Discretionary family trusts can be a useful tax-planning tool for even the not-so-wealthy. In previous articles, I looked at how these trusts work, choosing the right trustee, and avoiding the non-resident tax trap. This time, I’ll look at the bottom line – the tax impacts of trusts. And I’ll finish off with a summary of why setting up a trust is worthwhile in the first place.
Tax planning is very important when drafting the trust agreement. In a previous article I discussed the tax trap that could be sprung on you if you want to want to contribute property to a family trust but you are also a beneficiary of the trust. There is an attribution rule under the Income Tax Actthat would be triggered if property that is transferred to the trust by an individual could potentially revert back to the individual (i.e., by virtue of your being a beneficiary of the trust). This attribution rule will also kick in if the individual who contributes property to the trust is able to determine how the trust property is to be distributed (i.e., if he or she is the sale trustee or has a veto power as a trustee).As if that weren’t enough, there are some additional attribution rules that may apply in certain circumstances.
If you transfer/gift property to the trust for no consideration, and that property generates income that is to be allocated to your spouse or your minor kids through the trust, that income could be attributed back to you. There are exceptions to the application of these attribution rules – for example, ensuring that the trust agreement contains an appropriate anti-attribution clause that would prevent distributions of income to your spouse or minor child. It is important to speak to your tax advisor to ensure that the proper steps are taken or provisions included in the trust agreement at the time that the trust is formed. It’s vitally important that you speak to your advisor before you finalize the trust agreement, because it is very difficult to amend a trust agree-ment once it’s executed. And in some instances, simply fixing the problem after the fact won’t save you from a tax problem.
It’s also important to keep in mind that a discretionary family trust has a tax shelf life of only 21 years. The tax rules say that a discretionary family trust is deemed to have sold all of its assets on its 21st anniversary (and every 21st anniversary thereafter). So, if the discretionary trust owns assets with a large pregnant gain, it could be stuck with a huge tax bill if nothing is done. The rule of thumb with discretionary family trusts, then, is to ensure that the trustees distribute the trust capital to the beneficiaries just prior to the trust’s 21st birthday.
Why a discretionary trust?
For tax purposes, a family trust can allow for income splitting with minors. If you were to simply gift funds to your minor children, any interest income would be taxed in your hands. However, if you were to lend the funds at the prescribed rate (2% for the third quarter of 2018), then the income can be taxed in your minor children’s hands at low rates. However, legally, a minor child cannot borrow funds. Hence, a family trust can provide the vehicle by which a loan at the prescribed rate can be made for the benefit of your minor children.
Another benefit of a trust is that if you are not yet sure how certain property is to be held among your family members, then having a family trust hold the property in the meantime gives you the ability to control how the property is managed. It also gives you at least 21 years before you need to decide how the assets get hold by your family members.
As you can see, a family trust can provide some robust estate and tax-planning tools and benefits to you and your family – even if you’re not necessarily rich or famous. But because these things are legally quite complicated, I’d highly recommend speaking to your financial, estate planning, or tax advisor before you jump in.
Courtesy Fundata Canada Inc. ©2018. Samantha Prasad, LL.B. is Tax Partner with Toronto law firm Minden Gross LLP. Portions of this article appeared in The TaxLetter, published by MPL Communications Ltd. Used with permission.