shares will not appreciate in value, any future appreciation of the PIM shares will accrue to the common shares that the holding company now owns. As a result, the capital gains can be split among the five family members (as beneficiaries of the trust) while Hugh retains the original $1 million.

This strategy avoids the need for the prescribed-rate loan because there is no need to transfer a large amount of money to the trust.

In addition, the holding company would not pay taxes on the dividends it receives for the PIM shares if it qualifies as “connected” for tax purposes under the ITA. (To qualify as “connected,” Moody says, the PIM shares that the holding company holds would have to represent more than 10% of the value of the PIM corporation and the voting rights in all circumstances.) If the holding company does not qualify as “connected,” it would pay 33.3% in taxes on dividends received – but the holding company would get a refund of those taxes if it pays dividends to the trust.

The downside is that there will be two layers – the trust and the holding company. Both structures will involve annual costs, including filing income tax returns.

Using these strategies requires great care and professional advice. If trust agreements and other legal documents aren’t exactly right, the tax advantages could be lost. Here’s a look at the details and the potential pitfalls:

– Trust settlor. Generally, the settlor should not be a beneficiary or a trustee. Both advisors suggest a relative, such as a sibling or parent of Hugh.

– Trust beneficiaries. The beneficiaries all should be Canadian residents for tax purposes. If they are not, complications will arise. In particular, none of the beneficiaries should be U.S. persons for tax purposes.

– Trustee. The trustee’s or trustees’ powers should be fully discretionary so that he, she or they can decide how much of the trust’s distributions go to each beneficiary. This is important, both to avoid the “kiddie tax” (reviewed below) and to allow for different allocations to Hugh and Sharon. Sharon, with little income of her own, could receive a fairly large amount each year without being taxed in the highest tax bracket.

– Kiddie tax. When taxable dividends from a private corporation are paid directly (or indirectly through a trust) to minor beneficiaries, the dividends are taxed at the highest marginal rate. However, there are some exceptions, including capital gains realized from arm’s-length dispositions and dividends paid to the trust from shares of publicly traded corporations.

– Other trust distributions. Cheng notes that a trust also can provide tax-free distributions to or for the benefit of minor beneficiaries if the distributions are used for specified purposes, such as school fees, medical expenses or the beneficiary’s pro-rated share of family vacations.

– Prescribed loan. A prescribed loan is a loan for investment purposes between related parties, such as family members. Such loans are allowed to be made at the CRA’s prescribed interest rate at the time the loan is made. The current prescribed rate is 1%, but it can change. It was 1% during the April 2009-September 2013 period, moved up to 2% for the October-December 2013 period, then dropped back to 1%. But the rate for any given prescribed loan remains what it was when the loan was initially made throughout the term of the loan.

A prescribed loan should be properly documented, outlining repayment terms as well as the interest rate, and this information may be required by the CRA. The interest received – by Hugh, in this case – from a prescribed loan is taxable and must be declared on his tax return.

Interest payments made by the trust are tax-deductible in the trust’s hands, so cash flow from dividends from the PIM could be used to pay the interest on the prescribed loan.

– Shareholders’ agreement. Both Cheng and Moody strongly recommend creating a shareholders’ agreement to lay out what happens to the PIM shares – i.e., how the other PIM shareholders can buy the trust’s shares – when Hugh dies or in the event of bankruptcy or marital breakdown.

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