For years family trusts have been used as an effective tax planning tool for small business owners. A settlor creates a trust by way of a gift and appoints trustees to manage the trust property for the benefit of a class of beneficiaries. All of the rules are typically spelled out in an agreement signed by the settler and trustees.
Once created, the trust can be used to acquire shares in a private corporation. Often a trust becomes a shareholder as part of an estate freeze whereby the value of the business is locked in by the founding shareholder(s) and the future growth of the company is captured in a new class of shares held by a trust.
The effectiveness of the trust is in large part based on its flexibility. The trustees of the trust are typically given the discretion to determine the allocation of the ‘benefits’ of the trust among the beneficiaries. The allocations do not have to be in equal proportions and, in fact, beneficiaries can be excluded. Furthermore, the allocations can be changed from year to year.
The other aspect of a trust that is a key to its effectiveness is that it is treated as a conduit for tax purposes. Therefore, whatever goes into a trust retains its tax characteristics as it comes out to the beneficiaries. Accordingly dividends and capital gains received by the trust can be allocated out to the beneficiaries.
Based on these factors family trusts are an integral component in tax planning strategies involving income splitting and multiplying the capital gains exemption. In order to try to limit some of these strategies the Income Tax Act is laden with what are called attribution rules which are designed to attribute income and gains back to the original owner. Proper implementation is critical to ensure that there are no unintended tax results.
Not surprisingly, family trusts have over the years drawn the attention of CRA and the Department of Finance. It was in part due to the proliferation of family trusts that Finance passed the ‘Kiddy Tax’ legislation a number of years ago to prevent income splitting with minor children.
More recently, family trusts have been targeted for a CRA audit sweep as part of an overall move to more aggressive audit practices. This has been seen and talked about across the country. The focus has for the most part been on the basics. Some of the things to watch for are as follows:
• the settlement of the trust should be from someone other than a trustee or beneficiary
• the settlement property such as a $10 bill or coin should be kept with the trust and not used to produce income
• the funds for the subscription for shares should be from a lending institution or from an independent third party with proper borrowing terms
• proper execution and dating of documents
The recent Federal Court of Appeal decisions in Garon and Antle seem to have given CRA a few extra arrows in the quiver. The Garon case was primarily about trust residency but in reaching the decision the court raised the issue of the mind and management of the trust. Arguably this can be used to challenge who is actually making decisions on behalf of the trust. It is therefore important to be able to demonstrate that the trustees were actually involved in the decisions after due consideration of all relevant factors. If decision making authority could be showed to actually reside in only one trustee it could have very serious tax consequences based on triggering one or more of the attribution rules. The Antle case is a textbook example of sloppy implementation leading to unintended and disastrous tax results. Once again highlighting the importance of dotting the I’s and crossing the T’s.
The moral of this story is that there are advantages still to be had through the use of trusts but all can be lost if the strategy is not implemented properly. As a final note of caution, CRA may, as part of the audit process, request documents or use questionnaires to get information about tax planning strategies. When faced with such a request the first step is to contact your tax advisor to make sure you understand your rights. Once everything is offered up, it may be too late.
Harold Feder is a partner with the law firm of BrazeauSeller.LLP. He practices in the areas of tax and estate planning for individuals and business owners. Harold can be reached at (613) 237-4000 ext. 242 or at firstname.lastname@example.org. For more information about Harold, visit www.brazeauseller.com.