Family trusts have traditionally been a popular and powerful tool in tax, financial and succession planning, especially for private family businesses. Over the past few years however, there have been some significant changes to tax legislation that have caused some entrepreneurs to question the continued benefit of including family trusts in their private company structure. So, are family trusts still worth the effort?
What is a Family Trust?
A trust is not a legal entity. Instead, it is a legal relationship between the trustees who control a trust’s assets, and the beneficiaries who benefit from a trust’s assets. A family trust is a common type of inter vivos (Latin, for ‘between the living’) discretionary trust that is established by someone during their lifetime to hold, manage and protect family assets (or own a family business) and support beneficiaries—usually family members.
Taxation of Trust Income
A trust is considered a taxpayer under Canadian law and required to pay tax at the highest marginal rate for individuals on any taxable income retained in the trust, without the benefit of any personal tax credits. Unfortunately, the introduction of the tax on split income (TOSI) rules in 2018 essentially eliminated the income-splitting benefits of a trust. Prior to the TOSI rules, it was common for private businesses to pay income to a trust and then allocate that income to family members to pay tax at lower graduated rates.
Currently, a trust has to file a T3 Trust Income Tax and Information Return (“T3”) if it has taxes payable, makes a distribution to one or more beneficiaries, or disposes of capital property. Personal information on trustees, beneficiaries, settlors, or anyone else connected to the trust, is not required to be reported to the CRA.
Changes to Tax Legislation
New trust reporting requirements
The 2018 federal budget proposed regulations that will significantly expand trust reporting requirements for tax years ending on or after December 31, 2021. As a result, many family trusts will soon be required to file a T3 for the first time, and will need to disclose considerable personal information on all taxpayers connected to the trust.
Once the new legislation is finalized, most family trusts in Canada will be required to file a T3 return every tax year—regardless of whether the trust has any income or gains to report. In addition to increased administrative and financial costs associated with annual tax filings, family trusts will need to be transparent with respect to all settlors, trustees and beneficiaries—even contingent beneficiaries. It may also be necessary to disclose personal information on any non-arm’s length people who participated in an estate freeze in favour of the trust, sold property or loaned money or property to the trust, or paid expenses on behalf of the trust.
There are some exceptions to these new reporting requirements, such as trusts in existence for less than three months, and trusts that hold less than $50,000 in assets throughout the taxation year.
Penalties for non-compliance
New penalties will accompany the new reporting and disclosure requirements. For 2021 and subsequent taxation years, failure to file the T3 (or any of the new schedules) will result in a penalty of $25 per day, with a minimum of $100 and a maximum of $2,500. Also, any error or omission made knowingly or under circumstances amounting to gross negligence—regardless of the magnitude of the error or omission—will result in an additional penalty of $2,500 or 5% of the maximum total fair market value of all the property held by the trust in the year, whichever is greater.
The 21-year Rule
Another drawback of a family trust is the 21-year deemed disposition rule. This ‘21-year rule’ for trusts means that a trust will generally be deemed to have disposed of all its assets at fair market value on its 21st anniversary, with taxes payable on any capital gains. This can result in a significant tax liability. Although there are several tax-planning strategies that can be utilized to avoid the 21-year rule, it is still important to factor in the associated planning and expense.
Continued Benefits of a Family Trust
For Canadian income tax purposes, the use of a family trust can still provide several valuable benefits, especially to private business owners.
Family trusts are frequently used in succession planning as they allow business owners to retain control of trust assets. They can be used to transfer wealth (including the increase in value of the shares of private corporations) to future generations in a tax-efficient manner and allow for the multiplication of the lifetime capital gains exemption. They can also reduce estate taxes upon death—as assets held by a trust are not subject to deemed disposition, except with respect to the 21-year year—which can considerably reduce an estate’s final tax liability.
One of the main advantages of a family trust is that it allows the control of assets to be separated from the value of assets. So, instead of issuing new common shares directly to dependents as part of an estate plan, a business owner can issue the shares to a family trust, naming their dependents as beneficiaries. The dependents benefit from the growth in value of the shares in the trust, but typically have no say in how the shares are managed. Instead, the trustees (one of which is often the business owner) maintain control over the shares.
Deferral of Capital Gains
An estate freeze is one of the most common tax planning strategies available to Canadian business owners to transition their wealth to the next generation. Frequently implemented as part of a family trust; an estate freeze allows the value of private company shares to be locked-in or ‘frozen’ at their current value, by exchanging common shares for ‘fixed value’ preferred shares. This can greatly reduce the capital gains tax that the next generation of shareholders would owe in the future.
Capital Gains Exemption
Because trusts can hold and sell corporate shares that qualify for the QSBC (qualified small business corporation) exemption, a family trust can facilitate the multiplication of the lifetime capital gains exemption (LCGE). As of January 1, 2021, every Canadian taxpayer is entitled to a LCGE of $892,218. So, on the sale of QSBC shares held in a family trust, the trust could sell the shares and allocate the resulting capital gain to the trust beneficiaries. Each beneficiary could then claim their LCGE, allowing $892,218 from the sale of the QSBC shares to flow tax-free to each individual.
Although the loss of income splitting advantages, and the additional compliance requirements, may seem to dilute the value of family trusts in current tax planning arrangements, they continue to be a valuable strategy for succession, tax and financial planning.
That said, it might be worth considering winding up a family trust that no longer serves its intended purpose. Additionally, if a trust is approaching its twenty-first anniversary, it is important to carefully plan for that event in advance.
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