For those who operate businesses through corporations, there is typically a desire to structure the corporation to permit the distribution of after tax earnings of the corporation to family members. There a two common structures – (1) the issue of shares directly to family members, and (2) the issue of shares to a discretionary family trust. Each has advantages and limitations.
Shares issued directly to family members may have differing rights depending on the family member. Spouses, for example may receive fully participating shares which allow the spouse to participate in the underlying value of the corporation. These shares may be voting or non-voting. Shares issued to children are more commonly restricted to receiving discretionary dividends if and when declared by the directors of the corporation. These shares would typically be issued for a small amount (perhaps $10.00 in total for example) and never increase in value. They would permit the payment of unlimited dividends but only when declared by the directors (usually the parent who controls the corporation). These shares create low risk in the event of separation by the child from his or her spouse because they do not carry any absolute right to payment of dividends and can be redeemed by the corporation at their initial issue price. Adult children will pay income tax on the dividends received, but typically at a lower income tax rate than the parent owner/shareholder.
The family trust would generally include all family members as beneficiaries and permit the distribution on income and capital to any one or more of the family members, as beneficiaries, to the exclusion of any other family member/beneficiary. The shareholder parents are typically the trustees of the trust and determine which family member beneficiaries receive income received by the trust. The trust holds shares of the corporation and can receive dividends from the corporation when declared by the directors of the corporation. The family trust has the additional benefit if the shares it holds in the corporation are participating shares. In the event of sale of the corporation by way of a sale of shares, the shares of the trust can be distributed to family member beneficiaries without income tax consequences to expand the availability of the capital gains exemption for qualifying small business corporation shares. That capital gain exemption is currently in excess of $800,000.00. As with the shares held directly by the family member, any distributions from the trust to the family member will be taxed at the marginal income tax rate of the family member provided, in the case of children, those children have attained the age 18. Children under the age of 18 are subject to income tax at the top marginal income tax rate on distributions received from the family trust or on shares held directly in the corporation. Unmarried beneficiaries who receive corporation shares from the trust may be subject to family law claims in the event of separation.
There is always risk of negative income tax consequences if income splitting initiatives are not properly considered and implemented. Competent legal and tax advice is a pre-requisite prior to implementation of an income splitting structure.