Family trusts are not just for the rich and famous. If your family runs a small business, owns rental properties or holds investments, it, too, may benefit from these trusts.
Other Family Trust Benefits
Setting up a trust while you are alive offers several advantages, including:
1. By making yourself a trustee, you can keep control of the trust assets (such as shares of your business).
2. By getting the assets out of your estate, you can reduce probate fees.
3. Because the assets will not be in your estate, they will not form part of the public record that anyone can examine in the court office.
To understand why family trusts have been used extensively in tax and succession planning, you should first have a clear grasp of how the Income Tax Act treats them. Family trusts are inter vivos trusts, perhaps more commonly known as living trusts. In other words, they are between living people and distinct from testamentary trusts, which are formed by wills and executed when an individual dies.
All income in family trusts is taxed at the highest personal tax rate — with no personal exemptions — if the money the trust earns isn’t distributed to its beneficiaries. When the money is distributed, however, the trust pays no tax.
Then, the beneficiaries include the distributions on their income tax returns, pay their (presumably) lower tax rates and claim any credits and deductions that are available to them. The family trust reports the distribution to the Canada Revenue Agency (CRA) on a T3 information slip and a copy is sent to the beneficiary.
The paid-out income retains its character. For example, if the distribution is dividend income, then the beneficiary can claim available dividend tax credits. If the income is from a capital gain, the beneficiary reports it as such and only half is included in income.
This concept should be familiar to anyone who owns mutual funds outside a registered retirement savings or income plan. Mutual funds are actually trusts and, like family trusts, issue T3 slips to their holders.
It is in the distributions that the flexibility and power of family trusts becomes apparent. The income earned by assets in the trust can be split among the beneficiaries as desired, if the trust is properly set up. This means that all of the beneficiaries can utilize their personal exemptions and benefit from the graduated income tax rates available to individuals.
However, over the years, the Department of Finance has imposed restrictions on the use of family trusts to close loopholes and end abusive practices related to two major provisions of the Income Tax Act:
1. The Tax on Split Income (more commonly called the “Kiddie Tax”). This applies to income a trust pays out to a child under the age of 18, where the money comes from a private corporation owned or operated by a related person. Essentially, the owner of a business is prevented from splitting income with a related minor through a trust. This tax does not apply to mutual funds or dividends from publicly traded companies.
2. The Attribution Rules. There are two sets of attribution rules that may apply to family trusts. The first set covers attribution related to income from property. This includes rental income, investment income and interest, but not business income. When income from these sources is transferred or lent to spouses, minor children, nieces and nephews, it is attributed back to the person who transferred it.
The second set of attribution rules applies to capital gains after disposal of property transferred to a spouse — but not a minor child. In this case, any capital gain is attributed back to the transferring spouse who must report it.
If you think you may benefit from a family trust, talk to your tax accountant and lawyer.