Uses of Family Trust to pay for kids educations

A family trust for small business pays dividends for tuition *

In previous entries, I mentionned several times the use of family trust for business owners. For almost every clients, I suggest the use of said Family trust, it is a great way of saving taxes.

Today, I would like to share with you an excellent article from Tim Cestnick from the Globe and Mail, explaining clairly the advantages of using different trusts. If you have any questions regarding the same, please do not hesitate to email me. A family trust for small business pays dividends for tuition.

Every few months my extended family gets together to visit. It's a chance to get caught up with my aunts, uncles and cousins. My cousin Erik didn't make it to our last get-together. Erik is something of a permanent student. He's got more degrees than the thermometer outside our kitchen window."Uncle Ron, how's Erik doing?" I ask."He's just fine, Tim. He's back at university this month.""Still?" I reply. "I thought he finished last year. What's Erik going to be when he graduates?""A very old man," he replies. At this point, Erik is paying for his own education. But if you're looking to help your kids with the cost of postsecondary education, and you're a business owner, consider a family trust. Let me explain.

The trust

This idea is best understood by an example. Consider Scott. Scott has three children, all in their teens. University is just around the corner for them and it won't be cheap -- about $16,000 each year, everything included.Scott runs a business that has sufficient cash flow to help pay for the education of his kids. One option for Scott is to pay himself additional salary from his company to help cover the cost of university when that time comes. Since Scott is in the highest marginal tax bracket, he'll pay tax of about 46 per cent (varies by province) on those dollars. So, a $10,000 payment from his company in this case will leave just $5,400 to help cover the costs of education.

There may be a better option. Scott could structure the ownership of his company so that some of the common shares of the company are owned by a family trust. Then, the company could pay dividends to the trust annually for each child once they're 18 and are attending university or college. The dividends could then be paid out of the trust to each child to help pay for school.

The results? Scott's company will pay tax of about 17 per cent (again, varies by province) on its active business income below $400,000.The dividends paid to the trust and then out to Scott's kids will not be taxed in the trust, and will face little or no tax in the kids' hands if they have little or no other income. In fact, each child could receive about $32,000 (varies by province) in cash dividends annually and pay little or no tax if he or she had no other income. This total tax cost of about 18 per cent is much less than the 46-per-cent tax cost of paying additional salary to Scott.

Other thoughts

Now, there are rules in Canadian tax law that will make this strategy less effective if you pay dividends directly or indirectly through a trust to a child under 18. These "kiddie tax" rules will cause tax at the highest marginal tax rate on those dividends. But the idea works well for kids 18 or older.In addition, there are some other benefits to the trust strategy. If you expect the value of your business to grow in the future, you may be able to shelter part of that growth from tax using the $750,000 capital gains exemption of each of your children who is a beneficiary of the trust. The trust will also protect the assets in the trust from any creditors or future spouses of your kids. Finally, those dividends paid out of the trust could be used for any purpose -- not just education.

* written by Tim Cestnick - Tim is a principal with WaterStreet Group Inc. and author of Winning the Tax Game, among other titles. This article was published in the Globe and Mail on September 28, 2006 and was slighty edited to reflect accurate numbers.