Family trust vs direct share transfer for business succession

An owner who plans to pass a corporation to the next generation has two broad routes. The shares can sit in a discretionary family trust, or they can move directly to the children by sale, gift or a gradual transfer. Each route triggers different rules in the Income Tax Act. This page compares them on federal tax and compliance points. Trust law itself is not covered here, so check the rules of the province where the trust is set up. For the trust side on its own, see how a discretionary family trust is used in succession.

The family trust route

In this route the trustees hold the shares for the beneficiaries. Section 104(4) deems every trust to dispose of its capital property other than depreciable property, and land in a business’s inventory, but not exempt property, at fair market value at the end of each day the section lists. One listed day is 21 years after the latest of the dates the section sets out, and the section lists other days. Section 104(5) does the same for depreciable property on those days. CRA lists taxable capital gains a trust allocates and designates to a beneficiary from a disposition of qualified small business corporation shares among the gains eligible for the capital gains deduction, if the beneficiary meets CRA’s conditions.

Compliance is a separate cost. CRA’s T3 guide says a trust, other than a listed trust, that is required to file a T3 return generally must report beneficial ownership information on Schedule 15, filed each tax year with the T3 return even if nothing has changed. The guide also describes proposed changes to who must file.

The direct transfer route

A direct transfer to someone the owner does not deal with at arm’s length can be taxed at fair market value rather than at the price paid. Except as expressly otherwise provided in the Act, section 69(1)(b) deems proceeds equal to fair market value where property goes to a non-arm’s length person for no proceeds or lower proceeds, or by gift. Section 160 makes the transferee and transferor jointly and severally liable for the lesser of two amounts, the shortfall in consideration and the transferor’s tax for that year or any earlier year, for transfers to a non-arm’s length person, a spouse or a person under 18. It applies to transfers made directly, indirectly or by means of a trust, subject to the exception in section 160(4).

Where the two differ

A sale of shares to a child’s own corporation can fall under section 84.1, which reduces paid-up capital and deems a dividend. Sections 84.1(2.31) and (2.32) treat an immediate or gradual intergenerational business transfer as arm’s length if conditions are met, including an adult child controlling the purchaser, qualified small business corporation or family farm or fishing shares, 36-month tests and a joint election.

CRA says a nine-year reserve period applies to transfers to a child of qualified small business corporation shares or family farm or fishing property, and to intergenerational business transfers under certain conditions. Income splitting limits can matter on either route: section 120.4 adds tax at the highest individual percentage to a specified individual’s split income, subject to excluded amounts such as an excluded business.

Which fits depends on the facts

• If the family wants trustees to decide who benefits and when, the trust structure applies; if it wants named children to own shares now, a direct transfer does
• If the shares are qualified small business corporation or family farm shares, then each beneficiary’s unused lifetime exemption matters for a trust designation
• If the children will control a purchaser corporation, then section 84.1 and the intergenerational conditions apply
• If the transfer is a gift or a sale below fair market value, then sections 69(1)(b) and 160 compare the consideration with fair market value
• If a trust is kept, then the 21-year date and the T3 reporting burden continue

These rules interact, so a tax professional and a lawyer should review the family’s facts.