Tax strategies for the HNW family

No two family scenarios are the same, and this is especially true when it comes to clients with significant sources of wealth.

Their wealth may come from operating or selling a successful business, an inheritance, a wise investment or other sources. They may have children or others who depend on them for support, at different ages and stages of life. Their personal and family values, and objectives regarding wealth succession, will also vary. Some will have done no previous planning, while others will already have implemented some planning that may involve wills, holding companies and trusts.

What is common among these high-net-worth clients, however, is they’ll face a variety of wealth-related issues on which they’ll want or need advice, with particular focus on how to reduce and save tax.

In particular, tax minimization is often an important objective for high-net-worth clients. You’ll want to advise them on how they can minimize their overall family tax burden, both during their lifetime and on death, using various income-splitting strategies, trusts, insurance strategies and will-planning techniques. Here’s how.

Income splitting

Despite extensive attribution rules designed to prevent the splitting of family income with lower-taxed family members, there are still some opportunities to do so.

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 (currently 1%), there’s no attribution of that income back to the lender.

These types of loans can be made to a spouse or minor child directly or through an inter vivos trust. The advantage to using a trust where several family members are beneficiaries is 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 certain 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.

Alternatively, an outright gift can be made to a trust where the income and gains generated can be distributed to various family members. The ability to distribute income to a spouse and minors will be limited, but it’ll be possible to funnel income to other relatives.

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, and this will be funded by after-tax dollars.

A more tax-effective way to fund such a gift is to make an income distribution to that relative as a beneficiary of 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.

Where 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.

Salaries and shares

In the right circumstances, such as where your client owns and operates 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.

Where the business is operated through a corporation that meets the income tax definition of “small business 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 the capacity of shareholder. Remember, though: A small business corporation is a Canadian-controlled private corporation that uses more than 90% of the FMV of its assets in an active business carried on primarily in Canada. So operating companies with foreign operations or significant investment assets may not qualify.

Different classes of shares 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. But it’s critical that the company is a small business corporation and the shareholders purchase their shares with their own funds or funds borrowed from an arm’s-length lender.

There’s greater flexibility to make distributions of dividends from an investment corporation or income from a trust to children who are 18 years of age or older. This will be a good way to finance post-secondary education costs on a tax-efficient basis.

When an investment company pays dividends to its shareholders, it’ll 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. Other sources of business income can be earned by a trust and flowed through the trust to be distributed among multiple low-rate taxpayers. For example, a trust can provide management or other types of services through its employees, retaining significant profits that can be allocated to the beneficiaries.

But these arrangements are complex, and the broad anti-avoidance rules must be carefully considered.

Use of trusts

The high-net-worth client will be as interested in deferring tax as in saving tax—and trusts are often a useful means of doing so.

Normally, the transfer or disposition of property will occur at fair market value, which triggers the realization of accrued gains in the property. However, this tax realization event will be deferred where 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. 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 the use of a spouse or partner trust can achieve a significant deferral of tax, it may also allow the high-net-worth client 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 event or deemed disposition on any accrued gains or losses in the trust every 21 years following its formation. This 21-year rule must be kept in mind in any tax-planning structures involving trusts.

Will planning and death

The high-net-worth client will need your advice on how to distribute the family wealth after his or her death. So, the entire asset picture should be examined on a regular basis in light of changing personal circumstances and to ensure the tax burden on death is minimized.

It’s essential that your client have a will that’s fairly current—and possibly, more than one will to deal with different assets and jurisdictions.

Where 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 and it 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 HNW individuals with many children and other beneficiaries establish multiple testamentary sub-trusts to multiply this tax-saving opportunity after death.

Insurance

That said, even where the tax on death has been deferred and minimized, there’ll be a tax burden to satisfy at some point, and the family will have to plan for that eventual liquidity call. Creative 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.

There are also interesting insurance strategies for investment-holding companies.

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 that can be distributed to shareholders on a tax-free basis. And 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.