Using a Family Trust to multiply access to the Capital Gains Exemption on a sale of your business

Capital gains can be distributed through a Family Trust in a way that is more flexible, practical and efficient than capital gains realized directly by a family member shareholder.

Sean Rheubottom, B.A., LL.B., TEP

Is it still worthwhile to have a Family Trust own shares of your family business?

Way back in the “golden era” of estate and tax planning, one big tax benefit of such a structure was the ability to “split income” with low-rate family members by paying dividends on the shares held by the Trust. It was even possible able to pay dividends to minor children and access their marginal tax rates. That was cancelled by the “kiddie” tax back in the early 2000s. More recently, the “Tax on Split Income” (“TOSI”) rules have been created. Like the kiddie tax, these rules impose tax at the highest marginal rate on dividends paid to family members through a Family Trust, except in certain limited situations.

It may seem like the benefits of planning a Family Trust, or perhaps the value of your existing Family Trust, have been completely cancelled. But that isn’t the case. One tax benefit of using a Family Trust is still very much available, and in the right situation it can provide the biggest tax win of all.

The tax win is the splitting of capital gains on the sale of private corporation shares that qualify for the capital gains exemption. The TOSI rules do not apply in this context. The Income Tax Act (Canada) expressly provides that capital gains realized by your family members, whether they’re involved in the business or not, and no matter what their age (even if they are under the age of majority), on the sale of “qualified small business corporation” (“QSBC”) shares are not subject to the TOSI rules. And each family member has his or her own separate lifetime capital gains exemption (“CGE”) to offset gains realized on the sale. In 2023 the lifetime CGE limit for each individual is $971,190. The CGE amount is indexed annually until it reaches $1,000,000.

Capital gains can be distributed through a Family Trust in a way that is more flexible, practical and efficient than capital gains realized directly by a family member who is a shareholder.

Let’s say you “froze” your interest in your business several years ago, using a Family Trust. At the time of the freeze you would have received fixed-value shares equal to the value of your interest in the company. New “growth” shares valued at a nominal amount like $100 would have been issued to the Family Trust.

As part of the “freeze” reorganization, you would normally move real estate and non-business assets to a separate holding company. This helps to ensure that the shares will qualify for the CGE. In order for your shares to qualify for the CGE, the shares must be QSBC shares at the time of the sale, meaning that 90% or more of the assets of the corporation, by value, are assets used in the active business carried on primarily in Canada. Excess cash and investments don’t qualify.

As the business grew in value, the Family Trust’s shares grew in value. Now, several years later, those shares are worth $5,000,000, and they still have their initial cost base of $100. The beneficiaries of the Family Trust include you, your spouse, and your three children.

A purchaser comes along and offers to buy your business, and is willing to buy all the shares of the company rather than assets. You will keep the separate company you set up to hold the buildings and cash. The shares to be purchased include the shares held by the Family Trust. The Trust realizes the capital gain of $5,000,000. In accordance with the tax laws regarding trusts, the Trustees of the trust (who would include you) can decide how to allocate the capital gains among the beneficiaries. Provided the Trustees file certain tax elections designating the allocations as taxable gains that qualify for the CGE, each beneficiary who receives such gains can use his or her own separate $971,190 CGE.

Accordingly, with 5 beneficiaries who receive capital gains, it is possible to shelter close to $5,000,000 in capital gains from tax, provided each beneficiary has his or her full CGE available.

But does that mean you have to give $1,000,000 to each beneficiary? No; you can allocate as much or as little as you want to each, unequally if you want, provided the Trust was drafted properly.

Furthermore, because of tax rules that expressly give special options to Trustees, only the taxable portions of the capital gains need to be allocated to the beneficiaries to access their full CGEs. The capital gains “exemption” is really a “deduction” of the taxable 50% portion of the qualifying gain. As a simple example, say the capital gains “exemption” is $900,000. Each beneficiary therefore has a $450,000 capital gains “deduction”. If the Family Trust allocates a $450,000 taxable capital gain to a beneficiary, that can be sheltered by the “deduction”. The non-taxable portion of the gain, $450,000, can be distributed to other beneficiaries. You might want to simply give that portion back to yourself and your spouse. A Family Trust allows you to do that.

You need to be working with good legal advice regarding questions such as how the taxable gains are practically allocated and paid to beneficiaries with minimal risk and complexity.

© Heritage Private Wealth Law

General information only; not intended as legal or tax advice. Readers are encouraged to obtain legal and tax advice before acting in their specific circumstances.