What is a family trust? It’s an agreement to hold assets aside for someone’s benefit. A family trust can give you more options to reduce and/or delay paying taxes on your hard-earned money. Trusts are used by many Canadian business owners, professionals and wealthy families. But they can be a bit complicated to understand and expensive to set up. To make it easier to understand how a family trust works, let’s use an imaginary Canadian family that is considering setting one up.
Barb Smith is a software developer and her husband, Jim, is an engineer. They have two young children.
The Smiths have done well and have accumulated a considerable amount of money through Barb’s company stock plan. They are interested in reducing their tax burden and setting aside money for their children’s future.
Jim and Barb have heard about family trusts and wonder if the structure might be right for their family. So, they consult their investment advisor, an experienced lawyer and an accountant and decide a trust makes sense for them.
With the help of their advisors, they draw up a formal trust agreement. It sets out how the trust is to be administered. It also names the key people involved in the trust. The settlor, who creates the trust, the trustees, who manage the trust and the beneficiaries who will ultimately receive income and assets from the trust.
Jim and Barb ask a good friend to act as the settlor. This is a nominal task because once the trust is created the settlor has no further role to play.
Jim and Barb name themselves as trustees and because they live in Quebec, they must also name a third trustee. This person has to be independent in that he or she can’t be a beneficiary or the settlor. Together, the trustees will control the trust, making decisions about how the assets should be managed and distributed, within the parameters of the trust agreement.
Jim and Barb name their two children as beneficiaries, and they name themselves as beneficiaries too. You’ll see why this is important in a moment.
To reduce their tax burden, Jim and Barb loan the family trust $1 million. Under the rules, the trust must pay the Smiths interest on the loan at the going rate prescribed by the Canada Revenue Agency—which is currently 1% a year. This interest must be paid by the trust to the Smiths before January 31 every year for the previous year.
The interest rate prescribed by the CRA at the time the loan is made is locked-in for as long as the loan is outstanding. Today’s low interest rates mean the potential tax saving opportunity is greater for Jim and Barb than if rates were higher.
After deducting the interest paid to the Smiths, the excess investment gains earned on the $1 million—interest, dividends and capital gains—accrue in the trust and can be allocated to the children for income tax purposes.
Since the children have no other income, the investment gains allocated to them likely won’t incur much income tax, if any at all. This creates an important tax savings for Jim and Barb over investing the money in their own non-registered accounts, where the investment gains would be taxed at their higher tax rates.
It’s important to note that the income allocated to the children doesn’t have to be paid out to them right away. However, the children do have a legal claim on that income when they become adults.
Using income for the benefit of the children to pay for their education, extra-curricular activities, camp fees or other expenses will reduce this liability. So, careful records should be kept. It is a best practice to maintain a minute book where all decisions about distributing income or capital from the trust are recorded every year.
Now, what happens if Jim and Barb fall on hard times and they need the money back from the trust? Well, for starters, they can have the trust repay the loan to them. That money comes back to Jim and Barb tax free. They can also take out any investment gains in their own name because they are also named beneficiaries of the trust. However, the tax on any investment gains taken out in Jim and Barb’s name would be taxed at their higher marginal tax rates.
The important takeaway here is that the trust can be unwound at any time because Barb and Jim were also named as beneficiaries of the trust at its inception. That’s a key element in the flexibility of setting up a trust like this.
This is just one of the uses of a family trust. It’s a very flexible structure but the rules to establish, maintain and realize the benefits are complicated. That’s why it’s important to get advice from professionals.
You may be wondering what it costs to put this in place. Well, you’ll have to work with a lawyer to get the trust agreement drafted. This will generally cost you around $4,000 to $5,000 depending on the complexity of the trust. You’ll also need to have an accountant file tax returns for the trust each year, as well as for your children, who probably hadn’t filed them before. That’s all likely to cost between $2,000 and $3,000 per year.
Based on these costs, you generally want to consider this strategy if you can put more then $1 million into the trust. Below that amount and the costs eat into the benefits too much.
