Although the use of family trusts for income splitting is no longer as effective as it was before the introductions of the “Kiddie Tax”, a family trust remains one of the premier tax planning vehicles recommended by our expert Canadian tax lawyers.
The Canadian income tax system imposes progressive rates of taxation. The higher the income the higher the tax rate. Income splitting is a tax planning tool that makes use of this progressive tax rate structure by shifting income from a high marginal tax rate taxpayer to a lower marginal tax rate family member, thereby reducing the overall amount of tax paid by the family. A trust is an equitable relationship between a person who legally owns assets, called the trustee, and one or more persons who are entitled to the benefits of those owners, called a beneficiary. In a family trust situation set up for income splitting the trust is normally set up by a third party who is neither a trustee nor a beneficiary, called the settlor.
The way in which is family trust is used to income split is by having multiple family members, typically the spouses and the children, as beneficiaries of the trust. The trust earns income and that income is allocated for tax purposes to the different beneficiaries. If one or more of the beneficiaries are in a lower marginal income tax bracket then others, income splitting has been achieved. The income splitting family trust is normally discretionary, which means that the trustee has discretion as to how much, if any, income or capital is allocated to each beneficiary.
Seems simple? Yes, but beware of numerous tax planning traps and make sure our top Canadian tax lawyers provide you with the tax planning help that you need. The most dangerous trap is subsection 75(2) of the Canadian Income Tax Act, which has the effect of attributing back to the settlor any income from property placed into the trust if they are also a beneficiary.
The Tax Act also contains specific anti-avoidance provisions designed to attribute back to parents, in their capacity as settlor or trustee, income that would normally be payable to them in order to prevent income splitting with their minor children. These attributions rules only apply to income derived from property, not to income from a business. Care must be taken to ensure that the attribution rules do not affect the ongoing distributions from the trust. The attribution rules, for example subsection 74.1(1) and section 74.2 which deal with spousal income splitting, contemplate the use of a trust to allow for what CRA views as “improper” income splitting. As mentioned the attribution rules only apply to income earned from property, or passive income, so to the extent that the funds have a source of active business there will be no concern with attribution. Further, even though dividend income paid to shareholders is typically considered income from property, Canadian income tax law characterizes income according to its original source, not by the method in which it is paid. This means that income from an active business will retain its character even if it is paid out as a dividend and that therefore the above-noted attribution rules will not apply to a dividend if the dividend is paid out of active business income.
Please continue to part 2 of this tax planning article which will discuss some more of the tax planning traps to avoid, and will discuss the Lifetime Capital Gains Exemption available through the use of a family trust.
Nathaniel completed his Juris Doctor degree at Osgoode Hall Law School where he excelled in the areas of tax law and legal writing and research.He successfully completed all of the requirements of Osgoode’s Taxation Law Curricular Stream
Carson Pillar articled with us and then joined our tax law firm as an associate Canadian tax lawyer having been called to the Ontario bar in June 2016. Carson runs our Calgary tax office. Carson earned his Juris Doctor from Western University and graduated in 2015.
Ian Thomas joined our Toronto tax law firm as an articling student (student at law) in July 2016 and upon becoming a Canadian tax lawyer in June 2017 he becomes our latest tax associate. Ian earned his Juris Doctor from Osgoode Hall Law School and graduated in 2016.
Tigra Bailey has now joined our tax law firm as a summer tax law student and is expected to return as an Articling Student in 2017-2018. Tigra is completing her Juris Doctor at Queen’s University and her expected graduation date is in 2017.
Ildi has joined the law firm of Rotfleisch & Samulovitch PC in June, 2000 and brings over 25 years of legal secretarial experience to the firm. She started as a Legal Secretary and after obtaining Certificates from The Institute of Law Clerks of Ontario
Jamin Chen joins our tax law firm as an articling student in September 2016 after earning his Juris Doctor from Allard Hall at the University of British Columbia.