Family trusts have been used for years to control the timing of passing on wealth to family members and to distribute such wealth in a discretionary manner. As an extension of this idea, they are also being used to manage taxes within the family unit efficiently.
Changes to the way these trusts are taxed will add to the cost of maintaining them starting in 2024. These changes are the result of the Federal government legislation effecting the alternative minimum tax (AMT) rules.
AMT is a parallel tax calculation for individuals and trusts that allows fewer deductions, exemptions, and tax credits than under regular income tax rules. AMT has been around since 1986, but significant changes were made to the way AMT works starting in 2024.
This article will focus on the impact that these 2024 AMT changes have on a subset of family trusts. A more general discussion of AMT can be found in our article, Alternative minimum tax changes that could affect you. One component of the 2024 changes is an increased basic exemption for individual taxpayers. This change means fewer individual taxpayers will be affected by AMT, but more family trusts will be affected by the new rules since trusts are not eligible for the basic exemption.
Who is affected?
The subset of trusts addressed in this article are family trusts that:
have been financed by prescribed rate loans (in general, a prescribed rate loan is one made by a high-earning family member to a spouse or trust where the loan rate is set at the government prescribed rate at the time the loan is made.) Further information can be found in our article Using prescribed rate loans to lower your family's income tax bill;
have used the proceeds of the loan to invest in income producing marketable securities that generate a typical income stream of capital gains, dividends and/or interest;
have discretionary low-income beneficiaries such as children or grandchildren of the taxpayer who advanced the prescribed rate loan.
How these trusts work
This type of trust would typically allocate all the net income earned in the trust to the beneficiaries because such income would be taxed at the beneficiaries' tax rates, which is usually lower than the tax rate that would apply to income retained in the trust. Inter-vivos trusts, such as these family trusts, are taxed at the highest personal tax rate or 33% federal tax, plus the applicable provincial tax rate. The beneficiaries pay tax on their allocated income at graduated tax rates on income over the basic personal tax credit of $15,705 (2024 federal amount). In addition, as the dividend tax credit flows through to the beneficiaries who have been allocated dividend income, a beneficiary with no other income could pay no tax on dividend income allocated up to approximately $72,000 (eligible dividends, using Ontario rates) because of the personal tax credit and the dividend tax credit. Trusts are not allowed a personal tax exemption, nor are they allowed to earn a minimum amount of income that is exempt from minimum tax. An amount can be taxed in the beneficiary's hands without being distributed, if such income is payable to the beneficiary at the end of the year.
Why are these trusts affected?
The trust can deduct these allocations to beneficiaries from its taxable income, with the result that it could have no taxable income for regular income tax purposes. However, for AMT purposes, the trust needs to calculate taxable income in accordance with the AMT rules. Starting in 2024, the trust will no longer be able to deduct all its expenses relating to earning the investment income, notably only 50% of the interest paid on the prescribed rate loan will be deductible for AMT purposes. In addition, it is proposed that amounts paid by the trust for investment counsel fees will also be subject to this 50% restriction.
Other expenses may be affected by the change in AMT rules, but for family trusts, interest costs and investment counsel fees will be the most affected expenses.
The AMT tax rate (federally) is a flat 20.5% so this 50% restriction means that interest expense in the trust that reduces regular taxable income will result in a 10.25% federal AMT in the trust. This means $10,000 of interest that would otherwise reduce taxable income allocated from the trust will result in $5,000 of taxable income for AMT purposes, which taxed at 20.5% will result in tax of $1,025. Provincial AMT taxes will also apply.
While AMT can be refunded in future years when regular tax exceeds AMT, the nature of these trusts means that the trust is likely to have a pattern of always paying AMT, with very little likelihood of an AMT credit against regular tax in the seven-year carry forward period.
What does this mean?
For most family trusts, this means that a tax payment will be due on or before the filing deadline of March 31, 2025.
Depending on the nature of the income and the beneficiaries, it may be worthwhile considering leaving some income in the trust to generate regular tax to reduce the impact of the AMT. However, if the income would otherwise be taxable to a lower income beneficiary, this is unlikely to produce an overall tax saving in the family unit. The evaluation of whether to leave income in the trust or allocate it to discretionary beneficiaries prior to year-end is something that trustees will need to consider before the end of the calendar year.
The unfortunate result of the new rules is that family trusts have become more expensive from a tax perspective. However, in many cases, they will still generate overall tax savings within the family unit.
Changes in capital gains inclusion rates
The proposed changes to capital gains inclusion rates (see Government confirms changes to capital gains inclusion rate), if passed for 2024, will impact the calculation of net income in the trust. However, they must be considered along with the mix of other income in the trust to determine if they will impact AMT in the trust in 2024.
Designated allocations from the trust
In order for a discretionary trust to claim a deduction for amounts allocated to beneficiaries in the taxation year, the amount must have been paid in the year or be payable at year-end. For an amount to be payable, there must be an actual liability to the discretionary beneficiaries. It will be important for trustees to decide and document their discretionary decisions of allocations to beneficiaries, as well as to issue promissory notes as payment before Dec. 31, 2024.
How BDO can help
Your BDO advisor can help you navigate these issues and proposed changes in trust taxation. We are here to help you understand what actions need to be taken to continue to use trusts for minimizing taxes within the family group.
The information in this publication is current as of November 6, 2024.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.