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Discretionary Family Trust

Discretionary family trusts are a very popular tax and estate planning tool. Under a discretionary family trust, a settlor transfers non-income producing property to the trustee of the trust who holds asset in trust for the beneficiaries. Trusts can be used to facilitate income splitting with family members without losing control of the assets. If the beneficiaries are in a lower tax bracket, tax can be saved by having the trust income paid or made payable to them.

Property transferred to a trust is a disposition at fair market value and therefore a trust is usually used to acquire assets with no current accrued gains but that will appreciate in the future. A good example is the new nominal value common shares of a corporation, acquired on incorporation (or internal freeze). Typical uses of new corporations in this manner are professionals who are entitled to incorporate and investors who transfer portfolio investments to a holding company as part of the estate freeze. The former can take advantage of the lower tax rate for corporations on business income and can avoid the corporate attribution rules as long as the corporation continues to be a small business corporation. The latter can still benefit from income splitting if the portfolio can generate a return greater than the specified minimum amount that has to be paid to the transferor, or if the other shareholders are not a spouse or minor children.

The corporate tax rate on business income is lower than the personal tax rates. The income now earned on the asset is taxed in the corporation with the corporation then paying dividends to the trust. The trust will not pay any tax if the trustee, at his discretion, distributes the dividends received out to the beneficiaries. A beneficiary who has no other income could receive approx. $49,000 of eligible dividends and approximately $37,000 of non-eligible dividends without incurring any personal tax. A beneficiary who is your child must be 18 years of age or older to receive such dividends without paying any income tax. If some of the beneficiaries of the trust have other income, there could be some tax to pay on the dividend received from the trust, but this is generally lower than the tax paid by the transferor on the business income if he had not established the corporation and the family trust in the first place.

The corporate tax rate on investment income is higher than the personal tax rates. However, taxes can still be saved if the corporation pays dividends to the trust and the trust can distribute the income to an adult child beneficiary (18 years of age or older) who is in a lower income tax bracket.

Establishing a family trust is a legal matter, and all of the legal steps must be properly completed in order to be accepted by the Canada Revenue Agency. If one step is not done properly, the whole thing can fall apart. The proper steps to be accomplished are deciding on the settlor, the method of settlement of the trust, the trustee, the beneficiaries, and the termination date or event, which would cause a wind up of the trust.

From an accounting perspective, trusts should have a separate bank account and proper books and records should be kept, including decisions by the discretionary trustee as to any income and capital distributions. The trust becomes another entity for accounting and tax purposes, and must file a trust income tax return. If the income of the trust is not paid out or made payable to the beneficiaries of the trust, then the trust would have to pay tax on the remaining income at the maximum personal tax rate.

In addition to the income splitting aspects of a family trust, other benefits include estate freezing; in that future growth on a growth oriented business or investment portfolio would attribute to other members of the family, generally younger ones, and would not be part of the transferor’s estate on death. Trusts are generally considered to be creditor-proof, that is, the transferor’s creditors cannot attack the trust for debts of the creditor, unless this was the purpose of establishing the trust in the first place.

The Income Tax Act has been amended to allow a trust which owns a principal residence for the beneficiary of the trust who is the resident of the home to claim the principal residence exemption on behalf of the beneficiary. This removes the previous impediment in having a principal residence owned by a trust.