Canadian family trusts have become part of Canadian folklore as this famous family has one and that famous family has one. We have all heard people say, “Everybody is using one and it’s paying for private school and university.” But, what is it? A Canadian family trust is an arrangement whereby an individual may allow family members to share in the growth and value of an incorporated active business without that individual losing control over the operations of the business. In the typical situation, an individual (the “trustee” of the family trust), will hold property (shares of the active corporation) “in trust” for the benefit of family members (the beneficiaries of the trust).
Although title to the property is in the trustee’s name and the property (the active corporation’s shares) are under the trustee’s control, the income and capital growth attributable to the shares accrues to the beneficiaries. If that income earned by the trust is paid to its beneficiaries, the income is taxed in the beneficiaries’ hands. These beneficiaries may pay little or no income tax on those distributions, assuming they are not subject to the Canadian “Kiddie Tax” in Section 120 of the Income Tax act.
Keep in mind that a typical family trust agreement is drafted so that the trustee(s) may pay that income out to, or for the benefit of, any or all beneficiaries at their discretion as they see fit. In that way, future problems associated with issuing shares directly to children may be avoided. Legitimately used, family trusts are a good method of splitting income, because they allow parents to allocate income to their adult children’s needs and pay little or no tax. A family trust is established when a person referred to as the settlor (usually a relative) gives a gift to the trustee for the benefit of (typically) other family members.
At the same time, a written agreement is drafted stating the terms whereby the trustee will hold and manage the property on behalf of the beneficiaries. As it is this agreement that gives the trustee the power to distribute funds from the trust at his discretion, the trust agreement is a critical part of any family trust arrangement.
Income splitting and capital gains planning
Scenario 1: Income splitting
Mr. X establishes a trust for the benefit of himself, Mrs. X, and their three children, A, B and C. A and B are over 18 years of age and are enrolled at a university. C is a minor living at home. The participating shares of Opco, Mr. X’s active business corporation, are owned 100 percent by the trust. After salaries are paid to Mr. X, Opco is earning $100,000 before tax and $82,000 after tax. Based on current tax rates, if Mr. X wishes to pay out the net after corporate tax income of $82,000 to himself to use it personally, he would pay additional taxes of more than $26,000 if he were the sole shareholder of the company.
Using the family trust arrangement and paying the income earned by the trust equally to the adult beneficiaries (except Mr. X.), the trust’s dividend could be split evenly between Mrs. X, A and B. The tax liability and the dividend are taxed as follows: Mrs. X, A, B taking equal dividends of $27,334, $27,333 and $27,333. assuming that Mrs. X, A and B have no other sources of income by using a family trust arrangement, Mr. X has just saved the family unit approximately $26,000 in tax.
Scenario 2: Capital gains splitting
Mr. X has received an offer to sell the shares of Opco (which are qualified small business corporation shares) for $2,000,000. The shares were acquired for a nominal amount ($100). If Mr. X were to receive the sale proceeds as sole shareholder of the business, his tax liability might be computed as follows: proceeds $2,000,000; cost ($100); capital gain $1,999,900; capital gains exemption ($750,000); capital gains subject to tax $1,249,900; taxable capital gain $624,950; and tax $271,290 (Ontario combined federal/ provincial 2010 tax rates 2010 at 43.41 percent).
Under the family trust arrangement, the trust receives the total $2,000,000 proceeds and the trust’s capital gain could be paid out to trust’s beneficiaries. In addition, the beneficiaries could now shelter the gain with their own $750,000 capital gains exemptions. In this case, up to the entire amount of tax could potentially be saved, subject to alternative minimum tax considerations, in section 127 of the Income Tax act. (For an individual alternative minimum tax calculation, contact a trusted tax professional, as it calculated using the particular tax circumstances of the taxpayer and everyone is different.) Note that this benefit can be achieved even if the beneficiary is a minor child, since the “Kiddie Tax,” does not apply to capital gains. Similar tax savings exist when other situations occur such as the death of the small business owner.
Making payments to adult beneficiaries under a family trust
Under the most recent guidelines released by the Canada Revenue Agency (CRa), a family trust can pay for, or reimburse, a wide variety of expenses for an adult child as long as the payment of the expense clearly benefits the child. Such expenses may include, but are not necessarily limited to: education and tuition expenses, including private schools; sports and music camps; recreation expenses and equipment; the child’s share of restaurant meals and family grocery bills; clothing, medical and dental expenses; spending allowances; and toys.
However, a proportionate share of vacation costs for asset purchases (e.g., cars, boats, vacation properties) and mortgage payments that cannot or will not be legally registered in a child’s name are problematic and should not be reimbursed by the trust. In all cases, receipts should be retained documenting the fact that trust funds were spent on the beneficiary’s ‘s behalf.
The CRa pronouncement decision appears to make it clear that, notwithstanding the Langer Trust case, ordinary expenses (i.e., the basic necessities of life) are acceptable expenditures of a family trust. The reasoning behind this is likely that such expenses are difficult to pin down as to who received the benefit. For example, if parents purchase groceries using funds from the family trust and argue that they are for the beneficiaries, how would they allocate the amount? Would you keep track of what each beneficiary ate and record it?
There are numerous ways to make the trust work. It is recommended that a bank account be established and a ledger sheet for each beneficiary be kept. Amounts will be paid or payable to a beneficiary in the year under the following scenarios:
- The trustee pays the cost incurred by the beneficiary directly to the institution like a university, hockey camp or dance camp and any accommodations needed to attend these.
- An expense report detailing the year’s expenses incurred by the parent on behalf of a beneficiary is submitted by the parent to the trustee. The trustee initials the report to evidence the exercise of his discretion pursuant to the terms of the trust agreement, and a trust check is issued to the parent before the end of the year.
- The parent requests, in writing, tht the trustee make certain payments to a third party for the benefit of the beneficiary. The trustee initials the written request to evidence the exercise of his dis- cretion and makes the payments to the third party before the end of the year.
- The trustee declares an income distribution using a trustee’s minute and either issues a trust check payable to the beneficiary before the end of the year, or issues a demand promissory note to the beneficiary as evidence of payment before the end of the year.
- When the amount of trust income earned is not known in a particular year (e.g., when a trust owns units in a mutual fund trust), the trustee resolves to make an income distribution to a beneficiary equal to a certain percentage of the undistributed income earned by the trust in the year using a trustee’s minute and issues a demand promissory note to the beneficiary as evidence of payment before the end of the year.
What are the practicalities?
Many small business owners run the trust out of a normal trust bank account, and once it runs for one year, many owners say it runs simply as balancing the books for any business—the only difference is that your family is your trust’s business.
First, it is normal practice to transfer funds into a trust by dividends. The typical scenario is: dividend from operating company to holding company, dividend from holding company to family trust. Second, to successfully run the trust, remember three important dates:
- Important date #1: December 31
all trusts in Canada have a calendar year-end, and one must ensure that little to no funds remain in the trust account to avoid tax on excess funds. any trust income not actually paid or payable to a specific beneficiary in a given year is taxable in the trust at the highest marginal tax bracket, thus eliminating the benefits of using the trust. Therefore, a yearly reconciliation for each beneficiary must also be completed. The taxation compliance is simple. Taxes are levied on all income and capital gains reported on the T3 or T5 slips, and an annual T3 return is filed.
- Important date #2: The late February filing date
File any T4, T4A, T4A-NR, T5 (dividends) slips and T4 and T5 summaries by the last day of February after the calendar year in which the trust made the payment. Income earned on money loaned to any person who does not deal with a taxpayer at arm’s length will generally be taxable in the lender’s hands, regardless of the age of the debtor. The rule does not apply if interest is charged on the loan at the CRA’s prescribed rates. The CRa’s prescribed rate of interest for family loans is only one percent (however, as this rate can fluctuate, please check with a tax professional regarding the current rate). This creates an opportunity to lock in a family loan at a low rate of interest and save tax on a portion of the investment income earned on the loaned funds.
- Important date #3: The late March filing date
It’s important to file the T3 return; T3 and NR4 slips; and T3 and NR4 summaries no later than 90 days after the trust’s tax year-end of December 31, this being March 30. Make note of these important dates and work with your tax professional if you feel you need assistance.
Of course, the income attribution rules of the Income Tax Act, found in many sections including sections 74, 75 and 107, must be carefully considered in structuring a Canadian family trust. These rules can cause income earned by a taxpayer to be taxed in the hands of another, thus potentially eliminating the advantages of establishing the trust.
a family trust, when planned with a professional, will normally avoid the income attribution rules. as a general rule, the family trust arrangement will work best when the trust purchases shares of a small business corporation that carries on an active business in Canada. a tax professional’s advice is important because several anti-avoidance rules surrounding the Income Tax act must be considered.
The foregoing is only a brief overview of the benefits and mechanics of utilizing a family trust in income tax planning. If you remember the importance of December 31, February 28 and March 30, then trust compliance becomes easy. The use of competent professional advisors when establishing and maintaining a family trust is mandatory if the many pitfalls associated with this form of tax planning are to be avoided.