Tax Strategies For The High-Net-Worth Family

Overview

No two family scenarios are the same, and this is especially true when it comes to moderate or very wealthy families.

Your wealth may come from a successful business, an inheritance, a wise investment or other sources. You may have children or others, who depend on you for support, at different ages and stages of life. Your personal and family values and wealth-succession objectives will also be unique. You may have done no planning, or you may already have implemented some planning involving wills, holding companies or trusts.

One thing is common among moderate to high-net-worth families, however: they face a variety of wealth-related issues that require professional advice, with particular focus on reducing taxes.

A comprehensive income tax plan can minimize your overall family tax burden, both during your lifetime and on death. In this article, we provide a primer of frequently applied techniques, including income splitting, trusts, insurance and will planning techniques.

Income Splitting

Despite extensive attribution rules introduced by the Income Tax Act designed to prevent the splitting of family income with lower-taxed family members, there are still some planning opportunities available.

A prescribed-rate loan, for example, can be made to a lower-taxed family member, or to a trust for the benefit of several family members, with the income on the invested proceeds being taxed at the lower tax rate applicable to the borrower. Provided the loan requires interest to be paid, and is paid to the lender at the prescribed rate set by the government, there’s no attribution of the net income back to the lender. The prescribed interest rate changes quarterly, but has reached a low rate of 1% recently.

These types of loans can be made to a spouse, adult children or trusts for minor children and grandchildren. The advantage of using a trust where several family members are beneficiaries is that there can be flexibility as to the distribution of income. This can also be an effective way to fund education costs. The income from the loan proceeds can fund their tuition, books, other school activity costs and other personal expenses.

And the loan can always be repaid to the lender and the income-splitting arrangement reversed if the tax results are no longer advantageous.

Often, wealthy individuals assume responsibility for helping other family members in need, whether parents, grandparents or others. Typically, an outright gift will be made to the recipient, funded by after-tax dollars. A more tax-effective way to fund such a gift is to make an income distribution to that relative through a trust, the income from which can be paid to the relative-beneficiary, deducted from the income of the trust and taxed at the lower tax rate that applies to the individual.

If there are disabled children for whom a disability tax credit is claimed, a preferred beneficiary designation can be made. That designation allows income to be allocated and taxed to the preferred beneficiary without having to make an actual distribution to that person.

When implementing any tax planning strategies, however, you need to bear in mind that many lower-income members of the extended family qualify for other income-tested benefits. For example, splitting income with a disabled relative may impair their eligibility for provincial benefits. Older relatives can lose access to the Guaranteed Income Supplement, or see their Old Age Security benefits clawed back. Young families can lose access to the Canada Child Tax Benefit. Often, these benefits, plus the lower-income earner’s lower tax bracket, result in an aggregate cost in excess of the top personal tax rate.

Salaries And Dividends

In the right circumstances, such as if you own and operate a business, it may be possible to employ family members and pay them salaries for services rendered to the business. The salary paid, however, must be reasonable for the services actually provided.

If the business is operated through a corporation, it’s also possible to pay dividends on shares held by, or for the benefit of, low-tax-rate family members. In that case, the shareholders don’t have to render services to the corporation, and they can receive dividends in their capacity as shareholder.

Different classes of share capital can be issued to different family members and the dividend rights can be discretionary. This will allow for the payment of dividends on some classes of shares and not on others, enabling the streaming of dividends to those shareholders who need the funds and who will pay tax on the dividends at a lower rate. However, the attribution rules must be considered if the shareholders do not purchase their shares with their own funds or with funds borrowed from an arm’s-length lender.

When an investment company pays taxable dividends to its shareholders, it will receive a refund of part of the tax it paid on the investment income. And when the dividends are received by shareholders with little or no other income, they may not pay any tax on the receipt of the dividends. This substantially reduces the effective tax rate on the investment income earned by the company.

Trusts

The high-net-worth family will be as interested in deferring tax as in saving tax – and trusts are often a useful means in deferring income taxes.

Normally, the transfer or disposition of property will occur at fair market value, triggering the realization of accrued gains in the property. However, when property is transferred between spouses or common-law partners or to special types of trusts for the benefit of a spouse or common-law partner, the tax realization is deferred. Any tax on accrued gains will only be payable when the property is actually sold, or upon the death of the surviving spouse or partner.

Note, though, that while a spouse or partner trust can achieve a significant deferral of tax, this may also allow the high net-worth taxpayer to retain some measure of control and decision-making over the property in the trust, provided the broad attribution rules don’t apply. The trust can provide a scheme of distribution (whether fixed or flexible) that can remain in place long after the trust is established.

Generally, there’s a tax realization or deemed disposition on any accrued gains or losses in the trust every 21 years following its formation. Keep this 21-year rule in mind if you implement any tax-planning structures involving trusts.

Will Planning And Death

You should seek advice on how the family wealth should be distributed when you die, and regularly monitor the advice in light of your changing personal circumstances.

It’s essential that you have a will that’s fairly current – and possibly more than one will to deal with different assets and jurisdictions.

In cases in which provincial probate tax is applicable, and may be significant, probate tax reduction strategies should be considered. This may involve transferring assets, such as the family cottage or non-appreciated assets, to a family or alter ego trust, with the effect that the transferred asset won’t be owned by an individual on death.

It may also be effective to use multiple trusts to address different types of assets, thereby shielding certain assets from the probate tax net.

A trust established under a will is a testamentary trust that will be taxed in a more favourable way than an inter vivos trust. An inter vivos trust is taxed at the top marginal tax rate on every dollar of income, while a testamentary trust enjoys the graduated rates of tax.

Multiplying access to the graduated rates achieves absolute tax savings. For this reason, some of the income of an estate can be retained and taxed in the estate (or testamentary trust) until the top marginal rate is reached, and then the balance can be allocated to the beneficiaries. In fact, some wills for high-net-worth individuals with many children and other beneficiaries establish multiple testamentary sub-trusts to multiply this tax-saving opportunity after death.

Insurance

Even when the tax on death has been deferred and minimized, there will be a tax burden to satisfy at some point, and the family will have to plan for that eventual liquidity call.

Well-planned insurance strategies – such as joint-last-to-die policies that pay the death benefit on the second-to-die of the spouses or life-insured annuity contracts that provide the necessary liquidity at the right time – can be put in place to provide tax-sheltered investment return, estate preservation and liquidity to pay the ultimate tax burden.

If the insurance policy is owned by the corporation, the death of the insured will trigger payment of the death benefit. Most of this death benefit is added to a surplus account, called the capital dividend account, which can be distributed to Shareholders on a tax-free basis. If the insurance proceeds are used to redeem or buy back shares held by the estate, the insurance can be used not only to fund the tax payable on death, but also to reduce the net tax payable, leaving more insurance money for the estate beneficiaries.

Keep in mind, though, that this redemption planning must be completed within the first year following the death of the insured person.

Plan Well For Today And Tomorrow

All Canadians owe it to themselves and their families to regularly review their lifetime and estate financial plans. It’s important to be aware of opportunities to reduce or defer tax. However, these opportunities may not fit all situations. You should seek professional advice when selecting those that are right for you, especially if your family is very wealthy.

Conclusion

Joe Truscott has been advising his clients for over 30 years and is very familiar with the various tax planning alternatives available to clients of the firm. Joe Truscott has assisted many of his clients in a number of tax and estate planning methods to minimize the income taxes payable upon the death of a significant family member.

If you wish to engage Joe Truscott’s services in this area, or in any related personal or corporate income tax area, you can reach Joe at 905-528-0234 ext: 224, or email Joe at joetruscott@josephtruscott.com.

November 2012