A trust can be an important vehicle in helping many Canadians achieve their estate planning goals. Through the use of a trust, Canadians can protect and continue to control/manage their assets as well as minimize and defer income tax liabilities through common planning techniques such as estate freezes, prescribed rate loans, and other income splitting strategies. However, trusts must be well understood in order to be used effectively. Trusts are ideal for estate planning given the flexibility that they can offer.
What is a trust? At law, a trust is a legal relationship in which one person (the settlor) gives property to another person (the “trustee”) who holds that property for the benefit of another (the “beneficiary”). Although the trustee legally owns the property, his or her ability to use that property must be guided by the best interests of the beneficiary. Conversely, the beneficiary’s lack of legal title precludes him or her from being able to control the property.
For income tax purposes, a trust is considered to be a separate taxpayer. A trust must file its own tax return and report its own income. While there are a variety of tax advantages which make trusts attractive, three major tax benefits stand out. The first of these benefits is the income-splitting opportunity trusts provide. Although the income of most trusts is taxed at the highest bracket, distributed income can be taxed in the hands of the beneficiaries to whom it has been paid or made payable instead of being taxed in the trust. Accordingly, distributing income to children and spouses who otherwise have little or no income can allow for effective income-splitting. Recent amendments to the TOSI regime will limit income splitting from a private corporation in some cases. The second of these benefits is the ability to limit and defer capital gains tax that would otherwise be realized on a taxpayer’s death. By transferring capital property which is expected to increase in value into a trust, a taxpayer could limit the tax associated with the future value of that property on the taxpayer’s death. A third benefit is the ability to multiply the lifetime capital gains exemption on the sale of private company shares that qualify for the exemption. Currently, the exemption is set at $835,000 per individual (as indexed for inflation up to $1,000,000), including spouses and children (even if under the age of 18).
Capital property can be held in a trust for up to 21 years without incurring a deemed taxable disposition. Prior to the 21st anniversary, the property held by the trust is typically distributed to one or more Canadian resident beneficiaries on a tax-deferred basis. In other words, the tax associated with the gain on the property can skip one generation and pass to another. This planning technique can provide a significant tax deferral and avoid a tax liability associated with a private company that may have little liquidity. An additional benefit of placing capital property into a trust is that any property placed into a trust should not be subject to estate administration tax (known as “probate”) on the death of the transferor.
There are numerous tax traps which commonly arise when trusts are implemented as part of an estate plan. For example, if the terms of the trust allow for the property to revert to the settlor, then all income and gains in the trust realized from that property will automatically revert back to the settlor. Furthermore, income distributed to the settlor’s minor children, minor grandchildren or spouse will automatically revert back to the settlor, unless certain technical requirements are met.