Family Trust Audits Highlight Need for Proper Trust Records
A family trust can provide significant benefits as the legalities and benefits of ownership can be separated. A discretionary trust allows the benefits of ownership to flow to beneficiaries while the trustee maintains control and ownership of trust property and can ultimately decide on who will receive the property at a later date. Due to this, family trusts are a powerful tool in terms of income splitting and capital gains splitting, including multiplying access to the capital gains exemption.
As is often the case, beneficial tax planning vehicles often carry a greater recordkeeping and compliance burden, and family trusts are no different. In particular, one of the key benefits of a discretionary family trust is the ability to allocate income in different shares to different beneficiaries, or to retain the income in the trust. For a discretionary family trust, it is important to note that the default position is that all of the income belongs to the trust and will be taxed there if no further action is taken. If it is beneficial to have income taxed in the hands of a beneficiary, that income can be allocated in one of two ways:
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It can be paid to them during the year, or the trustee(s) can declare that the income is payable to the beneficiary at the end of the year. In other words, the income belongs to the beneficiary.
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It can be allocated by way of a special tax rule called the preferred beneficiary election (under this election, it is possible to allocate income to a beneficiary of the trust that is mentally or physically infirm or disabled without giving them a right to that income).
Most likely due to the popularity of family trusts and the tax benefits they provide, the Canada Revenue Agency (CRA) implemented an audit project on these trusts. The CRA’s audit work on trusts is focused on the following issues:
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Has the trust been properly formed? If your trust was set up in writing by a lawyer, this should not be a significant issue.
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Where trust income has been allocated, was the income actually paid or is there a bona fide obligation to pay that income to a particular beneficiary? The CRA will be looking for documentation such as trustee resolutions that allocate the trust’s income, proof of payment for income paid during the year and promissory notes or other proof that the trust has made the income payable to the individual beneficiaries.
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Where the trustees make payments to third parties, was the payment made for the benefit of the beneficiary? It is also possible to “pay income” to a beneficiary by making payments to third parties for the benefit of that beneficiary. In this case, the trustee will need to document the payments made and also provide evidence that the payment benefited a particular beneficiary. For example, if a parent is reimbursed for expenses incurred on behalf of a child who is a beneficiary, receipts for the expenses should be retained to prove the child benefited from the payment and not the parent.
In addition to these particular issues that arise for family trusts, the CRA will also be reviewing the records of the trust in the same way it does for other taxable entities to determine whether income has been calculated and reported properly. So, you should ensure that bank and investment accounts are set up as needed and proper records are maintained. Also, your trust agreement and the property used to settle the trust should be kept in a safe place.
Based on discussions with the CRA, it is believed that the trust audit project has become a regular and continuing part of the CRA’s audit process. So, the need to keep proper records has and will always be necessary. If you are unsure of whether the records of your family trust will stand up to a CRA audit, contact your BDO advisor.
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