Trusts come in many shapes and sizes and can be used in a variety of ways to minimize tax.
Here’s how to use an inter vivos trust (a trust created while the donor is alive to hold property for the benefit of others – usually family members) for income splitting.
Under Canadian tax laws, the income of an inter vivos trust is taxed at the highest marginal rate tax. But, if an income-producing asset is held by an inter vivos trust, its income and capital gains can be flowed-through to the trust’s beneficiaries, and taxed in their hands at their own marginal rates. This is tax-effective only if the trust is properly structured from a tax perspective, and the beneficiaries have marginal tax rates that are below the top marginal rate.
Two common uses of an inter vivos trust for these purposes are:
- To hold capital-growth investments for the benefit of children and grandchildren, including those under 18 years of age; and
- To hold investments which earn interest, dividends and capital gains for the benefit of children and grandchildren who are 18 or older.
Under the Income Tax Act, if property is gifted or loaned to a trust and the trust earns capital gains, there is no attribution of those gains to the person who contributed the property when the gains are paid to children or grandchildren who are under age 18. Interest and dividend income would, though, be attributed to the contributor and be taxable unless the funds were loaned to the trust on a commercial-rate basis.
Here’s an example of how this structure is used for capital gains splitting:
Ken MacDonald wants to invest $50,000 in growth-oriented investments such as equity mutual funds, primarily to save for university education costs for his children, Kevin and Keira, who are now ages three and one respectively.
If the $50,000 investment grows approximately 10% per year and no withdrawals are made, it will be worth almost $220,000 in fifteen years when Kevin is ready for university.
If Ken invests the funds in his own name and later uses them to pay for university expenses, capital gains of approximately $170,000 will be taxed at a current top rate of approximately 25%. This will result in about $42,500 in tax.
If Ken waits until the children start university and pays their expenses using his after-tax income or interest from investments, he’ll be paying a rate of almost 50% of his earnings to fund their expenses.
But, if Ken instead either gifts or loans the funds using a family trust, and if capital gains are triggered and paid to the children while they’re attending university, little or no tax may be payable.
The children would report the capital gains paid to them in their own income tax returns, but as long as the taxable capital gains (currently one-half of the capital gains) in each year don’t exceed their basic personal credit and as long as each has no other sources of income, no tax will be payable. So, based on current rates, approximately $20,000 of capital gains can be paid out annually to each child without payment of any tax. Funds in excess of this amount for education or other purposes (financing for a home, assistance with a business, etc.) will attract the lower marginal rates paid by each child; as opposed to Ken’s high marginal rate.
Ken can also use this strategy as a tax-effective way to fund some of Kevin and Keira’s current expenses, such as private school fees, music lessons, summer camp and travel expenses, rather than using his after-tax income. The family trust could also be used for income-splitting of interest and dividends (as opposed to only capital gains) when Kevin and Keira are over age 18.
Since Ken’s children are under age 18, tax rules would attribute interest and dividend income (but not capital gains) earned by the trust to Ken unless he loans the funds to the trust on a commercial-rate basis.
Once a child reaches age 18, if funds are either gifted outright to the trust or loaned to the trustees on a commercial-rate basis, this tax rule no longer applies.
All interest and dividend income, and capital gains received by the trust can be taxed in each child’s hands, rather than Ken’s.
Ken could combine both these strategies by establishing a family trust while the children are under 18. He could ensure the trust’s investment strategy in the early years is geared towards capital growth; and then changed when the children are older to generate interest and dividend income, taking into account prevailing market conditions. Given the prescribed rate under the Income Tax Act is very low, (currently 1%) he could loan funds at the prescribed rate, and not be subject to income attribution, allowing him more flexibility in the trust’s investment strategy.
Margaret O’Sullivan is founder of O’Sullivan Estate Lawyers LLP.