Family Trusts and Income Splitting – Canadian Tax Lawyer Tax Planning Information
Although the use of family trusts for income splitting is no longer as effective as it was before the introductions of the “Kiddie Tax”, a family trust remains one of the premier tax planning vehicles recommended by our expert Canadian tax lawyers.
The Canadian income tax system imposes progressive rates of taxation. The higher the income the higher the tax rate. Income splitting is a tax planning tool that makes use of this progressive tax rate structure by shifting income from a high marginal tax rate taxpayer to a lower marginal tax rate family member, thereby reducing the overall amount of tax paid by the family. A trust is an equitable relationship between a person who legally owns assets, called the trustee, and one or more persons who are entitled to the benefits of those owners, called a beneficiary. In a family trust situation set up for income splitting the trust is normally set up by a third party who is neither a trustee nor a beneficiary, called the settlor.
The way in which is family trust is used to income split is by having multiple family members, typically the spouses and the children, as beneficiaries of the trust. The trust earns income and that income is allocated for tax purposes to the different beneficiaries. If one or more of the beneficiaries are in a lower marginal income tax bracket then others, income splitting has been achieved. The income splitting family trust is normally discretionary, which means that the trustee has discretion as to how much, if any, income or capital is allocated to each beneficiary.
Seems simple? Yes, but beware of numerous tax planning traps and make sure our top Canadian tax lawyers provide you with the tax planning help that you need. The most dangerous trap is subsection 75(2) of the Canadian Income Tax Act, which has the effect of attributing back to the settlor any income from property placed into the trust if they are also a beneficiary.
The Tax Act also contains specific anti-avoidance provisions designed to attribute back to parents, in their capacity as settlor or trustee, income that would normally be payable to them in order to prevent income splitting with their minor children. These attributions rules only apply to income derived from property, not to income from a business. Care must be taken to ensure that the attribution rules do not affect the ongoing distributions from the trust. The attribution rules, for example subsection 74.1(1) and section 74.2 which deal with spousal income splitting, contemplate the use of a trust to allow for what CRA views as “improper” income splitting. As mentioned the attribution rules only apply to income earned from property, or passive income, so to the extent that the funds have a source of active business there will be no concern with attribution. Further, even though dividend income paid to shareholders is typically considered income from property, Canadian income tax law characterizes income according to its original source, not by the method in which it is paid. This means that income from an active business will retain its character even if it is paid out as a dividend and that therefore the above-noted attribution rules will not apply to a dividend if the dividend is paid out of active business income.
Tax Traps in Family Trusts and Income Splitting – Canadian Tax Lawyer Tax Planning Information
Care must be taken to avoid another major tax planning trap, the application of the “kiddie tax” contained in Income Tax Act section 120.4. The kiddie tax operates to tax the “split income” of a minor at the highest marginal federal tax rate, in the hands of the minor, unless they are enrolled as a full-time student at a post-secondary institution or disabled. The definition of “split income” in subsection 120.4(1) of the Act is lengthy but it is important to note that “split income” includes any income for the minor from the trust that “can reasonably be considered” to be in respect of taxable dividends from privately-held corporations. The application of the “kiddie tax” is not predicated on the source of income, as in the case of the above-noted attribution rules in section 74 of the Tax Act.
One final tax planning trap to beware is corporate attribution in subsection 74.4(2). Subsection 74.4(2) of the Income Tax Act can potentially result in adverse income tax consequences where property is transferred by an individual to a corporation, whether directly or indirectly including via a trust, and CRA can reasonably conclude that one of the main purposes of the transfer is to benefit a “designated person”, which is defined in subsection 74.5(5) of the Act to include a spouse and minor children. The effect of subsection 74.2(2) of the Act would be to deem transferors (usually one of the parents) to receive interest at the prescribed rate calculated on the value of the property transferred, adjusted for certain statutory offsets in paragraphs 74.4(2)(e)-(g). 74.4(2) is defined to have a wide scope and it is CRA’s position that it can apply to rollover transactions, such as a section 86 estate freeze often used to transfer assets into an income splitting family trust. However, where the corporations involved are small business corporations, Income Tax Act paragraph 74.4(2)(c) functions to completely avoid the application of the corporate attribution rules.
A further income tax planning benefit of a family trust is the possible multiplication of the Lifetime Capital Gains Exemption (LCGE). The LCGE allows for a deduction on the capital gain realized by a shareholder who has disposed of shares in a Canadian Controlled Private Corporation up to a limit prescribed by Parliament. As of 2014, the Lifetime Capital Gains Exemption was set at $800,000 and indexed to inflation. In 2017 the current permitted deduction is $835,715. Each of the beneficiaries of a family trust that owns shares that qualify for the Lifetime Capital Gains Exemption has the potential to claim the LCGE on the sale of the shares.
Our experienced Canadian tax lawyers can assist you in the planning and implementation of an income splitting family trust.