A Family Trust, a Holding Company and the Policy: How the Three Relate

Many incorporated families end up with three things that were set up at different times by different people. A family trust, created years ago on an accountant's advice, holds the shares of a holding company. The holding company owns a life insurance policy on the founder. And a binder somewhere holds a trust deed, the company's articles and perhaps a shareholder agreement that nobody has read side by side.

Each piece can be sound and the three can still pull in different directions. The trust deed says who may benefit, the minute book says who decides, and the insurer's file says who is paid. At the founder's death the money follows the insurer's file first, the company's decisions second and the deed last. If the three were never lined up, the family learns it in the worst possible month.

This page walks the chain from top to bottom: who decides what at each level, where the money travels at death, what the 21-year rule and the tax on split income mean for it, and what changes in Quebec. It is general information from a licensed insurance professional. It is not tax or legal advice, and every point that matters for your own file is one to settle with your accountant and your lawyer, or your notary in Quebec.

What does the chain look like, from the founder to the policy?

The chain has three links. A family trust owns the shares of a holding company. The holding company owns a life insurance policy on the founder and is its beneficiary. The family members are beneficiaries of the trust. Nobody in the family owns the policy directly, and nobody owns the shares directly either.

This is a different arrangement from a family trust that owns a policy itself, which is the subject of a family trust as the owner of a life insurance policy. Here the trust never deals with the insurer. It holds shares, and the shares give it a say over the company that holds the policy. If the word trust itself is new to you, the plain language version of settlor, trustee and beneficiary is on what a trust is for someone who owns life insurance.

The holding company link has its own page, which company should hold the contract, and this page does not repeat it. What a trust above the holding company changes is who stands behind the shares, and so who eventually receives what the company receives. Every kind of owner a policy can have is compared on who can own a life insurance policy in Canada.

Who decides what at each level of the chain?

Each level has its own decision makers. The trustees decide how the trust votes its shares and when it pays its beneficiaries. The shareholders, here the trust, elect the directors. The directors of the holding company decide everything about the policy: premiums, beneficiary designation, loans and dividend options. The insurer deals only with the policyholder.

That division surprises people. A founder who is a trustee often assumes that this means controlling the policy. It does not. Control sits with the holding company's directors, acting by resolution. A founder who is also a director decides about the policy in that capacity only.

The trustees' power over the policy is indirect but real. Because the trust votes the shares, the trustees can, within the limits of the deed and the company's articles, change who sits on the board. A board that ignored the plan could in principle be replaced. That power carries duties: trustees act for the beneficiaries of the trust, not for themselves, and the deed may require more than one trustee to agree.

So there are three hats here, trustee, director and person insured, and often one person wears all three. Writing down which hat each decision was taken under lets a successor understand, years later, why the policy was set up as it was.

Where does the money go when the founder dies?

At death the insurer pays the policyholder's named beneficiary, here the holding company. The company's capital dividend account is credited with the amount received over the policy's adjusted cost basis. The company may then pay a capital dividend to its shareholder, the trust, and the trustees deal with the money under the trust deed.

Here is each step with its section, in plain words. Subsection 148(9) of the Income Tax Act says a payment under an exempt policy because the person insured died is not a disposition of the policy. Subsection 89(1), in its definition of capital dividend account, adds to the account the amount by which the proceeds received by the corporation exceed the policy's adjusted cost basis immediately before the death. The account is a running record kept for the corporation, not a pot of cash, and other transactions over the company's life change it too.

Next, subsection 83(2) lets a private corporation elect to treat a dividend as a capital dividend, to the extent of its capital dividend account immediately before the dividend becomes payable. The election is made in prescribed form, on the full amount of the dividend, at or before the time the dividend becomes payable or is first paid. On the Canada Revenue Agency's page on special elections, the form for it is T2054. When the election is valid, no part of the dividend is included in the income of the shareholder, which here is the trust. The mechanics and the timing traps are set out on paying a capital dividend after a death, and the account itself on the capital dividend account.

Then the trust. When the trustees pay or make payable the amount to a beneficiary, subsection 104(20) requires the trust to designate, in respect of that beneficiary, the portion of non-taxable dividends that can reasonably be considered part of the amount payable, for the purposes the subsection lists. How that designation and the trust's other rules produce the final result in each beneficiary's hands is exactly the analysis to leave to the accountant, on the real deed and the real figures.

Two qualifications belong next to every step. The credit is the excess over the adjusted cost basis, never automatically the whole amount paid. And nothing happens by itself: the dividend, the election, the trustees' decision and the designation are four separate acts, each with its own paperwork.

How does this chain compare with the holding company owning the policy alone?

The difference is who stands behind the shares. Without a trust, the founder or the family owns the holding company directly, and a capital dividend goes straight to them. With a trust, the dividend stops at the trust, and the trustees decide what happens next under the deed. The table sets out what changes.

Neither column is a recommendation. The trust adds a layer of decisions and of cost. Some families want that layer, because it keeps the shares together after the founder's death and lets trustees share the benefit as needs change. Others find it is paperwork with no task. Whether the policy should sit in a corporation at all is a separate question, treated on personal or corporate ownership of the contract.

What changes when an operating company sits under the holding company?

In the common version the trust owns the holding company, and the holding company owns the operating company that runs the business. The policy can sit in either company. Wherever it sits, that company receives the proceeds and the capital dividend account credit, and money has to climb each level to reach the trust.

If the operating company owns the policy and is its beneficiary, the credit arises there. A capital dividend paid from the operating company goes to its shareholder, the holding company, which then needs its own election to pass a capital dividend up to the trust, on figures the accountant confirms. Two companies, two elections, two sets of minutes. If the holding company owns the policy, one step disappears. That trade off, and the trade risk that sits in the operating company, is the subject of which company should hold the contract.

A mismatch inside the group creates its own problem. An operating company paying the premium on a policy the holding company owns can raise a benefit question, as explained on when the corporation pays and the shareholder owns. And if the operating company is the one in financial trouble, what a creditor can reach is set out on a corporate contract when the company is in trouble.

What must the trust deed and the shareholder agreement say?

They must agree with each other and with the insurer's file. The trust deed should allow the trust to hold private company shares and to receive and pay out capital dividends. The company documents should say who may be a director and how. The policy should name the company the plan expects to be paid.

On the trust side, read the deed for practical answers. Can the trust hold shares of this private company? Can the trustees choose among beneficiaries, or are the shares fixed? Who replaces a trustee who dies or loses capacity? Can the trustees distribute capital, including shares, before the 21st anniversary, and to whom?

On the company side, the articles and any shareholder agreement decide how directors are elected, how a deceased director is replaced, what dividends each class of shares may receive, and whether anyone may buy shares at a death. An agreement written before the trust existed may say nothing about a trust shareholder.

And on the insurer's file, three names have to match the plan: the policyholder, the person insured and the beneficiary. A personal designation left on a corporate policy, or a policy still owned by an individual when the plan assumes the company owns it, defeats every document above it. How a designation works, including a contingent beneficiary, is explained on contingent beneficiary.

What does the 21-year rule do when the trust holds the shares?

Under subsection 104(4) of the Income Tax Act, a trust is deemed to dispose of certain property at fair market value on the day 21 years after it was created, and every 21 years after that. If the trust still holds shares of the holding company on that day, any gain on the shares can be taxed in the trust.

The policy matters here even though the trust does not own it. The holding company owns the policy, and the value of the holding company's shares can reflect what the company owns, including the policy. How a life insurance policy is counted in a share valuation, before and after a death, is a technical question with its own rules, and it is one to put to the accountant and, where needed, a business valuator. Do not assume either a high or a low number.

Trustees rarely wait for the deemed disposition. Depending on the deed and the tax analysis, they may distribute shares to beneficiaries before the anniversary, or plan for the tax in the trust. A distribution changes who owns the holding company, and so who elects the directors who decide about the policy.

The date itself is the easiest part to miss. Ask the accountant for the 21st anniversary in writing, and keep it with the policy's own anniversary date.

Why should you ask about the tax on split income?

Because section 120.4 of the Income Tax Act taxes split income at the highest individual rate, and split income can include amounts a beneficiary receives through a trust that relate to taxable dividends on private company shares. Whether any amount in your plan is caught depends on facts only the accountant can weigh.

The question does not usually concern the capital dividend itself. Subsection 83(2) says a valid capital dividend is not included in the shareholder's income, and the definition in section 120.4 speaks of taxable dividends among its sources. But a family trust above a holding company often receives ordinary dividends during the founder's life and pays them out to family members, and those are exactly the amounts the rule was written for.

So the honest instruction is narrow. Before the trust pays any family member anything, ask the accountant whether the payment is split income for that person, and why. Ask again when a beneficiary's age, work in the business or ownership changes, because the answer can change with them.

How are the shares and the policy valued?

A value is needed when the trust is funded, when shares are distributed, on the 21st anniversary, at the founder's death and in any sale. Each valuation of the holding company's shares must account for the policy it owns. The method and the figure belong to the accountant and a qualified valuator.

The insurer reports the policy's own values: the cash surrender value and, on request, the adjusted cost basis. If the policy is participating, its dividends are not guaranteed, because the insurer's board declares them each year. None of those figures is by itself the policy's fair market value for tax purposes, nor the value of the shares.

The policy can also move. If the holding company ever transfers the policy to a shareholder, to the trust or to someone else it does not deal with at arm's length, subsection 148(7) deems the company to receive the greatest of the value of the policy, the fair market value of anything received for it, and the adjusted cost basis. A transfer that looks like a tidy reorganisation can produce income in the company. Ask before any change of owner.

What changes in Quebec?

In Quebec the trust is a creature of the Civil Code of Québec, not of the common law, and a notary often drafts it. The federal tax rules above apply in the same way, and Quebec may add its own tax filings. The trust deed, the company's documents and the policy designation are read under Quebec civil law.

The Civil Code's own chapter on trusts begins at article 1260. As Quebec notaries usually explain it, a trust there is a patrimony set aside for a purpose, distinct from the settlor, the trustee and the beneficiary, and none of them owns it in the common law sense. Read articles 1260 and 1261 with your notary rather than relying on any summary, including this one, because the wording of the code is what governs.

The designation of a beneficiary under a policy is also governed by the Civil Code in Quebec, with rules that differ from those of the other provinces, including when a designation is revocable. For a policy owned by a holding company and payable to that company, the main question is simpler: does the insurer's file name the company the plan expects? The interaction with creditors is set out on the designation and what a creditor can reach.

On the tax side, Quebec has its own income tax system alongside the federal one, so a Quebec trust and a Quebec corporation may have provincial returns and elections to file in addition to the federal ones. Ask the accountant which Revenu Québec forms apply to your trust and your companies each year, and when.

What can go wrong in this structure?

The usual failures are not exotic. Documents that do not match, a beneficiary designation that sends the money somewhere the plan did not expect, and a trust that reaches its 21st anniversary with no plan are the three that cause the most trouble. Each is preventable with a review.

Documents that do not match. A trust deed that does not allow the trustees to distribute capital, a shareholder agreement that predates the trust, a minute book that never recorded the holding company as policyholder: any of these can block a step at the moment it is needed. The fix is to read the deed, the articles, the agreement and the policy together, once, with the accountant and the lawyer or notary in the same conversation.

A designation that bypasses the plan. If the policy names an individual or the founder's estate as beneficiary instead of the holding company, the proceeds never reach the company, no capital dividend account credit arises there, and the trust receives nothing through the chain. The opposite error happens too: a policy moved into the company years ago that still names a former spouse. Ask the insurer for a written confirmation of the owner and the beneficiary on file, and keep it with the trust deed.

An anniversary nobody planned. Illustrative example: a founder, a spouse and two adult children, with a trust created when the business was small and a holding company that owns a policy on the founder. In year 19 the accountant notes the anniversary, and the trustees, the directors and the family meet to decide, with professional advice, whether shares should be distributed and to whom. That meeting, held two years early, is the whole lesson.

What this page will not tell you

It will not tell you whether to create a trust, whether to place a policy in a corporation, or how much tax any step will cost. Those answers depend on your share structure, your trust deed, your province and your family, and they belong to your accountant and your lawyer or notary.

It will not give a figure for a capital dividend account, a valuation or a premium, because none can be stated honestly without your documents. It also does not cover how the trust was first funded, the attribution rules or how a trust is taxed on its own income in detail; for the basics of the trust itself, read what a trust is for someone who owns life insurance.

Bring these questions to the accountant. What is our trust's 21st anniversary date? What credit to the capital dividend account would arise on the current adjusted cost basis? Which company should be the beneficiary? How would a capital dividend reach each beneficiary? Could any payment be split income? Bring these to the lawyer or notary. Does the deed allow every step we are counting on? Who replaces each trustee and director? Do the shareholder agreement and the policy designation match the deed?

Who this does not suit

It does not suit a family without a holding company or without surplus in it, nor one that is not ready to pay every year for a trust return, a valuation from time to time and legal review. The structure only earns its cost when there is something real for each level to do.

It also does not suit a founder who wants personal control of the policy and the shares. Once a trust holds the shares, trustees decide under a deed and directors under the company's rules, with duties to others. A simpler arrangement, compared on who can own a life insurance policy in Canada, may fit better.

And it does not suit a policy chosen for the structure rather than for a need. The life insurance has to make sense on its own, with premiums the company can carry for many years. For the wider set of questions incorporated owners face, start from the business owners section, and look at the succession planning process if the shares are meant to pass to the next generation.