A match made in heaven

By Brigitte Alepin
Illustration: John Sapsford

Trusts aren’t just for big corporations, they’re a business-friendly tool that all enterprises can benefit from

Trusts are not just for multinationals. It would be a mistake to overlook a tool that can do so much for you and your small or medium enter-prise. In fact, to stay ahead in business, it is important to have all the tools available to competitors, who are increasingly aware of just how business-friendly a trust can be.

Basically, four types of trusts are suited to small businesses and owner-managers: asset protection trusts, estate freeze trusts, investment trusts and real estate trusts. Each works differently and has its advantages.

Asset protection trust
Surprisingly, although most entrepreneurs buy life insurance to protect their families and ensure that their business continues after their death, only a fraction dares to transfer their assets to an asset protection trust. Isn’t this the same as insurance? It could be called “bankruptcy insurance.” The effect of bankruptcy insurance on an entrepreneur, especially one who has to take risks, should not be underestimated, since it leaves more room for creativity and leadership in business. In short, it’s the key to success.

It is best to plan an asset protection trust as soon as a business begins operating. Even if several years have gone by, it still makes sense to set up a trust if the business is financially sound. Otherwise, it might be too late. An asset protection trust protects such personal assets as homes, income property or investments against creditors by segregating them from business assets (and debts).

Technically speaking, a trust involves three major players: the settlor, who sets up the trust; the trustee, who administers the trust’s assets; and the beneficiary, who pockets the trust income and capital.

The beauty of it is since the assets we want to protect belong to the trust and the settlor, trustee and beneficiary have no real rights over them, theoretically creditors cannot seize them to cover the beneficiary’s debts. The only creditors who could claim any rights over the trust’s assets are the creditors of the trust itself.

What about the tax authorities? Although asset protection trusts are subject to the same basic rules as other inter vivos trusts, legislators indirectly encourage them by allowing a tax-free rollover of assets in some cases. Protection for the beneficiary in business will be optimal if the annual income and capital distribution are both left to the discretion of the trustee. It should be noted, however, that even if the income is not distributed to the beneficiary, under subsection 75(2) of the Income Tax Act, the beneficiary must pay tax on the trust income as though the assets still belonged to him or her.

Once the trust has been set up, any subsequent acquisition of personal assets should be done by the trust. Finally, the trust can always be terminated and the assets transferred back to the original estate of the settlor-beneficiary, without tax implications under most circumstances.

Estate freeze trust
The estate freeze trust is a perfect fit for an owner of a prosperous business who is thinking of retirement and has identified potential successors, but hesitates and asks if they are really ready to take up the torch and will they eventually take an interest?

By integrating potential successors through an estate freeze trust, the entrepreneur gives himself or herself enough leeway to resolve the dilemma. He or she exchanges his or her common shares for preferred shares and the potential successors buy new common shares through the trust.

In this case, the trust beneficiaries are usually the entrepreneur and the successor. If the business is staying in the family, the entrepreneur might consider integrating the grandchildren as well as children. One of the trustees must be the entrepreneur, who thereby retains control over the management of the business and the final choice of successors.

Because the entrepreneur is both trustee and beneficiary, this type of structure will allow him or her to backtrack and recover company dividends or even take back the common shares.

Under certain tax rules, income earned from an estate freeze trust could be taxed to the trust or the beneficiaries. That’s where the magic words “income splitting” come in. Finally, like an asset protection trust, depending on how the trust deed is worded, the trust can be terminated without tax implications.

For the sake of flexibility, drafters of estate freeze trusts often give joint-stock companies, whether incorporated or to be incorporated, and of which the only shareholders are one or several of the beneficiaries, the opportunity to also be beneficiaries. This type of clause leads to strange situations in which a company could be the beneficiary of shares that it has also issued. Thus, a company could end up receiving dividend income that it has just declared and paid to the trust. What’s more, when the trust capital is distributed, the company’s shares could be attributed to the company itself.

Canada Revenue Agency, which had stated that subsection 75(2) of the act would apply in this type of situation, has changed its position. It indicated that subsection 75(2) should not apply when a trust subscribes to a corporation’s treasury shares for a consideration equal to their fair market value, even if the issuing company’s shares are current or future beneficiaries of the trust. Despite the government’s about face, it is important to be aware of the legal issues inherent in this type of situation.

Investment trust
In the following example, investment trust and entrepreneur are made for each other. The owner of a prosperous business has identified key employees he wants to retain by making them shareholders, but he hesitates. Often having minority shareholders complicates the regulatory burden and the need for a shareholders’ agreement with the employees are major concerns. Such an entrepreneur likes the investment trust, which can be called a profit-sharing trust, because it allows him or her to keep control.

To set up an investment trust, you simply effect a freeze and issue new common shares to both the entrepreneur and a discretionary trust, whose trustee is empowered to determine annually to whom and when the income and capital will be distributed. The trust beneficiaries will obviously be employees to whom you want to give a stake in the firm. As a precautionary measure and to give some leeway, the entrepreneur, or a firm of which he or she is a share-holder, could also be a trust beneficiary.

The trust instrument could be written in a way that other beneficiaries or employees can be added any time, i.e., under certain conditions such as “has accumulated 10years of service with the company.” Obviously, a clause would stipulate that in case of termination, the employee would lose his or her status as beneficiary.

An investment trust gives a key employee a potential stake in the company with- out making him or her a shareholder. Granted, this is not the ideal formula for the employee as he or she doesn’t acquire a vested interest in the trust or company until the entrepreneur decides otherwise. To make things less uncertain for the employee, the trust deed could provide for a mechanism to split income among the beneficiaries, which could be applied automatically once a predetermined percentage of profit has been achieved.

If the entrepreneur uses an investment trust to grant rights of company shares to an employee, these rights will be subject to the same tax rules that govern stock-option plans (Section 7 ITA).

Real estate trust
Unlike a joint-stock company, a real estate trust is not subject to tax on capital, which is still in effect in Manitoba, Saskatchewan, New Brunswick, Nova Scotia, Ontario and Quebec. It should be noted, however, that the provinces will abolish this tax gradually over the next few years. Furthermore, contrary to all other legal models, a real estate trust, if set up properly, is not taxed upon liquidation. Imagine the savings if the assets held by the entrepreneur are primarily real estate holdings, which are traditionally capital-rich and sure to appreciate over the years.

If the real estate generates business income, the trust will usually not pay off since it is taxed at the highest marginal tax rate for individuals. Moreover, even if the beneficiary is a company, the business income the trust could attribute to it would automatically change into property income, which is taxed at a higher rate and ineligible for the refundable dividend tax.

By optimizing these different rules and combining them with the tax system applicable to joint-stock companies and partnerships, you’ll discover that a trust is an ideal way to meet your needs in certain circumstances. The most popular scenario is probably one where the taxpayer considers realizing property income from buildings. Not only are real estate trusts exempt from tax on capital, they are also taxed at a lower rate than joint-stock companies, depending on the province of residence of the trust and the individual. Moreover, if a taxpayer opts for a trust rather than a partnership or limited partnership, his or her real estate assets are usually safer in the event of financial strain. The taxpayer will also avoid a tax bill when the trust is liquidated.

The real estate trust is a favourite because, in certain circumstances, it is the legal vehicle subject to the least tax. This alone makes it worthwhile. Estate freeze and investment trusts are also worth their weight in gold and are often the only way for entrepreneurs to feel secure enough to start their succession planning.

Lastly, as long as an entrepreneur wants to preserve his or her hard-earned assets, suggesting he or she consider a trust is probably the most practical advice anyone can offer. Find out more about trusts and what they can do for you. You’ll be glad you did.

Brigitte Alepin, M.Fisc, MPA, CA, is president AGORA,Services de fiscalité inc. in Montreal. She is Technical editor for Taxation – small business