Example of the Operation of A Family Trust
Scenario 1: Income Splitting
Mr. X establishes a trust for the benefit of himself, his spouse, Mrs. X, and their three children, A, B and C. A and B are over 18 years of age and attending university. C is a minor living at home.
The participating shares of Opco, Mr. X’s active business corporation, are owned 100% by the trust.
After salaries are paid to Mr. X, Opco is earning $100,000 before tax and $82,000 after tax.
Based on current tax rates, if Mr. X wishes to pay out the net after corporate tax income of $82,000 to himself to enable him to use it personally, he would pay additional taxes of over $26,000 if he were the sole shareholder of the company.
Using the family trust arrangement and paying the income earned by the trust equally to the adult beneficiaries (except Mr. X.), the trust’s dividend could be split evenly between Mrs. X, A, and B. The tax liability on the dividend would thus be taxed as follows:
Mr. X = O in dividend (he is paid via salary)
Mrs. X, A and B all take a Dividend of $27,334 each for a total of $82,000. Hence, if Mrs. X, A, and B have no other sources of income, they would pay no taxes at all on this amount.
Note, that dividends allocated to the minor child would be subject to tax at top marginal rates with no personal tax credits applicable, pursuant to the “Kiddie Tax” provisions.
By using a family trust arrangement, Mr. X has just saved the family unit about $26,000 in tax.
Scenario 2: Capital Gains Splitting
Mr. X has received an offer to sell the shares of Opco (which are "qualified small business corporation shares") for $2,000,000. The shares were acquired for a nominal amount ($100). If Mr. X were to receive the sale proceeds as sole shareholder of the business, his tax liability might be computed as follows:
Proceeds $ 2,000,000
Cost (100)
Capital Gain 1,999,900
Capital Gains Exemption (750,000)
Capital Gains Subject to Tax $ 1,240,900
Taxable Capital Gain $ 620,450
Tax $ 310,225
Under the family trust arrangement, the trust would receive the total $2,000,000 proceeds. The trust's capital gain could be paid out to trust's beneficiaries (if desired by the trustee) and the beneficiaries could shelter the gain with their own $750,000 capital gains exemptions. In this case up to the entire $310,225 in tax calculated above could potentially be saved (subject to alternative minimum tax
considerations).
Note that this benefit can be achieved even if the beneficiary is a minor child, since the "Kiddie Tax" does not apply to capital gains.
Any trust income not actually paid or payable to a specific beneficiary in a given year would be taxable in the trust at the highest marginal tax bracket (thus eliminating the benefits of using the trust).
Amounts will be paid or payable to a beneficiary in the year under the following scenarios:
1. An expense report detailing the year’s expenses incurred by the parent on behalf of a beneficiary is submitted by the parent to the trustee. The trustee initials the report to evidence the exercise of his discretion pursuant to the terms of the trust agreement, and a trust cheque is issued to the parent before the end of the year.
2. The parent requests the trustee in writing to make certain payments to a third party for the benefit of the beneficiary. The trustee initials the written request to evidence the exercise of his discretion and makes the payments to the third party before the end of the year.
3. The trustee declares an income distribution using a trustee’s minute and either issues a trust cheque payable to the beneficiary before the end of the year, or issues a demand promissory note to the beneficiary as evidence of payment before the end of the year.
4. Where the amount of trust income earned is not known in the year (e.g., where a trust owns units in a mutual fund trust) the trustee resolves to make an income distribution to a beneficiary equal to a certain percentage of the undistributed income earned by the trust in the year using a trustee’s minute, and issues a demand promissory note to the beneficiary as evidence of payment before the end of the year.
Under the most recent guidelines released by Canada Revenue Agency, the trust can pay for, or reimburse a wide variety of expenses for a child as long as the payment of the expense clearly benefits the child. Such expenses may include (but are not necessarily limited to):
• Education and tuition expenses
• Recreation expenses and equipment
• The child’s share of restaurant meals and family grocery bills
• Clothing
• Medical and dental expenses
• Spending allowances
• Toys
• Car expenses, including per kilometre reimbursements for driving to and from the child’s activities
• A proportionate share of vacation costs
Asset purchases (e.g., cars, boats, vacation properties) and mortgage payments which cannot or will not be legally registered in a child’s name are problematic and we generally suggest that they not be reimbursed by the trust.
In all cases, receipts should be retained that document the fact that trust funds were spent on the beneficiary’s behalf.
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