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How will changes to the Alternative Minimum Tax (AMT) affect my family trust?

Thursday June 13, 2024

How will the recently announced changes to the Alternative Minimum Tax (AMT) affect my family trust?

A number of our clients have made prescribed rate loans to a family trust and are wondering if and how the changes to the AMT will affect them.

Prescribed rate loans
A prescribed rate loan is created when a higher-income family member loans investment funds at a ‘prescribed’ interest rate to a lower-income family member or family trust using a formal written loan agreement. This arrangement avoids attribution rules and is generally used as an income splitting strategy to ease a family’s tax burden—as any investment income in excess of the interest payable on the loan is made payable to the trust beneficiaries, who may have little to no income tax liability.

Note: The prescribed interest rate is determined by the CRA based on the average rate of three-month treasury bills sold during the first month of the previous quarter, rounded up to the next highest percentage point. The prescribed rate for the third quarter of 2024 will be 5%. The interest on a prescribed rate loan does not need to be adjusted when the prescribed rate changes. A loan established at a 1% prescribed interest rate will remain at 1%, as long as the loan remains in good standing.

For example, a trust with investment income of $100,000 (5% return on $2M of investments) and interest expense of $20,000 (1% interest on $2M loan), would have a net income of $80,000.

The trust would typically distribute the $80,000 income to the trust beneficiaries, who would pay personal tax on their allocated share at a low tax rate. After this distribution, the trust would have no taxable income, and no retained earnings.

Unfortunately, changes to the Alternative Minimum Tax (AMT) will result in these trusts needing to pay tax on ‘phantom’ income.

Alternative Minimum Tax and Phantom Income
Certain individuals, estates and trusts (including family trusts) that receive a significant portion of their income as dividends or capital gains, or that use deductions or tax credits to significantly reduce their regular tax payable, are required calculate their federal tax payable under the regular income tax method and the AMT method and then pay the higher of the two amounts.

Prior to the AMT changes, 100% of the $20,000 interest paid on the loan would be an allowable deduction for AMT purposes. But as of January 1, 2024, only 50% of the interest will be deductible. This will leave affected trusts with AMT taxable income and AMT tax payable, even if the trust has no actual income left.

In the example above, the trust would either need to sell some of its investments or retain some of the $80,000 income (i.e. distribute less than $80,000 to the beneficiaries) in order to have sufficient cash to pay the tax liability. The retained amount would be taxed at a higher rate than the beneficiaries would have paid, since the trust pays tax at the top marginal rate on any undistributed income.

Bottom line: Prescribed rate loans may still be attractive (particularly if the loan was made when the prescribed rate was 1%) but the AMT change may reduce the benefits of your trust arrangement.

S+C Partners is here to help
A family trust involves numerous legal and tax considerations, and the rules around AMT and TOSI (tax on split income) are complex. Our dedicated team of tax professionals and our fully qualified and experienced Trust and Estate Practitioners are here to assist you. Please contact us at 905-821-9215 or if you have any questions regarding Alternative Minimum Tax or Family Trusts.

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S+C Partners is a full-service firm of Chartered Professional Accountants, tax specialists, and business advisors with in-house expertise that extends well beyond traditional CPA servicesIn addition to audit, accounting, and Canadian tax services, we also offer business advisory services, comprehensive IT solutions, Human Resource consulting, and in-house expertise within highly focused areas such as US taxation, business valuations, and estate planning. We provide all the technical expertise of a large CPA firm, but with the personal touch and partner-level attention of a boutique accounting and advisory firm.