Trusts are a valuable planning tool that can be a very important part of wealth management planning for high net worth families. A well structured trust can be very effective, allowing for a number of advanced tax and estate planning strategies. The key to successfully using trusts is understanding how they work, when they work and how they can fit into your long term planning. In this issue of Wealth, Health & Kids we explore the strategic use of trusts and why they are a very effective vehicle for minimizing tax and protecting your assets.
The Basics
A trust is simply a legal relationship where one person, the settlor, transfers ownership of his or her assets to another person, the trustee, who controls and manages the asset for the benefit of another, the beneficiary. The asset(s) or property that is transferred can consist of cash, stocks, bonds, real estate, art or other assets of a significant value. Schematically, a trust relationship is as follows:
Trusts have many different characteristics depending on the provisions included in the trust deed. For example, a trust may be discretionary or specific. This paper deals with discretionary trusts. A discretionary trust exists when the settlor gives discretionary decision making rights to the trustees, rather than defining in the trust agreement specific rules relating to the operation of the trust. This discretionary power allows the trustees to make decisions relating to the allocation of future income or capital to the beneficiaries. Under a discretionary trust, the beneficiaries are typically family members.
Trusts are extremely flexible tax and estate planning vehicles and can be used for many different purposes. The following is a brief overview of some of the primary strategies that can be implemented through Family Trusts.
Tax Planning and the Taxation of Family Trusts
A Family Trust may be established during your lifetime (an inter vivos trust) or upon your death under the terms of your Will (testamentary trust). Testamentary trusts are subject to the graduated tax rates that are applicable to ordinary individuals and each trust within a Will is generally treated as a separate taxpayer. With inter vivos trusts, income earned and retained by the trust is taxed at the top marginal rate: in Ontario, rates are 46.4% on interest income, 32.6% on ineligible dividends, 26.5% on eligible dividends and 23.2% on capital gains; however, trust income and capital gains can be flowed through to beneficiaries and taxed in their hands at their own marginal rates. Given that the trust pays tax at the top personal tax rates, it is generally advisable that all of the income of the trust be distributed on an annual basis to the beneficiaries. The beneficiaries then include their share of the income from the trust on their personal tax returns and pay the appropriate tax based on their marginal rates (subject to the application of the income attribution rules described below). Because of this, the tax benefits of an inter vivos trust can be realized. This “income splitting” benefit is discussed in more detail below.
Income Splitting
As previously outlined, one of the most popular uses of Family Trusts is income splitting. Income splitting is a relatively simple way to reduce tax. Because Canada’s tax system is based on graduated tax rates, by shifting income from high income earning family members to lower income family members, the overall tax burden of the family is reduced as the shifted income is taxed at lower marginal rates.
In a typical family situation, one or both parents may have substantial income while the children, including minors, may not be effectively using their low marginal tax rates. In situations such as these, tax savings can be recognized if the high income earning parent transfers an income generating asset to a Family Trust. If the income of the trust is passed through the trust to be taxed in the hands of the low income beneficiaries, then an overall tax savings can be achieved. This is because every individual in Canada can earn approximately $10,000 of taxable income tax‐free every year due to the basic personal tax exemption.
Since only 50% of capital gains are taxable, this means that up to $18,000 of capital gains can be earned tax‐free every year by a person who has no other income, regardless of their age (there may be a small alternative maximum tax charged to the trust on capital gains). Finally, $37,500 of ineligible dividends ($48,275 of eligible dividends) can flow out tax‐free (however, this may be subject to a small Ontario Health Tax).
Attribution Rules
There are attribution rules contained in the Income Tax Act that are designed to prevent you from achieving a tax advantage when you simply give funds to your lower‐income spouse or minor children. The Canada Revenue Agency (“CRA”) attributes any investment income earned on these funds back to you, as if you had earned it yourself, and it is taxable in your hands at your higher marginal tax rate. While tax rules restrict income splitting, it is still possible to use a Family Trust for income splitting. The following table shows how the attribution rules apply depending on how the trust is funded and depending on what type of investment income is then distributed from the trust to the related beneficiary:
| Method of Funding | Beneficiary of Trust | Interest/Dividents | Capital Gains |
|---|---|---|---|
| Gift or non-interest bearing loan to trust | Minor child or minor grandchild | Attribution | No attribution |
| Gift or non-interest bearing loan to trust | spouse | Attribution | Attribution |
| Gift to trust | Adult child or adult grandchild | No attribution | No attribution |
| Non-interest bearing loan to trust | Adult child or adult grandchild | Attribution | No attribution |
| Prescribed rate loan to trust | Spouse or child or grandchild of any age | No attribution | No attribution |
Despite these attribution rules, there are ways to structure a trust so that income splitting can be achieved. Below are two case studies that illustrate this:
1. Income Splitting with Adult Children
A Family Trust can allow the income generated by investment assets to be split among adult family members to achieve tax savings if family members are in lower tax brackets. A Family Trust could be created where a parent in the highest tax bracket could place investment assets into the Trust for the benefit of one or more adult children who are in lower tax brackets. The income earned by the trust on the investments would be made payable to the children (or grandchildren) where it would be taxed at their lower rate.
This is a very effective way for parents (or grandparents) to gift money and provide assistance to adult family members. It should be noted; however, that for tax purposes, a transfer of assets to aFamily Trust is treated as a sale of the assets at their fair market value at the time of the transfer. Accordingly, any accumulated gains in the transferred assets would be taxable to the transferring individual in the year the transfer was made. Because of this, it is often best to transfer assets with a cost base, for tax purposes, that is approximately equal to the value of the assets. Alternatively, cash could be gifted to the trust. The following chart illustrates an example of how an individual can establish a Family Trust for their two children.
2. Income splitting using a Prescribed Rate Loan
High income family members can split income by making loans to a Family Trust through the use of a “prescribed rate loan” and the time to set one up has never been better. The CRA’s prescribed rate for loans between family members has been at an all‐time low of 1% since April 2009 and it will remain unchanged until at least the end of June 30, 2010. The prescribed rate is the base interest rate that the government sets each calendar quarter. If you properly set up a prescribed rate loan, the attribution rules noted above do not apply. In a prescribed loan strategy, a family member with the higher income loans cash or assets to the Family Trust where a spouse, child or grandchild who earns a lower income and is in a lower tax bracket are the beneficiaries. The Family Trust must pay interest on the loan at the prescribed rate before January 30th of the following year. The loan rate remains fixed for the life of the loan. The lender would be required to report the 1% interest on their personal tax return; however, there would be no attribution of other income earned by the trust to the lender. As long as the investments earn more than 1%, the resulting net investment income has been shifted from the high tax bracket person to be taxed at the lower marginal rates.
The use of a prescribed rate interest loan, especially at this low rate, provides a wonderful tool for families looking to effectively split income. The concept of the prescribed rate interest loan can be made outside of a Family Trust. The benefit of using a Family Trust is the flexibility it provides in terms of how the gains and income are distributed to beneficiaries. The following is an illustration of the mechanics of a prescribed rate loan strategy:
Tax Planning for Business Owners
In the small business context, the Family Trust allows the business owner to effectively plan the distribution of capital and income to other family members. Three key strategies are outlined below:
1. Multiply the Lifetime Capital Gains Exemption for “Qualified Small Business Corporation Shares”
For business owners, a trust can be used to multiply the small business capital gains exemption. The Family Trust is commonly used to hold shares of a small business corporation. It is possible to income split with the beneficiaries of the trust on the sale of the shares of such a corporation by using each beneficiary’s small business capital gains exemption. According to the Income Tax Act, each individual is entitled to a lifetime capital gains exemption of up to $750,000 on the sale of shares of a qualifying small business corporation. For example, a Family Trust with 3 beneficiaries can receive up to $2.25 million tax‐free (3 x $750,000) on the sale of shares that qualify for this exemption.
2. Income Splitting for Business Owners
Corporate income splitting from an active small business corporation is possible with your spouse and adult children. In fact, it is possible to achieve significant tax savings each year by paying out annual after tax corporate income to an individual’s Family Trust with the trust flowing dividends to family members (the “kiddie tax” will apply if you flow to minors).
3. Corporate Deferral for Business Owners
Shareholders who own greater than 10% of their company and do not need all of the cash flow from the company can take advantage of a tax deferral mechanism. A separate investment corporation is created and named as a beneficiary to the Family Trust. Dividends received by the Family Trust can be allocated to the investment corporation. These dividends flow from the Family Trust to the investment corporation tax‐free as they are considered inter‐corporate. This provides a tax deferral benefit as the investment corporation will receive income thathas only been taxed at corporate tax rates. As a result, there is a larger pool of funds available for investment than if the amounts were paid to the shareholder as a salary/ bonus. In 2009, the tax deferral would have been 13% – difference between personal tax rate of 46.4% and corporate tax rate of 33%. In 2010, the tax deferral increases to 15% as corporate tax rates decrease to 31%. Using the 2010 corporate and personal tax rates, a $500,000 payment made as a dividend that is flowed out to an investment corporation vs salary/bonus translates into a $75,000 tax deferral. The benefit of the tax deferral mechanism can accumulate quickly – $375,000 over 5 years; $750,000 over 10 years.
To maximize the flexibility under this structure, the investment corporation should be owned by the Family Trust. When the time comes that you want to extract money from the investment corporation, a dividend is paid to the shareholder (Family Trust). In turn, the Family Trust can allocate the dividend to the beneficiaries as it chooses.
Estate Planning and Wealth Preservation
While the trust can offer the tax planning benefits mentioned above, it can also play a very important role in your estate planning and the transfer of your wealth from one generation to the next.
Confidentiality
Unlike a Will, which becomes a matter of public record once it passes through probate, a trust (testamentary or inter vivos) exists outside of an individual’s estate. Because of this, assets transferred to a trust for distribution to beneficiaries do not need to be disclosed to anyone aside from those individuals directly involved in the trust. For this very reason, a trust is an ideal tool for those families who do not want their estate to attract attention. Furthermore, since it is not part of your estate on death, the property in your trust is not affected by anyone who challenges your Will.
Succession Planning
For many family business owners, succession planning is a long and often confusing process. The business owner/parent may wish to control the ownership of the family business but want the future growth to go to all family members. This can be accomplished by structuring the ownership so that the owner or his/her holding company owns the voting shares and the trust owns the non-voting and growth shares. This also allows for flexibility around the transfer of the business. Using a trust allows for determining the best time to deliver the shares of the corporation to the children and allocating them in a way that is consistent to their role in the business.
Protect Children
Most parents plan to pass on their wealth to their children. If the inheritance is made before the children are mature enough to handle it, the results can be disastrous. Trusts can protect young heirs from the temptations associated with receiving large lump sums of capital. Trusts can be structured to pass on wealth when children reach a certain age or upon a significant life event, etc. They can also be designed so that if the trustees are satisfied that the beneficiaries have proven that they can handle the money themselves, the trust can be collapsed and the funds can be distributed out to the beneficiaries.
Trusts can also allow for the protection of your estate assets to ensure that if you remarry or your surviving spouse remarries, the assets are not considered part of the new matrimonial property. Similarly, you can prevent the future spouses of your children from benefitting from your capital by placing assets in a Family Trust, and in the event of a divorce, the assets may be protected.
Asset Protection
Depending on the circumstances, the trust can offer protection against exposure of its assets to creditors and others. If all distributions of income and capital are at the discretion of the trustees, the beneficiaries’ creditors cannot seize any of the trust’s assets.
Strategic Philanthropy
Trusts can assist you in making a tax efficient charitable donation. A Charitable Remainder Trust allows an individual to put cash, securities or real estate aside for a charity. During the individual’s lifetime, he/she continues to receive all the income from those assets but upon death the assets transfer to the charity. When the trust is set up, an actuary estimates the value of the charity’s residual interest and the donor gets a tax receipt for that amount (as long as the terms of the trust do not allow for capital encroachment). If you are planning to give a donation to charity upon death, you can do that through a trust and get the tax benefits now.
An individual transfers $500,000 of cash into a charitable remainder trust and names the Canadian Women’s Foundation as the beneficiary. She is 75 years of age and, using current actuarial tables, the charity has determined the discount rate to be 5%. The donation receipt would be calculated as follows:
$500,000
(1 + 0.05)9.6 = $312,500 (donation receipt)*
* approximate based on prevailing rates and actuarial tables
This strategy can provide current tax savings of up to $145,000.
Limitations of Trusts
Despite our enthusiasm for trusts, there are some limitations. First, the irrevocable nature of most trusts. Once assets pass into a trust, it is difficult to get them out. Second, establishing a trust may, in some cases, create a tax liability in the form of a deemed disposition. When assets are passed into a trust they are effectively considered to be sold and tax will be owed on the asset. Finally, trusts are subject to the 21‐year deemed disposition rule. The Family Trust does not end, but the Income Tax Act deems a disposition of all capital property held by the trust at fair market value after 21 years. Steps can be taken to defer this tax (tax‐free roll out to Canadian resident beneficiaries is possible).
Summary
Trusts have existed for hundreds of years and remain a viable and valuable estate and tax planning vehicle. The benefits associated with proper trust structures are hard to ignore: they can provide a flexible and tax effective way to transfer family assets from one generation to the next. In the right circumstances and with the proper planning, trusts are a useful tool in long term wealth management planning.
