How can a discretionary family trust be used in business succession?

Succession planning, as the Canadian Federation of Independent Business describes it, involves the safe and orderly transfer of assets, and poorly managed transitions may result in a premature sale. A discretionary family trust is one tool for it. It holds shares for named family members, and the trust deed lets the trustees choose who receives income or capital. The structure, and how it is usually paired with an estate freeze, is explained in our entry on the family trust. The limits come from the Income Tax Act.

The 21-year rule

A trust is not a permanent holding place. Under section 104 of the Income Tax Act, a trust is deemed to sell its capital property (other than depreciable property and exempt property), and land held as business inventory, at fair market value, and to buy it back, at the end of the day 21 years after it was created and again every 21 years after that, and, for some trusts, on earlier days the section lists. Gains built up inside the trust are taxed when that day arrives, so the date has to be planned for from the start.

Using the trust on a sale

The Canada Revenue Agency’s guidance on the capital gains deduction notes that a trust can allocate and designate taxable capital gains from disposing of qualified small business corporation shares, and beneficiaries who receive those amounts may be able to claim the deduction themselves. That is how a trust can let several family members each use their own entitlement, if each qualifies.

Limits on splitting income

Section 120.4 adds tax at the highest individual rate to the split income of a specified individual, and split income includes taxable dividends on shares of private corporations. Exclusions exist and depend on matters such as age and involvement in the business, so family dividends paid through a trust are not automatically taxed at the recipient’s low rate.