Simply put, a trust is a legal relationship which allows an individual to control property for the benefit of someone else.
When discussing trusts, people refer to either “inter vivos” trusts
(created while the donor is still alive) or “testamentary” trusts
(“created within a will to take effect on the death of the grantor”).
Simply put, a trust is a legal relationship which allows an individual to control property for the benefit of someone else.
When discussing trusts, people refer to either “inter vivos” trusts (created while the donor is still alive) or “testamentary” trusts (“created within a will to take effect on the death of the grantor”).
Taxation of trusts
For income tax purposes, a trust is considered to be a separate taxpayer. The income earned in a trust is taxed in a similar manner to that of an individual. Income taxable within a trust is the amount that remains after distributions are made to the beneficiaries of the trust.
Income remaining in a “testamentary trust” is taxable at the graduated personal income tax rates, whereas income in an “inter vivos” trust is taxable at the highest personal income tax marginal rate.
Adding to the complexity, the Federal budget of February 16, 1999, introduced a “Kiddie Tax” effective for 2000 and later taxation years.
The “Kiddie Tax” applies to income of a child, under the age of 18, attributable to dividends from private corporations, or income earned through a trust that is derived from goods or services provided to (or in support of) a related person’s business. Income applicable to the “Kiddie Tax” is taxable at the highest personal income marginal tax rate.
What is a discretionary family trust?
A discretionary family trust is created by and for members of the same family. A discretionary family trust is a legal relationship created through a contract (the trust agreement) in which a person (the settlor) transfers assets to one or more persons (the trustee(s)) to control those assets for the benefit of other persons (the beneficiaries).
A settlor may transfer a variety of assets into the trust (shares of a family corporation, investments, rental properties, etc.). In accordance with the level of discretion described in the trust agreement, the trustee(s) may allocate the trust’s capital or income to one or more of the named beneficiaries.
Beneficiaries can include the spouse, children, grandchildren, or, subject to certain tax provisions of the Income Tax Act, Canada (“Income Tax Act”), the settlor himself.
Tax planning considerations
The following outlines practical planning applications that remain viable for discretionary family trust:
Transferring capital gains to minor children
If an individual owns assets that will appreciate, it is possible to transfer those specifically identified assets to a discretionary family trust and have minor children as beneficiaries. There is a deemed disposition at fair market value when assets are transferred to a discretionary family trust.
Capital gains realized in the future on the assets transferred to the discretionary family trust can be allocated to the minor children and taxed without the application of the “Kiddie Tax” or attribution provisions of the Income Tax Act. As children generally have little taxable income, the gains often attract little or no income tax in the hands of the children.
Access to multiple exemptions and deductions
A discretionary family trust is an excellent vehicle by which a family can multiply certain tax benefits (the principal residence exemption and the enhanced capital gains deduction).
Splitting interest income
The “Kiddie Tax” is not applicable to interest income allocated to beneficiaries of discretionary family trusts that are minor children. An individual can loan funds to a discretionary family trust, charge interest at Canada Revenue Agency’s prescribed rate, and avoid all attribution and the “Kiddie Tax.”
Income earned on the funds loaned to the trust in excess of the interest charged can be allocated to the beneficiaries.
Second-generation income
Second-generation income is income earned on income. In situations where the “Kiddie Tax” might be applicable to dividends received, any subsequent income earned on these amounts will not be subject to the “Kiddie Tax.”
In situations where a discretionary family trust is unrelated to a private corporation and there are no “Kiddie Tax” concerns, the regular attribution provisions of the Income Tax Act can still apply to interest and dividends earned in the trust; however, second-generation income avoids the attribution provisions of the Income Tax Act.
It is also advisable to maintain separate investment accounts for the second-generation income.
To summarize, establishing a discretionary family trust can provide for many advantages. To ensure that such a strategy meets all your objectives, it is wise to consult experienced tax and legal advisors.
Carl Wachholz is a senior manager within Deloitte’s Windsor tax practice unit. Cwachholz@deloitte.ca, 519-967-7778
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