Use of family trusts
The Income Tax Act (ITA) provides for over 50 different types of trusts. Each type is used for different purposes and for different circumstances. Different rules apply for settlement and administration of different types of trusts. This post discusses only inter vivos family trusts.
A family (inter vivos) trust is a very common method of holding and dealing with family assets. A trust can hold assets, manage them, invest, have bank accounts and carry on business. A trust is established when a person (called the settlor) transfers property (called the trust property) to another person (called the trustee) to hold for the benefit of one or more persons (called the beneficiaries). Once the settlor has given the property to the trustee, the settlor no longer owns that property and usually has no ongoing involvement or liability with the trust. The trustee is then responsible for the custodianship of the trust property and has an ongoing obligation to administer the trust in accordance with the terms as set out in the trust deed, which is a contract between the settlor and the trustee.
A trust can be used to achieve a number of objectives, including asset protection, will substitute within estate planning and tax planning. Confidentiality is a good reason as well, but due to the coming changes to disclosure requirements this benefit will diminish.
The trust is used when a beneficiary does not want to or cannot manage assets. It is used for the protection of the beneficiaries. In a trust where the benefits are up to the discretion of the trustee, the beneficiaries have no right to the assets, which can only be distributed to them at the discretion of the trustee. If there is a claim by a creditor against a beneficiary, they can negotiate a settlement showing they have no right to trust assets. Asset protection planning is a legitimate form of wealth preservation.
As of today, the assets, terms and identities of beneficiaries are confidential, other than in regard to tax filing with Canada Revenue Agency (CRA) or, depending on the province, registration with the Land Title Office should the trust be a registered owner of real estate.
Currently filings with the CRA are not especially onerous in terms of the information that needs to be disclosed; however, requirement for disclosure of information for family trusts, subject to limited exemptions, will be changing for tax years ending after December 31, 2021 with the first reports due on March 30, 2022. This report will have to disclose the name, address, date of birth, residence and SIN for each trustee, each beneficiary and each settlor. Failure to file such return will attract penalties.
A trust is often used to hold an asset that is used by one beneficiary during their lifetime and would pass to another person upon death of that beneficiary. When the lifetime beneficiary dies, assets of the trust do not become a part of that beneficiary’s estate and is not probated, which avoids probate fees and delays in distribution. Because the asset does not pass under the will, there will be no will variation challenges. The assets’ management also will not be disrupted and will continue its normal course.
Tax – selected rules and continuing amendments
- Filing tax returns – the trustee is required to file a T3 trust information and income tax return within ninety (90) days of the end of each calendar year:
- Currently CRA does not require the return to be filed if:
- i) the trust’s income does not exceed $500.00;
- ii) the trust’s income of less than $100.00 is designated, paid or payable to any single beneficiary;
- iii) none of the income is taxable in the trust; and
- iv) none of the income is allocated to a non-resident beneficiary;
- New disclosure requirements – The current policy will be changing for tax years ending after December 31, 2022;
- Deemed Dispositions – the trust will be deemed to dispose of all of the capital property every 21 years following the date of its settlement. As a result, any accrued capital gains will be realized and taxed. The trustees should consider possibility of a distribution of the assets to the beneficiaries at cost (rollover) to avoid the tax;
- Non-Resident beneficiaries- if any of the beneficiaries cease to be residents of Canada, taxation and distribution of funds will be more complicated; withholding and other tax may be applicable, especially if trust holds real estate;
- Taxation of trusts:
- At the trust level – under the ITA the trust’s income is taxable in the hands of the trust at the flat highest tax rate applicable to the individuals;
- At the beneficiary’s level – the trust can distribute its income and/or capital to the beneficiaries. Capital distributions are tax free. If the income is distributed to the beneficiaries, it will be deductible to the trust and taxable in the hands of these beneficiaries at their marginal tax rates, which are, presumably, lower.
- Kiddie Tax (under18) and TOSI (18 and over)
- The “kiddie tax” is a set of special rules that subjects income received by individuals under the age of 18 from a business carried on by a related person to the highest marginal tax rate, restricting income splitting by business running parents with their kids under 18;
- Tax on split income (TOSI) extends application of special rules to individuals 18 and older subjecting income received by them from related business to the highest marginal tax rate, unless specifically exempted. This further restricts income splitting between persons running the business and their families.
- Amendments 2015-2019
- One of the main benefits of the trust is that it allows income to be taxed in the hands of low rate beneficiaries. The extent of that benefit has decreased over the last few years due to the extensive changes of the rules;
- The 2016 amendments resulted in personal trusts no longer able to claim principal residence exemption. That exemption is now only available to life interest (alter ego, spousal and joint partner) trusts and qualified disability trusts. The life interest trusts are not discussed in this post – they operate under different rules, are mostly put in place for non-tax purposes, largely tax neutral and generally produce the same tax results as if the assets had continued to be held personally;
- The 2018 amendments restricted benefits of using trusts further. For example, the commonly named tax benefits of using a discretionary family trust for holding family shares were:
- the ability to stream dividend income efficiently to family members;
- the ability to multiply the lifetime capital gain exemption (LCGE) for qualified small business corporations (QSBC) shares by utilizing the LCGE of beneficiaries; and
- the ability to permit share value and future gains to accrue to a younger generation of family members – all while preserving centralized control.
Tax planning with trusts became more challenging because of many recent tax changes, but still many planning opportunities remain:
- Even though dividend streaming through inter vivos trusts is severely restricted by the newly implemented TOSI rules, it is not eliminated and with careful planning the benefits still are worth getting; and
- The LCGE and capital gains planning is still intact.