Family Trust Audits Highlight Need for Proper Trust Records

Today, I would like to share an excellent article written by BDO Canada - As usual, please let me know if you have any questions.

Family Trust Audits Highlight Need for Proper Trust Records

A family trust can provide significant benefits as the
legalities and benefits of ownership can be separated. A
discretionary trust allows the benefits of ownership to flow
to beneficiaries while the trustee maintains control and ownership
of trust property and can ultimately decide on who will receive the
property at a later date. Due to this, family trusts are a powerful tool
in terms of income splitting and capital gains splitting, including
multiplying access to the capital gains exemption.

As is often the case, beneficial tax planning vehicles often carry a
greater recordkeeping and compliance burden, and family trusts are
no different. In particular, one of the key benefits of a discretionary
family trust is the ability to allocate income in different shares to
different beneficiaries, or to retain the income in the trust. For a
discretionary family trust, it is important to note that the default
position is that all of the income belongs to the trust and will be
taxed there if no further action is taken. If it is beneficial to have
income taxed in the hands of a beneficiary, that income can be
allocated in one of two ways:

• It can be paid to them during the year, or the trustee(s) can
declare that the income is payable to the beneficiary at the end
of the year. In other words, the income belongs to the beneficiary.

• It can be allocated by way of a special tax rule called the
preferred beneficiary election (under this election, it is possible to
allocate income to a beneficiary of the trust that is mentally or
physically infirm or disabled without giving them a right to that
income).

Most likely due to the popularity of family trusts and the tax
benefits they provide, the Canada Revenue Agency (CRA)
implemented an audit project on these trusts. The CRA’s audit work
on trusts is focused on the following:

• Has the trust been properly formed? If your trust was set up in writing by a lawyer, this should not be a significant issue.

• Where trust income has been allocated, was the income actually
paid or is there a bona fide obligation to pay that income to a
particular beneficiary? The CRA will be looking for documentation
such as trustee resolutions that allocate the trust’s income, proof
of payment for income paid during the year and promissory notes
or other proof that the trust has made the income payable to the
individual beneficiaries.

• Where the trustees make payments to third parties, was the
payment made for the benefit of the beneficiary? It is also
possible to “pay income” to a beneficiary by making payments
to third parties for the benefit of that beneficiary. In this case,
the trustee will need to document the payments made and
also provide evidence that the payment benefited a particular
beneficiary. For example, if a parent is reimbursed for expenses
incurred on behalf of a child who is a beneficiary, receipts for the
expenses should be retained to prove the child benefited from the
payment and not the parent.

In addition to these particular issues that arise for family trusts, the
CRA will also be reviewing the records of the trust in the same way
it does for other taxable entities to determine whether income has
been calculated and reported properly. So, you should ensure that
bank and investment accounts are set up as needed and proper
records are maintained. Also, your trust agreement and the property
used to settle the trust should be kept in a safe place.