Trusts can be a powerful tool for tax and financial planning. Their main benefit is that they separate control of an asset from ownership—a trustee(s) will control trust property on behalf of a single beneficiary, or a group of beneficiaries. A family trust allows individuals to create and preserve a financial legacy while at the same time protecting their assets for their family.
Let’s take a closer look at the key tax benefits and issues associated with family trusts.
What is a trust?
Unlike a corporation, a trust is not a legal entity, but a relationship between the trustee(s) and the trust’s beneficiaries. These relationships are set out in a trust agreement or deed. The trust agreement details the names of the initial settlor and trustees, the scope of their powers, the beneficiaries of the trust, and how the trust assets are to be managed. A lawyer should be used to establish the trust and document the trust agreement as there are many decisions to be made when a trust is first set up.
What are some different types of trusts?
An inter-vivos trust, as opposed to a testamentary trust, is a type of trust set up during an individual's lifetime. Testamentary trusts are trusts that are set up as a result of the death of an individual. This article focuses on inter-vivos trusts, which can be discretionary or non-discretionary.
A discretionary trust grants trustee(s) discretion to allocate the trust property among a number of beneficiaries. Family trusts are usually set up as a discretionary trust. Typically, the trustee will have complete discretion as to whether, when, and to whom trust property will be distributed and in what form and amount.
In a non-discretionary trust, the trustee(s) must make distributions in accordance with the trust agreement. It is possible for a trust to be both discretionary and non-discretionary when distributions can be made from trust income or capital. For example, the distribution of trust income could be left to the trustees’ discretion, while capital distributions to beneficiaries are fixed by the trust agreement.
By using a discretionary family trust, children or other family members can benefit from family wealth without having direct control or ownership of property. It also provides the trustees flexibility on which beneficiaries will ultimately benefit from trust property.
What are the income tax benefits of a family trust in Canada?
While many of the income splitting opportunities associated with inter-vivos discretionary family trusts were severely limited by the tax on split income rules, there are still advantages to having a family trust.
Multiplication of the lifetime capital gains exemption
The lifetime capital gains exemption (LCGE) is an income tax concept that permits individuals to sell shares in a qualified small business corporation (QSBC) or a qualified farm or fishing property (QFFP) without having to pay regular income tax on the resulting capital gain, up to a lifetime maximum dollar value. In 2022, this lifetime maximum was $913,630 for QSBC and $1,000,000 for dispositions of QFFP.
While a trust is specifically precluded from claiming the LCGE, a trust beneficiary may claim the LCGE on a capital gain that is realized in the trust and allocated to the beneficiary subject to the regular rules and limitations on individuals claiming the LCGE provided that:
- The trust document permits the distribution of capital gains to the particular beneficiary; and
- The trust makes the required designations under the Income Tax Act.
This means that the capital gains realized on qualifying property held in family trust can be taxed in the beneficiary’s hands as if they had disposed of the qualifying property themselves. Moreover, where there are multiple beneficiaries and where the criteria are met, the trust can allocate a portion of a capital gain realized by the trust on a disposition of QSBC shares or QFFP to the beneficiaries in a manner that maximizes the use of the beneficiaries’ available LCGE, thereby minimizing the family’s overall tax burden on the sale of that property. Care must be taken in allocating such a gain to beneficiaries who are minors.
One key point to remember is that gains allocated to trust beneficiaries will legally belong to those beneficiaries. Therefore, in order to benefit from this tax planning technique on a sale of a qualifying asset, the family must be prepared to allow trust beneficiaries to have the gains that are allocated to them.
Succession planning and family trusts
For Canadian tax purposes, when an individual dies they are deemed to have disposed of all their assets at fair market value (FMV). Taxes may result from the disposition of the assets if the FMV of these assets exceeds their cost base.
If the assets are transferred to a surviving spouse, taxation will be delayed until the death of that spouse. However, when a family trust owns the assets, the death of an individual does not create a tax liability for the assets held in the family trust, because the individual does not have ownership of the trust’s assets. The estate’s final tax liability will, therefore, be considerably reduced as the assets held by the trust are not subject to a deemed disposition.
Note that a trust is deemed to dispose of all its capital property on the 21st anniversary of the day on which the trust was created. This rule is designed to ensure that the taxation of gains accruing in a trust cannot be deferred indefinitely.
Speak to your BDO advisor to see if there are any opportunities for family trusts to mitigate or defer the tax arising on the 21st anniversary.
Using a family trust to implement a prescribed rate loan
A family trust can be also be used to implement a prescribed rate loan. This type of income-splitting plan allows a loan to be made to the trust where interest is paid at a prescribed rate of interest to the lender annually. To the extent that the loan can be invested to generate a return of income that is greater than the interest paid on the loan, there will be a net benefit to making the loan and having such investment income be taxed in the hands of the trust beneficiaries, provided that their tax rate is lower than the lender. Care must be taken in the type of investments made in the trust with the loan to avoid unintended tax consequences.
For more information, see our article on using prescribed rate loans to lower your family’s income tax bill.
Non-tax advantages of having a family trust
There are other non-tax benefits to using a family trust, including:
- If the trust is discretionary, it is possible that assets will be protected from creditors or be excluded from family assets in case of a marital breakdown. This is due to the fact that a specific beneficiary may not be able to benefit from any assets held in the trust.
- If the trust is discretionary, it may maximize benefits for infirm or financially incompetent family members that do not have an absolute right to income or property.
- As a will substitute, assets owned in a trust can avoid probate fees in provinces where they exist. This can also help ensure greater confidentiality regarding the property transferred and help avoid testamentary disputes regarding the property.
Don’t forget about filing requirements
For trust taxation years ending on or after Dec. 31, 2022, all non-resident trusts that currently have to file a T3 return and express trusts that are resident in Canada, with certain exceptions, will be required to report additional information as part of their T3 return each year.
For more information, read our article, New trust reporting requirements are coming.
How BDO can help
Family trusts can be a very important tool for tax and financial planning, but the rules around them are complex. Contact your BDO advisor to see if one is right for you and how it can be used to meet your goals.