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It’s pretty well-known that Canada’s ‘progressive’ tax system translates into ‘the more you make, the higher the rate of tax’. For example, someone earning $100,000 per year will owe a larger proportion of their salary to tax than someone who makes just $10,000. Strategic tax planning is all about deferring and minimizing tax exposure, typically by shifting a high-income family member’s earnings to a family member with a lower income. Income splitting or income smoothing tactics are just two of the ways to reduce your taxes, however when it comes to using an income splitting tax strategy, you need to carefully consider which approach is right for your business and personal situation.
Income smoothing involves dividing income between tax years to take advantage of lower tax brackets for two or more years, as opposed to a single year. Meanwhile, income splitting allows you to take advantage of lower tax brackets and special incentives such as the capital gains exemption of other family members year-over-year. To successfully split your income however, your family members need to hold shares of the family corporation either directly or indirectly, the latter of which is typically done through a family trust.
As always, there is rarely a perfect solution to accessing these tax advantages. Holding shares directly is simple, but will normally also result in a transfer of wealth and control to specific family members – like your spouse and children – and exposes equity to creditors or potential creditors of all family members holding shares (including ex-spouses, as an example).
For many years, an elegant solution to this issue has been holding shares through a discretionary family trust. The Trustee (that would be you, the business owner) alone has the ability to determine if and when any one beneficiary receives income or capital from the trust. This strategy allows you to split income and take advantage of lower tax rates and multiple capital gains exemptions on the sale of the business, without a loss of control or increased exposure to creditors.
However, trusts like this aren’t without their issues. For one, there is both a cost and time commitment for setting up and maintaining the trust. In addition, these trusts have become the subject of increased scrutiny by the CRA.
To look at another specific challenge in B.C., in the past, family trusts used to protect assets that may be transferred to a beneficiary from a potential claim. However the new family law act in B.C. treats ALL assets held by a trust as an ‘asset of marriage’ for ALL married beneficiaries. This means that, for example, should your child get divorced, it might not only impact what they receive from the trust, but what ALL beneficiaries of the trust might receive.
In response to all of these potential problems with family trusts, it’s time to revisit direct share ownership alternatives. Going back to the original issue regarding designing shares to take advantage of income splitting opportunities without compromising your control and exposure to creditors, the good news is there is a way around it. You can create shares that are redeemable at the discretion of the company for their nominal issue price. These shares will not grow in value, as is the case for standard common shares. However, they are entitled to dividends at the discretion of the company. If separate classes of these shares are issued to each family member, you’ll have full flexibility on paying dividends in any amount to each family member, to take into consideration their individual cash flow needs and personal tax situation. Arguably, this type of share ownership should attract less scrutiny from the CRA.
Again, these shares aren’t perfect. By capping the redemption value of these shares, the other shares you hold will continue to grow in value, along with your estate tax – although there are ways to mitigate this. In addition, these shares will be ineffective if you wanted to the access the capital gains exemption of other family members.
While income splitting is a great way to minimize your tax exposure, it’s not without its complications. Having a talk with your tax advisor is the best way to learn how to apply this tactic to your strategic tax planning.
Related Topics:Income Tax; Personal Tax
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