Trusts 101 – Common Uses and Common Traps
*For Common Law Purposes*
A trust can be an important tool in helping many Canadians achieve their estate planning goals. Through the use of a trust, Canadians can protect and manage their assets as well as minimize and defer income tax liabilities. However, trusts must be well understood in order to be used effectively.
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 example, by transferring funds to a trustee, a settlor can ensure
that his or her children will not squander money that has been set aside for
For income tax purposes, a trust is considered to be a separate taxpayer. A trust must file its own return and report its own income. While there are a variety of tax advantages which make trusts attractive, two 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 in the trust. Accordingly, distributing income to children and spouses who otherwise have little or no income can allow for effective income-splitting. 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. The capital property could be held in a trust for 21 years, at which point the property could then be distributed to Canadian resident beneficiaries on a tax-deferred basis. In other words, the tax associated with the gain on the property can bypass one generation and pass to another. 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 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.
Canadians who owns significant income-producing assets should consult with appropriate tax professionals to discuss the use of a trust.
JGW Business and Tax Law LLP
This document is not to be used or interpreted as legal or tax advice. Professional advice is required.