Article written by Marcil Lavallée’s team for Canadian News Quarterly, a newsletter published by
Canadian member firms
of
Moore North America
. This article on the advantages of a family trust is part of our mission to be your partner in success by keeping you informed.
Estate planning is an important issue for all individuals, regardless of their level of wealth. Poor planning, or the lack of it, can result in the loss of an excessive proportion of your estate upon your death, in the form of probate fees and/or taxes.
Fortunately, there’s a plethora of information available about estate planning, and the various strategies you can use to ensure that as much of your estate as possible passes to your heirs when you die (and, in some cases, before you die). One popular strategy is to create a family trust.
Definition of a trust
A trust is essentially an agreement between various individuals under which one person (the settlor) transfers property to the trust, which is managed by one or more separate persons (the trustees) for the benefit of present or future transferees of the property (the beneficiaries). In drawing up this agreement, the settlor organizes the transmission of assets belonging to him to the ultimate beneficiaries, either immediately or at a specified future time.
Once the assets have been transferred to the trust, they are usually no longer considered to belong to the settlor and no longer form part of his or her estate at the time of death. Rather, they are the legal ownership of the trustees and the beneficial ownership of the beneficiaries.
Non-tax benefits
In general, it’s not a good idea to set up a trust simply because of the potential tax benefits. Fortunately, a number of important non-tax advantages can take precedence over purely tax advantages, making potential tax benefits a valuable complement. For example, a parent may wish to transfer assets to a child who is not in a position at this time in his or her life to receive the full value, due to youth, incapacity, poor spending habits or other reasons. Once transferred to a trust, the assets can be administered by the trustees until they determine that the time has come to transfer their value to the beneficiary.
Transferring assets to a trust also provides great flexibility when a decision needs to be made about who will benefit from the assets in the future, and in what proportion.
Click here to read more about the tax advantages of a trust
For example, you may wish to transfer assets to your children in the future, but don’t yet know exactly how much will go to each of them. What’s more, you may also wish to leave an inheritance to your unborn grandchildren. When setting up a trust, it is possible to designate a “class” of beneficiaries (for example, a person’s children or grandchildren) rather than specifically naming each beneficiary. By grouping “children” or “grandchildren” in a beneficiary category and giving the trustees the discretion to determine how much will go to each beneficiary, it allows the trustees to determine, at a later date, how much each child or grandchild will receive. It is also possible to automatically include any unborn children among the potential beneficiaries.
If the parents of the beneficiaries are also the trustees of the trust, the use of a trust structure allows the parents to retain control of the assets transferred to the trust while they are in the trust. This also allows parents to adapt their distribution plans to future events (for example, by adding or eliminating beneficiaries, and distributing assets in a way that supports beneficiaries at important moments in their lives).
In certain circumstances, a trust can also be used to protect an individual from creditors. In general, assets transferred to a trust cannot be seized later if the settlor goes bankrupt, divorces or loses a lawsuit, provided the adverse event was neither known nor foreseen at the time the assets were transferred to the trust.
Procedure for setting up a trust
A trust is created by a person (the settlor) who drafts and signs (usually with the help of a professional advisor) a trust agreement and transfers assets to the trust. It is not uncommon for the settlor to pay a coin or a small amount of money into the trust to set it up. The Contract of Trust guides the Trustees as to the manner in which the trust is to be administered, and assigns various rights and imposes various restrictions on the Trustees with respect to the administration of the trust. The agreement designates the trustees, describes what they may and may not do, lists potential beneficiaries and explains when, and under what circumstances, assets may be transferred to them.
Click here to read more about setting up a trust
As mentioned above, it is not uncommon in a trust for the trustees to be the parents of the beneficiaries. Parent trustees can also be beneficiaries, so that trust funds can be released to them.
When only a small amount is paid at the inception of the trust, it is common for the settlor to be a grandparent of one or more beneficiaries, or a family friend. Given the various rules of the Income Tax Act (ITA), it is important that the settlor not also be a trustee or beneficiary of the trust. In addition, the settlor must have no control over how the trust assets are to be distributed, and no reimbursement must be made to him or her for the amounts he or she has paid into the trust. Why would a person contribute only a small amount to a trust? Because trusts are often used as part of a broader estate plan, which includes business reorganizations.
For example, a settlor could contribute $10 to a trust, which would then be used to purchase shares in a family business once it has been reorganized so that the new shares have a par value (this is known as an estate freeze). By doing so, the settlor can make a relatively small contribution to the trust, which can then accumulate significant value in subsequent years as the business grows.
Once the trust is “constituted”, the settlor no longer participates in any way in the administration of the debt. Control is vested in the trustees who administer the trust in accordance with the trust agreement.
Tax consequences
A trust is considered a separate person for the purposes of the ITA, which means that any income or gain earned on trust property is taxed in the hands of the trust (unless it is allocated to beneficiaries, as explained below).
A trust pays tax on all income and gains at the highest tax rate in its province of residence (in Ontario, 53.53% on ordinary income and 26.76% on capital gains). It therefore does not benefit from the marginal tax brackets for individuals.
This tax treatment generally renders the realization of income and gains in a trust tax inefficient. However, when a trust distributes income or gains to a beneficiary, the amounts in question may be taxed instead in the hands of the beneficiary. (The trust must recognize income for tax purposes, but generally obtains an offsetting deduction for amounts paid or payable to beneficiaries).
This can be advantageous if a beneficiary is in a low marginal tax bracket during the year. Thus, and subject to the “split income tax” (SIT) rules described below, income can be distributed among beneficiaries in a way that results in the lowest possible tax liability for the year.
The trust must file a T3 return each year, no later than 90 days after the end of the year, to report income and gains realized, and to deduct amounts distributed to beneficiaries, when the latter must pay the tax instead. The trust will also prepare T3 slips for the beneficiaries, providing them with the relevant information for their personal income tax returns. Beginning with the Page 18Q1, 2024 return for the year 2023, the trust must provide a significant amount of detail to identify all of its actual and potential beneficiaries, and allow the CRA to audit the trust and beneficiaries.
Income splitting
Historically, families have used family trusts to split income between family members, taking advantage of the marginal tax brackets of each beneficiary. Income splitting is possible because a high-income family member can contribute funds to a trust, and the trustees can decide to distribute the income and gains generated by these funds to one or more beneficiaries who pay tax at lower rates.
Because this planning has become so popular, new FIT rules were introduced in 2018 to put a stop to this type of income splitting, particularly when dividends are paid by an individual-operated business to members of that individual’s family. These rules apply both to dividends paid directly to family members and to those paid indirectly through a trust.
For example, if Dad, who ran a business, invited Mom and Son to be shareholders, he could effectively split the dividend income between them, rather than paying the full tax at a higher rate himself. This is part of what the IRF rules were designed to put an end to.
Where applicable, IRF rules mean that any income recognized is taxed in the hands of the beneficiary at the highest rate in force at the time, even if the beneficiary is not in the highest tax bracket.
IRF rules provide for various exceptions that still allow for some income splitting. It remains essential to obtain professional advice before making any form of gift or payment to family members, to ensure that you do not inadvertently trigger the application of the FIT rules or any of the many anti-avoidance rules in the ITA.
Learn more about planning with a prescribed-rate loan
Another common planning technique – albeit not very attractive at the moment – involving trusts is planning by means of a loan at the prescribed rate.
This planning is another way for family members to take advantage of a trust while keeping taxes to a minimum. Essentially, a high-tax family member can make a loan to the trust, which can then be invested to generate income for distribution to lower-tax family members.
This procedure will normally activate various ITA anti-avoidance rules. However, with a few specific measures, such planning can be advantageous without activating any unfavorable tax rules.
First, the lender must require the trust to pay interest on the amount loaned. As long as the interest rate is at least equal to the “prescribed rate” at the time of the loan, the application of a group of anti-avoidance rules – the attribution rules – can be overridden.
The prescribed rate is a rate set quarterly by the CRA based on the three-month average of Treasury Bill rates. The current rate is 6%, but given the forecast rate cuts, we can expect it to fall this year.
The other major group of anti-avoidance rules are the IRF rules. As described above, amounts distributed to beneficiaries from a family member may be subject to these rules. A significant exception is dividends received from listed companies.
As a result, the trust could invest the borrowed money in public companies. Any dividends received from these companies should not be subject to IRF and could be distributed to adult family members taxed at a lower rate.
The advantage of this planning lies in the difference between the prescribed interest rate (which has traditionally been relatively low) and the rate of return offered by portfolio investments. As a result, with the current prescribed interest rate of 6%, this type of planning is relatively unattractive at the moment. It remains possible, however, should the prescribed interest rate return to lower levels, as could happen in the future. (For the two years ending June 2022, the rate was 1%).
Multiplying the capital gains exemption
Although the use of trusts for income splitting has been restricted in recent years, there is still a significant advantage to holding assets, particularly shares, in a trust: the potential multiplication of the lifetime capital gains exemption (“LCGE”).
When an individual sells shares of certain corporations (“qualified small business corporation shares” – QSBCs), any gain resulting from the sale can effectively be tax-exempt through the use of his or her QSBC. The exemption may also apply to certain agricultural and fishing assets.
In 2024, just over $1 million in capital gains may be exempt from tax if the individual has not already used part of his or her ECGC. We studied the use of ECGC in connection with AAPEs in our January 2024 Tax Bulletin.
Trusts cannot take advantage of the ECGC, but individual beneficiaries can. Because of its ability to distribute gains to beneficiaries so that they are taxed in their hands, the trust may allocate portions of an eligible gain to one or more beneficiaries. If these beneficiaries have an ECGC balance available, they can use it to shelter some or all of the gain from tax.
As a result, instead of one individual realizing the gain and taking advantage of the ECGC, multiple individuals may do so, and multiple amounts may be claimed under the ECGC. In Ontario, the potential tax savings from using ECGC exceed $270,000 per taxpayer!
Defects and disadvantages of a trust
While trusts offer both tax and non-tax advantages, there are also some important disadvantages that we need to understand.
First, most trusts are required to file annual returns. This requirement includes the filing of an annual T3 tax return of income and gains realized and distributions made in the year, and T3 slips to provide beneficiaries with what they need to meet their personal reporting obligations.
The T3 return must be filed within 90 days of the trust’s year-end, and penalties for non-compliance apply to both the tax return and the T3 slips.
In addition, the trustees are required to keep adequate records of the trust’s income and assets. When the trust’s assets are numerous, this can become an arduous and costly task.
Starting in 2024 (for the year 2023), an additional administrative obligation is added in the form of new trust reporting rules, as discussed above. These rules have also increased the number of trusts required to file an annual T3 return.
Trusts are now required to provide a significant amount of personal information relating to the trust itself and the various individuals involved, including the settlor, trustees and beneficiaries. Information such as name, address, date of birth and social insurance number is required.
These new rules impose significant penalties if a return is not filed, or if inaccurate information is provided, particularly if the error or omission is considered to have been made knowingly or in circumstances amounting to gross negligence. The penalty can be 5% of the highest value of the trust’s assets in the year!
Another disadvantage of using a family trust is its limited lifespan. Trusts can only exist for 21 years before paying tax. On the trust’s 21st anniversary, the trust is deemed to sell and reacquire all of its assets at their then market value. Cumulative gains are then realized and taxed.
One way to avoid this tax burden is to distribute the trust assets to the beneficiaries before their 21st birthday. In many cases, it is possible to transfer assets to beneficiaries at cost, meaning that accumulated gains remain unrealized and tax is only paid when the beneficiary later sells or transfers the assets. The tax is then paid by the beneficiary, not the trust. (The rules in this respect are very complex, however, and sometimes this “rollover” is not possible).
In practice, trusts are most often liquidated just before their 21st anniversary, forcing them to make the ultimate decision as to which beneficiary will receive which asset. Depending on the beneficiaries’ situation at the time, the choice may be a difficult one: transfer assets at an inappropriate time, or assume a significant tax burden.
Conclusion
Although recent anti-avoidance rules have considerably limited the tax advantages of family trusts, such advantages still exist. More importantly, the non-tax advantages of a family trust, and the general flexibility that such structures produce in terms of estate planning, ensure that trusts remain a valuable estate planning tool in the right circumstances.
Our team is here to help you
If you have any questions or would like help with the tax planning involved in setting up a trust, please contact our tax or strategic planning team.
