What is a Trust
A Trust is not, strictly speaking, a separate legal and tax entity. A Trust is a relationship among 3 parties - the Settlor is the person setting up the Trust; the Trustees manage the Trust and make decisions about the property owned by the Trust; and the Beneficiaries are the parties on whose behalf the property is being managed.
A Trust can have different beneficiaries entitled to income and to ultimate distribution of trust property (capital).
There are two kinds of Trusts. Inter vivos trusts are set up during your lifetime and are often used for tax planning purposes, especially when ownership of business corporations is involved. Testamentary trusts are set up in a Will.
A Trust is extremely flexible. Properly drafted, the Trustees can determine from time to time, how to distribute income among various beneficiaries. This distribution can be changed easily. The Trustees can also determine how to distribute the trust property among different beneficiaries.
A Trust is also a good vehicle to protect assets from creditors. A discretionary interest in a trust is not a property that can be seized by creditors, nor can the trust property be seized by creditors of any particular beneficiary.
TAXATION OF TRUSTS
Tax Treatment of Testamentary Trusts
A testamentary trust is taxed as an individual with graduated tax rates, for the first three years, but no personal deductions
The Trustees (usually, but not necessarily, the same as the Executors of the Will) can pick the year end for tax purposes for the first 3 years – then the Trust will have a December 31st year end.
Tax Treatment of Inter Vivos Trusts
An inter vivos trust is taxed at top personal rates without any personal exemptions. This makes such a trust an inefficient vehicle for the accumulation of income. They are extremely efficient as a flow through entity to receive income and then to distribute it to one or more beneficiaries.
Tax Treatment of All Trusts
All trusts now have to have a December 31st year end, except a testamentary trust for the first 3 years.
Any amounts of income actually paid out to, or for the benefit of, a beneficiary are deducted from the trust’s income and taxed in the hands of the beneficiary.
Similarly, any amount which is legally payable to a beneficiary is deducted from the trust’s income and taxed in the hands of the beneficiary. This would include the situation where a beneficiary is legally entitled to an amount of income, but the right to receive it is delayed because the beneficiary is under-age. Often the Trustees of a Trust will allocate income to a particular beneficiary and the beneficiary will have a legally enforceable right to that income. In this situation the income would be deducted from the Trust’s income and would be included in the income of the beneficiary.
Finally, if property of a Trust is held in trust for a beneficiary for their lifetime, amounts expended by the trust in respect of the upkeep of the property are deducted from the trust’s income and taxed in the hands of the beneficiary. This is seen most often in the case of a testamentary trust, where, for example, a home might be left in trust for a surviving spouse and then will be left to other beneficiaries.
21 Year Rule
A Trust, except certain trusts exclusively for the benefit of a spouse, is deemed to dispose of all of its capital property every 21 years and capital gains and recaptured depreciation are taxed. This 21 year deemed disposition is a consideration for both testamentary and inter vivos trusts.
Care must be taken when approaching the 21 year disposition date. It is sometimes beneficial to allow the date to pass and to pay any tax that might be imposed, but this is not something to be done without due consideration of the tax consequences.
Transfer of Property to Beneficiaries
Subject to the terms of the Trust, capital property can be transferred to the capital beneficiaries in full or partial satisfaction of their capital interest. If the beneficiaries are Canadian residents for tax purposes, the property transfers at the tax cost of the property to the Trust. If the beneficiaries are not Canadian residents for tax purposes, the Trust will be treated as having sold the property at fair market value when it is transferred to the beneficiaries. If the Trust is properly structured, the Trustees will have the discretion to determine to whom the property will be transferred in order to avoid adverse tax consequences.
Holding Shares of Private Companies
A discretionary inter vivos Trust is often used to hold shares of a Qualified Small Business Corporation
Subject to the Tax on Split Income (TOSI) rules in respect of family members who are not active in the business of the corporation.
Kiddie Tax / Tax on Split Income (TOSI)
In the February 1999 Budget, Finance Minister Martin introduced a new tax, payable only by those under age 18. It is a tax at the highest marginal tax rate, and the parents will be jointly and severally liable to pay the tax. The tax is on dividends, whether received directly or through a trust, and on business income earned in a trust or partnership if a person related to the minor was providing goods or services related to the earning of that income.
In 2017, the Liberal Government introduced rules to extend the “kiddie tax” rules to include spouses and children over the age of 18 who own shares, or are beneficiaries of a family trust that owns shares in a family company and who are not actively involved in the business.
If TOSI applies to an individual’s income, that income is subject to tax at the highest marginal income tax rate. In order avoid the application of TOSI, the income must meet one of the exclusions contained in ITA 120.4. The TOSI rules are beyond the scope of this Memo.
If a Qualified Small Business Corporation is sold, the capital gain can be allocated among the capital beneficiaries, at the discretion of the Trustees. This will ensure that the maximum number of taxpayers can take advantage of the capital gains exemption, allowing them to receive up to $800,000.00 of tax free capital gains. The entitlement to the capital gains exemption is not dependent upon the beneficiaries being over age 18.
Initially, Morneau intended to include capital gains in respect of qualified small business corporation shares under the new TOSI rules, but he backed away from this position. If the corporation is not a qualified small business corporation, the capital gain will be subject to TOSI.
Overall Benefits of a Trust
A properly drafted Trust can give complete flexibility as to distribution of income and capital, and this distribution can change from year to year.
The Trustees can maintain complete control as to who gets what.
The value of the Trust property is excluded from the assets of any of the beneficiaries, for both estate purposes and for creditor protection. If holding qualified shares of a private company, the benefit of the LCGE can be multiplied.
I would be pleased to work with your advisors to ensure that you achieve the optimum advantages that can be achieved with a properly executed Trust.