Taxation of a Family Trust Income - Reminder of important issues to consider

Here is a great article written by Gisele Prevost, CGA, TEP, LL.M (tax) - Tax partner at the accounting firm Raymond Chabot Grant Thornton located in Ottawa, Ontario.

Taxation of a Family Trust Income - Reminder of important issues to consider:

The trust is independent from its settlor, trustees and beneficiaries;

Income Distribution:
There are several ways to distribute income to a beneficiary. The revenue may be paid by way of cheque, expense reimbursement or by way of note payable. Regardless of the form of payment, the income legally belongs to the beneficiary and, in the case of minor children, may only be paid out for the child’s needs. When the beneficiary turns 18 years of age, amounts paid or payable each year to that beneficiary and that were not distributed to the beneficiary legally belong to the beneficiary.

Income distributed/allocated to any beneficiaries is taxed in their hands and is deductible in the trust’s tax return. Distributions must meet certain conditions :

1st Condition: Income must have been paid or become payable to the beneficiaries in the year in question (i.e. before December 31);

2nd Condition: Due to the “kiddie tax” rules provided in tax legislation, only some types of income can be distributed/allocated to minors; we recommend that you verify the income type prior to making any distribution; and

3rd Condition: Since the amount of income for tax purposes that is equivalent to non-eligible expenses cannot be distributed to beneficiaries, it, therefore, must be taxed in the trust.

Any funds distributed/allocated from the trust to a beneficiary must have an accompanying resolution signed by the trustees. If tax authorities review a trust file which does not contain appropriate legal documentation to support that, either the funds were paid to the beneficiaries in the year in question, or were used for the benefit of the beneficiary, or the beneficiary received a demand note payable to him (her), the tax authorities could claim that no funds/revenue was paid/payable to the beneficiary. The tax authorities could deny the trust’s tax returns (T3) for such amount and/or the amount could be taxed in the trust (plus interest on the unpaid tax).

There must be documented evidence of the cash payments/demand loan covered by the trust’s resolutions. In the case of the spouse and adult children, the simplest proof of payment is the trust’s cheque to the spouse or children, or proof the funds were deposited in their personal accounts. In the case of minor children, income can be distributed by cheque and deposited in their personal accounts or by paying expenses for the children using the money owed to them (courses, sports, tuition, clothing, etc.). A proper resolution should be prepared to reflect the use of such funds. You should keep the related invoices for the expenses covered by this resolution. For any of the beneficiaries, proof of payment could also be a demand note payable to the beneficiary.

When a trust income is not distributed/allocated to the beneficiaries during the year, the income is taxed in the trust and the balance constitutes a tax-paid net capital that can be remitted to the beneficiaries without any further income tax.

Finally, it is important to mention that any contribution from a beneficiary to the trust (ex. depositing cash into the trust account, or paying the trust’s expenses) could result of the application of attribution rules or could ‘contaminate’ the trust (for tax purposes). If attribution rules apply, the income distributed/allocated to a beneficiary could be considered to be the income of another person and will be taxed accordingly. If the trust is contaminated, a subsequent distribution of an asset from the trust to a beneficiary could create a tax impact if the value of this particular asset increased through the time.