Family Trusts can be confusing to understand and therefore making it difficult to plan on how to utilize their characteristics to the best of their capabilities. This is why we have taken some commonly asked questions and shed the light on the Inter vivos (Family Trust) world.
What is a Family Trust?
An Inter vivos trust (Family Trust) is created for the benefit of a family or for certain members of that family and is created during the lifetime of the settlor (person settling the trust). A trust is an obligation that binds a person (the “trustee(s)”) to deal with the “trust property” for the benefit of specified persons (the “beneficiaries”). When establishing a trust, a person, the “settlor”, transfers legal ownership of the property through a trust agreement to the trustee(s), and provides instructions to the trustee(s) as to how the property is to be used for the benefit of the beneficiaries.
Why use a Family Trust?
There are many reasons to establish a Family Trust some key considerations are:
- Flexibility of selection of beneficiaries
- Ability to place difference kinds of assets into a trust
- Tax Planning/Benefits
- Income Splitting
- Estate Freezes
- Trusts for Charitable giving
- Family Planning (children from previous marriage, beneficiaries with financial difficulties, elderly parents that require financial support, etc.)
How are Family Trusts Taxed?
A Family Trust is considered to be a separate taxpayer and is required to file annual income tax returns. All inter vivos trusts adopt a year-end date of December 31st, and the deadline for filing these returns is 90 days after the year end (March 31st or March 30th in a leap year). The trust can deduct income and capital gains that are “paid or payable” to the beneficiaries during the year; the beneficiaries must then include these amounts in filing their own tax returns using the T3 slips issued to them by the trust.
Some common tax planning strategies for trusts include the use of dividends and capital gains that are received by a trust; these retain their identity when paid out to the beneficiaries.
- Capital gains received by a trust and paid to a beneficiary will continue to be considered capital gains in the hands of the beneficiary for income tax purposes; therefore only 50% of the capital gain received by the beneficiary would be taxable.
- Dividends received by a trust and distributed to a beneficiary would retain its character as a dividend and would still be taxed as a dividend in the hands of the beneficiary.
Since Family Trusts are lifetime trusts, all of the taxable income of the trust is taxed at the highest marginal tax bracket. Trusts are not allowed to claim personal tax credits and due to these rules, the trustees typically ensure that all income/capital gains earned by the Family Trust are paid or made payable to the beneficiaries, and taxed in the hands of the beneficiaries.
An Inter vivos Trust (Family Trust) is treated as having disposed of its capital property at fair market value every twenty-one years. This “twenty-one year rule” could trigger a capital gain (or loss) taxable within the trust. Planning for the “twenty-one year rule” should commence at least 2-3 years prior to the event.
What is a Promissory Note?
When a trust distributes income to a beneficiary the income is either paid in cash to them or made payable. An amount is only considered “payable” in a year if the beneficiary is able to legally enforce payment through a Promissory Note. Expenses paid on behalf of the beneficiary may be applied against the income payable to the beneficiary and therefore reduce the net Promissory Note payable. The current position of the Canada Revenue Agency (“CRA”) is that an expense may be considered if it was made for the beneficiary’s benefit. This may include an amount paid out of the trust for the support, maintenance, care, education, enjoyment and advancement of the beneficiary. Proper documentation must be kept in order to demonstrate the money was used for the benefit of the beneficiary.
Why is there “Interest Paid” from the Trust?
A trust can borrow funds to acquire investments such as shares in a private company, a vacation home, securities or other assets. The loan must have the CRA prescribed rate of interest charged on the principal. This interest must be paid each year no later than 30 days after year end (i.e. Trust year end Dec 31 2015 interest paid by Jan 30 2016). This interest is used as an expense on the trust’s tax return to reduce the income payable, and the interest that is paid to the lender must be included on the lenders T1 return as income.
Why prepare Trustee resolutions and minutes?
A resolution is a decision of the trustee(s) that was made with reference to the powers available to them under the trust agreement. Minutes are the written record of that resolution which is signed by the trustees. The minutes should be prepared when the trust allocated income to beneficiaries, has a promissory note payable; and or expenses paid on behalf of a beneficiary.
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