The last three years have seen significant changes in tax legislation. Private family businesses have felt the bulk of these changes, and many are still trying to digest the impact within their businesses. One area of particular confusion relates to the use of family trusts as part of the private corporate structure—specifically, whether these family trusts still serve any purpose or benefit.
What is a family trust?
A trust, unlike a corporation, is not a legal entity, but rather a relationship between the trustees 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 trustee(s), the scope of their powers, the beneficiary(ies) of the trust, and how the trust assets are to be managed. Trusts are designed to hold and protect assets, which are held legally by the trustee for the benefit of the beneficiaries.
As defined in the Income Tax Act, a settlor is typically a non-arm’s-length individual who creates a trust by transferring property into the trust for the benefit of the beneficiaries. The settlor will never benefit from the trust.
As an administrator of a trust, a trustee plays a role similar to that of a director of a corporation. The trustee holds legal title to property in a trust for the benefit of the trust’s beneficiaries but, as mentioned, not beneficial ownership, as this remains with the beneficiaries. A trustee’s duty is to manage the property, distributions, income, and capital allocations for these beneficiaries, subject to the trust deed.
A beneficiary is a taxpayer, individual, or corporation that is eligible to receive income and/or capital from a trust. Beneficiaries are able to take advantage of the income the trust generates and are “beneficially interested” in immediate or future income or capital or a right to capital or income.
Taxation of a trust
A trust is required to report its income and expenses on a Trust Income Tax and Information Return (T3 return) and pay income tax (if all income is not paid or payable to beneficiaries in the year). A trust pays tax at the highest personal marginal tax rate on all of its taxable income without the benefit of any personal tax credits.
If a trust distributes the income it has earned in the year to its beneficiaries, it gets a deduction for the amount of income distributed. The trust must file the required T3 slips to report the distributions, and the beneficiaries must include the income on their personal or corporate tax returns. If a trust fails to comply with these requirements, it may be subject to interest and penalties.
Lifetime of a trust
In British Columbia, a trust may have a maximum legal life of up to 80 years from the date it was settled. However, on its 21-year anniversary, a trust is subject to the 21-year deemed disposition rule, at which point it will generally be deemed to have disposed of all capital property for proceeds equal to the assets’ respective fair market value (FMV). The good news is that there are tax-planning strategies that can be used to prepare for the 21-year rule to avoid the deemed disposition at FMV and the associated tax liability.
Many private family businesses are still trying to digest the impact of recent changes to tax legislation, and the use of family trusts as part of the private corporate structure is an area of particular confusion.
Tax on split income
Due to the introduction of the tax on split income (TOSI) rules in 2018, the income-splitting benefits of a trust have primarily been eliminated. Prior to the TOSI rules, it was common for private corporations owned by a trust to pay income to the trust and allocate that income to adult family members.
New disclosure requirements were introduced in the 2018 federal budget, which come into effect in 2021 (applicable to taxation years that end on or after December 30, 2021). The personal details of all taxpayers involved with or connected to a trust will need to be disclosed to the CRA on a schedule on the T3 return; these individuals include:
- The settlor(s);
- The trustee(s);
- The beneficiary(ies); and
- Any control person(s) that has:
- Influence over the trustee’s decision regarding the income or capital distributions of the trust; and/or
- The power to appoint or dismiss the trustee and beneficiaries (also known as the “trust protector”).
The personal details that must be disclosed for all of the above include name, address, date of birth (in the case of an individual), jurisdiction of residence, and taxpayer identification number. Additionally, there will be a T3 return filing obligation for every taxation year, including years for which the trust has no income or gains to report.
Note: Several trusts are exempt from the new disclosure requirements under subsection 204.21 of the Income Tax Regulations.
Penalties for non-compliance
Failure to file the T3, including new schedules, will be subject to a penalty of $25 per day, with a minimum of $100 and a maximum of $2,500. Gross negligence penalties could also apply, and the amount of these penalties will be the greater of $2,500 or 5% of the maximum FMV of the property held in the trust in the year.
Penalties could also be imposed against the trustees in their personal capacities. It is unclear at this time what the trustees’ obligations and requirements are if they are unable to retrieve all of the required information stated above. More details on this matter are expected.
“Trusts are frequently used in succession planning, as they can be used to transfer wealth to future generations in a tax-efficient manner and can result in a deferral of capital gains.”
Capital gains exemption
A trust continues to be an effective instrument to use to multiply the lifetime capital gains exemption (LCGE), because trusts can sell shares of corporations that qualify for the QSBC (qualified small business corporation) exemption. The tax payable is minimized as the gain may be shared between the beneficiaries of the trust (multiplication of LCGE).
Each individual is entitled to their own LCGE, and effective January 1, 2020, the LCGE increased to $883,384. This means that $883,384 of capital gains resulting from the sale of QSBC shares could flow tax-free to an individual.
Trusts are frequently used in succession planning, as they can be used to transfer wealth to future generations in a tax-efficient manner and can result in a deferral of capital gains.
The use of a trust within the context of a private corporation allows for several benefits, including the control of trust assets (i.e., the shares of a private corporation), the reduction of estate taxes upon death, and the distribution of trust assets to beneficiaries on a tax-deferred basis. Here are some other benefits to consider:
- Control: When a discretionary trust is settled, a trustee will be appointed to administer and manage the trust. This trustee will have control over the trust and its assets.
- Deemed disposition: When an individual dies in Canada, they are deemed to have disposed of their assets at FMV for tax purposes (unless a spousal rollover applies). To the extent that the FMV of these assets exceeds their cost base, the “deemed disposition” will result in capital gains on which the estate must pay tax. Assets held by a trust are not subject to this deemed disposition, and this can considerably reduce an estate’s final tax liability.
- Transfer to beneficiaries: Capital property, which would generally include the shares of a private corporation, may be distributed to a trust’s Canadian-resident beneficiaries at cost (i.e., on a tax-deferred basis).
Used together, these tools can allow for a tax-efficient transfer of wealth to future generations.
Although the perception of trusts is that they’re only created to achieve tax savings, it is critical to note that trusts can offer significant other non-tax benefits, such as:
- Avoiding probate fees: In BC, probate fees must be paid based on the deceased individual’s estate value, and they can be as high as 1.4% of the estate’s gross value. These fees can be avoided if the assets are held by a trust.
- Protecting assets: A trust holds the assets for its beneficiary(ies), and these assets may be protected against creditor claims.
- Maintaining confidentiality: Once a will has been through probate, it becomes a public document, which means anyone can apply to the probate courts to view it. But probate does not apply to property held in a trust, because trust assets are not legally owned by the deceased person. Therefore, the will has no authority over a trust’s assets, and the trust’s assets are distributed to the beneficiary(ies) as per the trustee(s).
Although the loss of income splitting and the additional compliance requirements stemming from recent tax legislation changes may discourage people from using family trusts, they continue to be a valuable component of the private corporate structure.
Family trusts provide asset protection, help families achieve their financial goals, and allow for the transfer of assets to family members in a tax-efficient manner. As a result, family trusts will continue to be a useful and necessary strategy when planning for private enterprise structures, and it is our job as tax practitioners to communicate the ongoing benefits to our clients.
Disclaimer: This information is current to March 23, 2020. Tax legislation, interpretations, and administrative positions change constantly; therefore, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future.
The information contained in this document is of a general nature. It is not intended to address the circumstances of any particular individual or entity. No one should act on such information without seeking appropriate professional advice after conducting a thorough examination of the particular situation.
Bilal Kathrada, CPA, CA, is a partner at Clearline Chartered Professional Accountants specializing in income tax and succession planning for Canadian owner-managed businesses in various industries. Bilal is a member of the CPABC Taxation Forum and is CPABC’s media expert on RRSPs and income tax filings. Visit our personal finance section for more tax-related tips.
Originally published in the May/June 2020 issue of CPABC in Focus.
1See subsections 104(4) through 104(5.2) of the Income Tax Act.
2For more on the 21-year rule and its applicability to discretionary trusts, see “Discretionary Trust Rules: Planning Ahead to Mitigate Limitations” by Steve Youn, CPA, CA, in the January/February 2019 issue of CPABC in Focus.