Family Trusts and Income Splitting

Posted on by Tax Partners
13
Jan

Introduction

Family trusts have long been a popular vehicle for income splitting in Canada. Although legislative changes such as the introduction of the “Kiddie Tax” and updated Tax on Split Income (TOSI) rules have limited their effectiveness, family trusts remain a powerful tax-planning tool when properly structured. They offer opportunities for income splitting, tax deferral, and wealth management when aligned with current Canadian tax laws.

How Family Trusts Enable Income Splitting

The Canadian income tax system operates on progressive tax rates—higher income results in higher taxes. Income splitting seeks to minimize overall family tax liability by shifting income from higher-income family members to lower-income family members.

A family trust is a legal relationship where assets are held by a trustee for the benefit of named beneficiaries. In income-splitting arrangements, family members such as spouses and children are often beneficiaries. A discretionary family trust gives trustees the flexibility to allocate income or capital to beneficiaries based on tax optimization or other objectives.

Tax Planning Challenges and Risks

While family trusts can offer significant benefits, they also come with legal and tax compliance complexities. Subsection 75(2) and various attribution rules in the Income Tax Act (ITA) can negate tax benefits if not carefully managed. Below are the key considerations:

1. Subsection 75(2) – Attribution of Income to the Settlor

Under subsection 75(2), any income or capital gains earned from property contributed to a trust by the settlor (or anyone connected to them) may be attributed back to the settlor if:

  • The settlor retains control over the trust property.
  • The settlor or their family stands to benefit from the trust property.

Tax Tip: Avoid attribution under subsection 75(2) by ensuring the settlor does not act as a trustee or benefit directly or indirectly from the trust.

2. Spousal Attribution Rules (Subsection 74.1(1))

Under subsection 74.1(1), income from property transferred to a spouse or common-law partner is attributed back to the transferor. However, this does not apply to income derived from active business activities.

Tax Tip: Ensure that the trust income arises from an active business or that proper planning circumvents spousal attribution.

3. Kiddie Tax and Tax on Split Income (TOSI)

The Tax on Split Income (TOSI) rules under section 120.4 apply to income earned by minors and certain adults (e.g., family members receiving income from private corporations or trusts). Minors face the highest marginal tax rates on "split income," which includes dividends from private corporations or income allocated from a family trust.

Tax Tip: TOSI exemptions may apply for:

  • Income from active businesses.
  • Reasonable salaries for work performed by family members.
  • Income allocated to family members who are actively involved in the business.

4. Corporate Attribution (Subsection 74.4(2))

Corporate attribution rules under subsection 74.4(2) target situations where property is transferred to a corporation to benefit “designated persons” such as spouses or minor children. The transferor may be deemed to receive interest income based on the transferred property’s value.

Tax Tip: Use small business corporations to avoid corporate attribution under paragraph 74.4(2)(c).

Lifetime Capital Gains Exemption (LCGE) Multiplication

Family trusts can facilitate the multiplication of the Lifetime Capital Gains Exemption (LCGE). As of 2024, the LCGE amount is indexed to inflation and allows a deduction of up to $971,190 on the sale of qualifying shares in a Canadian-Controlled Private Corporation (CCPC).

If a trust holds qualifying shares and distributes them to beneficiaries, each beneficiary can claim their own LCGE, thereby multiplying the exemption across the family.

Tax Tip: Ensure the trust is properly structured, and beneficiaries meet the LCGE eligibility criteria to avoid issues during CRA audits.

Additional Benefits of Family Trusts

  1. Wealth Preservation: Protect family wealth from creditors or marital property claims.
  2. Tax Deferral: Defer taxes by retaining income within the trust.
  3. Intergenerational Wealth Transfer: Facilitate seamless wealth transfer without triggering immediate tax consequences.

Common Tax Traps to Avoid

  1. Improper Documentation: Failing to document contributions, income allocations, or trust agreements can lead to CRA challenges.
  2. Excessive Distributions to Minors: Allocating significant income to minors may trigger the Kiddie Tax or TOSI.
  3. Mismanagement of Settlor Role: A settlor acting as a trustee or beneficiary may lead to income attribution under subsection 75(2).
  4. Improper Valuation of Trust Property: Ensure all property transferred to the trust is properly valued to avoid CRA penalties.

Conclusion: Effective Family Trust Planning Requires Expert Guidance

Family trusts remain a powerful tool for income splitting and tax planning in Canada. However, their benefits are contingent on careful structuring, compliance with tax laws, and effective administration. With evolving tax rules such as TOSI and heightened CRA scrutiny, professional tax advice is essential to maximize benefits and avoid costly pitfalls.

For assistance with setting up or optimizing a family trust, contact our experienced Canadian tax advisors to ensure your family’s financial legacy is secure.

This article is written for educational purposes.

Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at info@taxpartners.ca, or by visiting our website at www.taxpartners.ca.

Tax Partners has been operational since 1981 and is recognized as one of the leading tax and accounting firms in North America. Contact us today for a FREE initial consultation appointment.

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