Trust for Investment Income
Using A Discretionary Family Trust to Pay for Your Minor Children or Grandchildren’s Expenses
Life in the Lower Mainland is expensive these days, particularly if raising children with significant expenses, like private school tuition, sports fees, activity costs or medical issues. Although it may not always be possible to reduce these expenses directly, it may be possible to make these costs more affordable in another way, through income tax savings. Using a trust to income split investment income so it is taxed on your children, grandchildren or spouse’s tax returns rather than your own is one way to achieve this goal, provided it is done correctly so that you don’t run afoul of the Income Tax Act.
For example, instead of having eligible dividends from Canadian investments taxed at 31.3% if your taxable income exceeds $200,000, what about being able to earn over $50,000 in such dividends tax-free when taxed in the hands of someone without any other taxable income? Or, if diverting interest income from a high earner to a child with no earnings, the tax savings from reporting $10,000 on the child’s tax return could be as much as $4,780. Although there is a cost to setting up and maintaining Trusts, as well as some administrative work, the savings more than justify the effort and expense in many cases. Read on to learn more.
How a Trust Works
In basic terms, a trust is a legal relationship where one person (“the Settlor”) gives property to another person (“the Trustee”) to manage for the benefit of others (“the Beneficiaries”). As well, sometimes, there is also someone else in charge of keeping an eye on the Trustee and potentially picking replacement Trustees (“the Protector” or “the Appointer”).
Due to our tax rules, it is usually required to have someone else as the Settlor than one of the Beneficiaries if the Settlor wants to potentially receive money from the Trust. A family friend or another relative who is not a Beneficiary are good choices. The Settlor’s only role is to provide a silver coin or ingot and sign the document creating the trust, which specifies the Trustee, the Beneficiaries and how the Trust is to be operated. The wealthy family member with the money to invest is usually named as one of the Trustees, as well as one of the Beneficiaries. Other beneficiaries include the spouse, children and grandchildren of any age and potentially other relatives who might receive payments from the Trust. The document creating the Trust gives the Trustee complete discretion each year to decide how any income or capital gains earned inside the Trust are to be distributed. In other words, it is the Trustee that really controls the Trust and he can decide exactly who gets how much each year, including himself, in order to get the best tax results and the best use of the money.
As you may have noticed, there is still a missing piece of the puzzle. Although the Settlor contributed a silver coin or ingot to fund the Trust, how does the Trust acquire an investment portfolio with such a small contribution? This is where the wealthy family member plays a role. He lends the Trust money at the prescribed government rate, currently 1% per year which can be locked in for life. Without the lending family member charging and collecting interest, the Income Tax Act will not allow income splitting with spouses or minor children / grandchildren. By January 30th each year, the Trust must pay the lender the interest owing for the previous year, which he declares as interest income on his tax return, although the Trust can claim this as a deductible expense. Provided that this is done, the Trustee can then allocate any income or gains earned in the Trust for that year as he likes among the Beneficiaries, who report this on their own tax returns and are taxed on it at their rates, which is where the savings arise.
The Trustee can continue to operate the Trust for at least 80 years, although these types of trusts are often wound up far sooner, such as when the lender spouse dies or when the children are finished university. Moreover, every 21 years, any unrealized capital gains on assets owned by the trust are taxed, which means that the Trust is often wrapped up at this point. When the Trustee wants to wind up the Trust, the Trust repays the loan by liquidating enough of the investments to do so and the Trustee
decides how to divide the remainder among the Beneficiaries. If there are any assets in the trust with unrealized gains at that time that haven’t been liquidated, the Trustee can transfer them to any of the Beneficiaries without triggering tax, although that person would now own the asset with the same cost and unrealized capital gain as was the case when owned by the Trust.
Additional Steps to Get the Trust Up and Running
After the Trust has been drafted by the lawyer and signed by the Settlor and Trustee, there still remains some work to be done, both to get the Trust functioning as intended, and to also keep up with ongoing administrative requirements. The first step is usually sending off a copy of the Trust to the CRA along with the following form http://www.cra-arc.gc.ca/E/pbg/tf/t3app/README.html in order to get a Trust Number, which is the Trust’s identity for tax purposes. This number will be needed for income tax purposes each year but most financial institutions will also require this number before opening up an investment (and potentially a bank account) for the Trust.
Once this number has been received, the investor can proceed to make the investment loan to the Trust. The Trustee signs a Director’s Resolution (a document used to record decisions made by the Trustee) confirming the decision to take out this loan. The Trustee and investor sign the loan documents, the investor writes the Trust a cheque, which gets deposited in the Trust’s investment account so the Trust can invest it and start making money. Either the Trustee can make the investment decisions directly or, as specified in most Trusts, he can delegate this to a professional investment advisor.
The Trustee will probably need to set up a separate bank account for the Trust, out of which it will write cheques when paying expenses or sending money to the Beneficiaries. It is a wise idea for the Trustee to get copies of all cancelled cheques and to get receipts from the Beneficiaries confirming payment.
Other than handling the investment portfolio directly or consulting with the person hired to do this for the Trust, the Trustee has other administrative tasks to attend to from time to time. Your lawyer and accountant can help the Trustee with these, particularly during the first year or so, after which you may wish to do a lot on your own.
First, prior to the end of each year, the Trustee must decide how to allocate money among the Beneficiaries or to the Trust (although it usually makes sense to tax income to the Beneficiaries). This is done by signing a separate Trustee’s Resolution that specifies who gets what, which can be done by stating dollar amounts or by allocating percentages to the different beneficiaries.
The Trustee will also need to work with a tax preparer to file a return for the Trust showing the realized capital gains and earned income, although most Trusts seldom have to pay any taxes directly. All the Beneficiaries will have to report taxable income received by the Trust on their own returns. For minor Beneficiaries receiving no other income, it might be the difference between them having to file a return or not.
The parents or guardians of minor Beneficiaries will also need to track the money received for the minors and how it is spent, preferably keeping the relevant receipts. Likewise, if any money is payable to that Beneficiary but not actually paid out, the Trustee needs to prepare the Demand Promissory Note to document the loan and give it to the Beneficiary (if an adult) or his guardian prior to yearend.
In some cases, the investor may wish to loan the trust more money in the future, in which case an additional Director’s Resolution and loan documents will be required. If making other major decisions, like adding or deleting Beneficiaries if allowed by document creating the Trust, winding up the trust or adding additional or new Trustees, additional Trustee’s Resolutions or similar documents may be required.
Finally, the Trustee must account to the Beneficiaries from time to time for how the Trust is operated. This requires essentially showing the trust’s income and expenses. This should be done within the first two years after the Trust is in existence and then more sporadically thereafter. It’s been suggested that this be done every 3 to 5 years. If a Beneficiary disputes the charges, he can get the Trustee to do a formal passing of accounts before a Registrar of the Court, although this is extremely uncommon for Trusts set up for this purpose.