How a trust can lighten the burden of raising a family

Today, we would like to share a great article written by Tim Cesnick and published in the Globe & Mail.

At HazloLaw, we often advise clients to consider the implementation of a Family Trust.

How a Trust can lighten the burden of raising a family

My friend Allan gave me a call this week.  “Tim, I just got an e-mail letting me know about my high-school reunion in the fall,” he said. “Sounds like fun, Al,” I replied. “Tim, I graduated 25 years ago, and I feel like I’ve been wasting time. The reunion is coming up fast. I only have four months to make something of myself. Got any ideas?” Then it hit me. “Al, why don’t you set up a family trust?” I suggested. “It really doesn’t matter how successful you’ve actually been – most successful people have a family trust. ” “Tim, I like it! So, when people at the reunion ask what I’m doing today, I can just tell them the truth – I play video games – but mostly I watch over my family trust. Wow, that sounds great. Uh, Tim, what am I going to do with this family trust once it’s set up?” I then shared with Allan a primer on how a trust can save a family significant tax dollars.

Here are the highlights.

A trust is actually a legal relationship between the settlor (the person who transfers the assets to be held in trust), the trustee (the person(s) who holds the assets that were transferred), and the beneficiary (the person(s) for whom the assets are being held). Now, from a tax perspective think of a trust as a vehicle to hold certain assets you choose to place in the trust. The trust is treated as a separate individual for tax purposes, and any income earned by the trust will be subject to tax. The trust can pay the tax, or the trustees may choose to distribute the income to the beneficiaries, in which case the trust claims a deduction for the amount distributed and the beneficiaries face the tax on that income instead (the beneficiaries will receive a T3 slip showing the amount of income they must report). So, it’s possible to sprinkle income to various family members (beneficiaries) who might pay tax at lower rates than you might face.

You should know that there are two types of trusts: An inter vivos trust, which is a trust you might establish during your lifetime, and a testamentary trust, which is established by your will after your death. I’m talking today about inter vivos trusts. These trusts are taxed at the highest possible marginal tax rate – which is not a good thing, obviously.

So, you’ll generally want to distribute the income of the trust to beneficiaries to face tax in their hands at lower rates.

Trust example.

Consider my friend Allan. He has children and regularly pays for many things for them. What if Allan could pay for these things using dollars that have been taxed in the kids hands rather than his own? The tax savings could be huge.

To make this possible, Allan is going to lend money to a family trust that will be established. Now, there’s no hard and fast rule around how much he should advance to the trust. In my view, it should be at least $500,000 over time in order to gain sufficient benefit.

If Allan lent, say, $500,000 to his family trust, the trust could invest those dollars.  Let’s assume the trust earns 5 per cent annually on those funds. This would result in $25,000 of income annually. If this income were taxed in Allan’s hands, he’d pay $11,600 in taxes (in the highest tax bracket in Ontario this year). In this case, however, the trustee of the family trust – Allan in this case – can distribute the $25,000 of income to Allan’s three kids.

The result? Each of his kids reports one-third of the income ($8,333 each) and pays little or no tax since these kids have little or no other income and they each have a basic personal tax credit that will shelter the first $10,527 of income from tax in 2011.

Here’s the problem: Allan doesn’t really want to distribute cash to each of his kids directly. No problem. Allan can simply use the income in the trust to pay for expenses related to the kids. He could, for example, pay for their tuition, sports, travel, and other costs. The taxman will generally consider these amounts to have been distributed to the kids even when paid directly to third parties, provided the costs are clearly for the benefit of the kids.

Small business owners should beware the taxman's test

written by Tim Cesnick and published in the Globe and Mail.

Small business owners should beware the taxman's test

I was at a local hockey arena last weekend when I ran into an old friend who I hadn’t seen in a while. “Jack, I haven’t seen you for a couple of years! I heard that you’ve started a new business. Is that right?” I asked. “That’s right,” Jack replied. “This time it’s a non-profit corporation,” he continued. “I didn’t intend it that way, but it is.” As it turns out, Jack is going to save big tax dollars because of his business losses. Many taxpayers have done the same thing in the past. Self-employment can be a great tax shelter, but you should understand the taxman’s – and the court’s – view of this. A recent court decision serves as a good reminder about the guidelines to follow. The tax shelter If you operate a business as a proprietorship (rather than incorporating the business), any losses you report from the business can be applied to offset other income you might be reporting on your personal tax return. Quite often, the losses stem from costs you’re incurring anyway.

You might, for example, use your car in your business and claim depreciation (known as “capital cost allowance” – or CCA) on your car. You’re paying for a car anyway, so why not make it deductible? It’s not uncommon to experience losses in the early years of a business. The story Brian Sumner is a gentleman who decided to start a business several years ago. Although he had a full-time job as an economist, he owned a vacation property in Victoria Beach, Man. (primarily a summer recreational area), spent weekends and vacations there, and felt there was a demand in that area for excavation services.

So, Mr. Sumner registered a business called Sumner Mechanical. He turned his garage into a maintenance shop and bought a back-hoe, tractor and skid-steer loader. Mr. Sumner reported losses on his tax returns in 2004, 2005 and 2006, and the Canada Revenue Agency disallowed losses amounting to $26,857, $29,648, and $32,710 for those years respectively. Most of the losses were created by claiming CCA on the equipment he had purchased. Mr. Sumner took CRA to court over the issue, and he lost his case. His story serves as a reminder as to what you need to do if you hope to have a small business (full- or part-time) to open the door to tax deductions. The lessons This type of battle with the taxman is nothing new. Yet, in the last few years, the courts have spelled out the principles that should be followed by taxpayers – and the CRA – when determining whether losses from an activity should be allowed.

In particular, it was the Supreme Court of Canada in the Stewart decision (2002 SCC 46) that set out the principles to consider. The Supreme Court recognized that Canadian tax law will allow deductions where a source of business or property income exists. The question in every case, including Mr. Sumner’s case, is whether a source of income existed. Canada’s top court established that if an endeavour is clearly commercial in nature, with no personal element to it, then a source of income exists. This is not to say that the endeavour must produce a profit in any particular year. Where an endeavour is commercial in nature, then there is no room for the CRA to disallow losses on the basis that there is no reasonable expectation of profit. Where the endeavour could be classified as being personal in nature, or having a personal element to it, then it must be determined whether or not the activity is being carried on in a sufficiently commercial manner to constitute a source of income. If so, then deductions and losses may be allowed.

A problem arises where the endeavour has a personal element to it and is not carried on in a sufficiently commercial manner. In this case, a source of income is not considered to exist, and losses won’t generally be tolerated by the taxman or the courts. When deciding whether an endeavour is sufficiently commercial in nature, the taxman will look at many factors, including: the profit and loss experience in past years, your training in the activity being carried on, your intended course of action, and the capability of the endeavour to show a profit. Mr. Sumner failed the commerciality test. Since he used his equipment more for his own personal property maintenance, advertised his business only seasonally, earned very little revenue, had little experience or training and lacked certain licences to operate some of his equipment on public roads, the courts ruled against him.

Business Owners: Tax savings should be top of your resolution list

Happy New Year 2012 to everyone who is readying this blog. Today, I would like to share an excellent article from Tim Cesnick and published in The Globe & Mail. &&&&&&&&&& Tax savings should be top of your resolution list Once again it’s time for my annual New Year’s resolution. That’s right, a single resolution. This year, I’m getting into shape again. I’m going to start by eating slowly in 2012. It’s not about slowing my metabolism. It’s about my kids. They eat so much that if I slow down my pace of eating, there won’t be anything left by the time I’ve finished my salad. That’ll do it. What about you? If you’re still thinking about your New Year’s resolutions, consider adding tax savings to the list. If you make just one change to your affairs annually to save tax, you’ll do yourself a world of good in a short time. Consider one of these ideas: 1. Create self-employment earnings. Self-employment is still one of the greatest tax shelters available. Why? Deductions. Operating a part-time business from home is all you need to do. This can open the door to deducting a portion of those things you’re paying for anyway, such as mortgage interest, rent, property taxes, home insurance, home repairs, utilities, vehicle repairs, gas, auto insurance, interest on a car loan or lease payments, computer costs and more. 2. Pay family members a salary. If you have self-employment earnings you can move income into the hands of a family member who is in a lower tax bracket by paying wages or a salary for work performed. If you’re an employee, speak to your employer about requiring you to hire your own assistant for your work. Our tax law will allow an employee to deduct salary or wages paid to an assistant provided your employer required you to pay for one. Hiring your spouse or a child who is in a lower tax bracket will keep the money in the family and will save tax dollars. 3. Make your interest deductible. If you’re paying interest costs that are not deductible, and have some cash or investments on hand, consider doing a “debt swap” to create a deduction for your interest. You can do this by taking some of your cash, or selling some investments to create the cash, and using the cash to fully or partially pay down your non-deductible debt. You can then re-borrow to replace those investments or that cash. As long as the new debt is used for an income-producing purpose you should be entitled to deduct your interest costs. 4. Extract cash from your company tax-free. If you own a corporation, consider paying yourself capital dividends, repaying shareholder loans owing to you, and returning “paid up capital” to yourself to access the cash in your company tax-effectively. Also, consider claiming a refund of “refundable dividend tax on hand” (RDTOH) by paying yourself taxable dividends. All of this may sound like a foreign language, but a visit to a tax pro, perhaps your friendly chartered accountant, will help. 5. Consider a leave of absence or sabbatical. You can defer tax by setting aside some money in a deferred salary leave plan (DSLP). You can then take a leave of absence or sabbatical in a later year and collect your deferred salary at that time. Speak to your employer about setting up a DSLP. A DSLP must be in writing and meet certain criteria, such as: No more than one-third of your salary can be set aside for the leave, your leave must be at least six consecutive months, the leave must begin no later than six years after the salary deferral begins, and following the leave you must return to work for a period at least as long as the leave. There are other details that must be looked after as well, so your employer will need to seek advice on this. 6. Create pension income for the credit. If you have eligible pension income you’ll be entitled to claim the pension tax credit. If you and your spouse each claim the credit, this could fully or partially shelter the tax on $4,000 ($2,000 each) of pension income. It’s not going to make you wealthy, but it’s all part of building up tax savings year after year. You can create eligible pension income by, for example, converting part of your registered retirement savings plan to a registered retirement income fund to create $2,000 of RRIF income annually. You can also provide your spouse with eligible pension income by reporting up to half of certain pension income in his or her hands.