Normally, when you pay dividends to shareholders, the dividends are split up according to the percentage of the ownership of shares. But, discretionary shares allow owners to pay dividends to shareholders of their choosing, which can be useful for income-splitting.
Discretionary shares are usually issued for a low amount, such as one dollar. They can be repurchased by the corporation at any time for that amount. Each shareholder is given a separate class of discretionary shares so that dividends can be paid to different shareholders in different amounts. To reduce the likelihood of an attack by the CRA, it would be highly recommended that the transactions are property structured through the use of an estate freeze. Before implementing discretionary shares, you should speak to your tax accountant first.
Benefits of Discretionary Shares:
One benefit of using discretionary shares is that family members can buy into the corporation, and that family member can be bought out later. Discretionary shares can be used for large tax savings. Suppose you are the sole shareholder of a company and you needed $40,000 to pay for your child’s education. If you payed yourself the money as a regular dividend, you would pay $13,800 on income tax (assuming you were already in the highest tax bracket). But, if you gave your adult child a class of discretionary shares, he or she would have to pay very little taxes. The use of discretionary shares will yield tax savings of over $13,000 in this particular case.
Discretionary shares can also be used for asset protection. Surplus funds can be transferred to a related holding company and protected from the operating company’s creditors. This is also useful in enabling corporations to qualify for capital gains exemption, as it removes investments out of the operating company.
“Kiddie Tax” Rules:
The large tax savings from the use of discretionary shares has got the attention of the CRA, and they have tried to find ways to limit the use of discretionary shares. So, they introduced the “kiddie tax” rule, which taxes dividends to minor children at the top rate. But, this rule does not apply to adult children or spouses. So the use of discretionary shares is gaining popularity as a method of substantial tax savings.