What is a Trust?
A trust is not, strictly speaking, a separate legal or tax entity. It is a relationship among three parties:
The Settlor: The person establishing the trust.
The Trustees: Those who manage the trust and make decisions about its property.
The Beneficiaries: Those on whose behalf the trust property is managed.
A trust can have different beneficiaries entitled to income versus the ultimate distribution of trust property (capital).
There are two kinds of trusts:
Inter vivos trusts, created during a person’s lifetime, often used for tax planning (e.g., business ownership).
Testamentary trusts, created through a Will.
Trusts are extremely flexible. Properly drafted, trustees can determine how to distribute income among beneficiaries, with the flexibility to adjust these distributions as needed. Trustees can also decide how to distribute trust property among beneficiaries.
Trusts also serve as effective vehicles for asset protection. A discretionary interest in a trust is not considered property that creditors can seize, nor can trust property be claimed by creditors of a particular beneficiary.
Taxation of Trusts
Testamentary Trusts
Taxed as individuals with graduated tax rates for the first three years, though no personal deductions apply.
Trustees can select a non-calendar year-end for tax purposes during the initial three years, after which the year-end becomes December 31.
Inter Vivos Trusts
Taxed at the highest personal tax rates without personal exemptions, making them inefficient for income accumulation. However, they are highly efficient as flow-through entities to distribute income to beneficiaries.
General Tax Rules for Trusts
All trusts, except testamentary trusts within their first three years, must have a December 31 year-end.
Income distributed to or legally payable to beneficiaries is deducted from the trust's income and taxed in the hands of the beneficiaries.
Expenses related to maintaining trust property for the lifetime use of a beneficiary are deductible from the trust’s income and taxed as beneficiary income (common in testamentary trusts).
21-Year Rule
Except for certain spousal trusts, all trusts are deemed to dispose of their capital property every 21 years, triggering taxes on capital gains and recaptured depreciation.
Careful planning is essential as the 21-year date approaches to optimize tax consequences.
Transfer of Property to Beneficiaries
Capital property can be transferred to capital beneficiaries, generally at the trust’s tax cost if the beneficiaries are Canadian residents. Non-resident beneficiaries trigger a deemed disposition at fair market value, potentially resulting in taxes.
Holding Shares of Private Companies
Discretionary inter vivos trusts often hold shares of a Qualified Small Business Corporation (QSBC). If the corporation is sold, the capital gain can be allocated among the trust’s beneficiaries, enabling each to claim the Lifetime Capital Gains Exemption (LCGE).
Tax on Split Income (TOSI)
Kiddie Tax originally applied to dividends received by a minor, either directly from a private corporation or indirectly through a trust.
The Tax on Split Income (TOSI) expanded these rules to include all non-active shareholders.
Income subject to TOSI is taxed at the highest marginal income tax rate. To avoid TOSI, the income must meet one of the exclusions set out in the Income Tax Act. (The details of TOSI rules are beyond the scope of this memo.
If a QSBC is sold, the capital gain can be allocated among beneficiaries, allowing them to claim the LCGE, regardless of their age. See my Memo discussing the LCGE.
Overall Benefits of a Trust
Flexibility in income and capital distribution.
Beneficiary protections against creditors and exclusion from estate assets.
Ability to multiply the benefits of the LCGE for private company shares.
I would be pleased to work with your advisors to ensure you achieve the optimum benefits of a properly structured trust.
-- Chuck
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