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Family trust can be an educational building block

Okay, I'll admit it. My reputation as a good father took a hit last week. You see, I wanted my son Winston (age seven) to take a nap.

He refused. So I bribed him. I paid him $5 for the first hour, then $2 per half hour after that. He negotiated these rates. He even negotiated payment for the first half hour when he was lying there wide awake.

What has my parenting come to? And even worse, where have my negotiating skills gone? Next thing you know, he'll want to be paid by the hour to attend school.

Oh, I know his schooling is going to cost me an arm and a leg. His post-secondary school that is (I'll refuse to pay him to attend Grade 2). Today, I want to share an idea for business owners that could make the cost of education easier to bear.

The idea

If you're a successful business owner, you can use the profits of your business to help fund the cost of your child's primary or post-secondary education. There's more than one way to skin this cat, but the idea of a family trust can make sense. Consider Warren.

Warren owns a business. His company earns decent profits, and he wants to use some of this money to pay for the costs of private school and eventually university for his kids.

When Warren incorporated his business several years ago, his accountant recommended that he issue some shares (call them class A voting common shares) directly to himself, and some shares (class B non-voting common shares) to a family trust. Warren is trustee, and his wife and two kids are beneficiaries of the trust.

Each year that his company has made profits, Warren has paid dividends on the class B shares to the trust. Last year, for example, he paid $35,000 to the trust for each of his two kids -- $70,000 in total. These dividends were taxed in the hands of his kids. There's no need to actually pay the cash to the kids. The amounts can simply be made payable to them, so the money will be paid out -- for education in this case -- at a later time.

The specifics

Now, prior to 2000, it used to be that the kids would pay little or no tax on dividends sprinkled to them this way. The taxman shut down that benefit in 2000 and now applies a "kiddie tax" at the highest marginal tax rate going. Nevertheless, this idea can still make sense.

So, Warren's kids will pay tax at about 31 per cent (varies by province) on those dividends. The $70,000 paid to the trust will end up as about $48,300 after taxes. Now, for the real benefit: Any income compounding on the $48,300 in the future (the second-generation income) can be taxed in the hands of Warren's kids, who will pay little or no tax, thanks to their basic personal credits.

If Warren paid dividends of $70,000 on the class B shares each year for five years, the trust would have about $278,000 after taxes at the end of that time, assuming the kids are reporting any second-generation income of the trust and paying little or no tax (assumes a 7-per-cent return annually). Over seven years, the trust would have about $418,000.

The money in the trust can then be paid out, tax-free, directly to the kids or to the school they attend. By the way, the money in the trust can be used for more than just education.

Tim Cestnick, FCA, CPA, CFP, TEP, is a tax specialist and author of Winning the Tax Game 2005 and The Tax Freedom Zone.

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