Using A Discretionary Family Trust To Income Split Your Investment Portfolio With Spouses And Children Of Any Age
I commonly hear the same refrain from family, friends and clients: it costs a lot to raise children these days. There is a seemingly endless list of activities to fund, pieces of equipment to buy, medical expenses to cover, and educational payments, such as private school tuition, to pony up. Many of my friends feel like glorified ATMs that also have carpooling duties and high cholesterol levels. Although it may not always be possible to reduce these expenses directly, it may be possible to make them more affordable in another way: through income tax savings. Although this article won’t help with the carpooling or cholesterol, it might at least guarantee that there is more money to pull out of the ATM on your way to drop your children at oboe lessons or to pick them up from hockey practice.
The Income Tax Act has clear rules about income splitting among spouses and minor children: any income is attributed back to the contributing spouse or parent, as are all capital gains on money gifted to your spouse (although at least gains on money gifted to minors can be taxed in the minor’s name). Of course, as anyone who funds an “in trust” investment account for minor children should know, once the child child becomes an adult, the money is theirs to use without restriction. Accordingly, even though it is possible to set up an “in trust” investment account for a minor designed to produce only capital gains in order to save on taxes now, many parents and grandparents simply don’t feel comfortable losing control over the amount of money needed to make this strategy really worthwhile. While the rules aren’t as tight when gifting money to adult children — although income can still be attributed back to the gifting parent if the Canada Revenue Agency (CRA) believes the gift was for incoming-splitting purposes — the same concern about giving too much money to people not ready to manage it still prevails.
For those of you gripped with a crushing despair after perusing the last paragraph, all hope is not lost: a properly constructed family trust, along with an investment loan, can save the day. (As an aside, if you’re just interested in income-spitting with your spouse, your solution may be even simpler, as you probably won’t need a trust, only an investment loan in favour of your spouse (per the rules provided later in this article). In any event, in order to tap into the whole family’s tax returns and make a trip to Disney World next year that much more affordable, it is necessary to do as follows: set up a trust controlled by one or both parents that borrows money from the high-income parent at the prescribed government rate, invest the money inside the trust, and then allocate the income and gains among the various family members named as beneficiaries any way you want. Provided all the formalities are obeyed (such as ensuring that the lending spouse is paid and declares loan interest each year), a whole new world of tax savings (and quality time with the Mouseketeers) awaits!
How it Works
In basic terms, a trust is a legal relationship whereby one person (the “settlor”) gives property to another person (the “trustee”) to manage for the benefit of others (the “beneficiaries”). As well, sometimes, there is someone else in charge of keeping an eye on the trustee and potentially picking replacement trustees (the “protector” or “appointer”).
Under Canadian tax rules, it is usually required to have someone other than mom and dad as the settlor. Instead, mom and dad would be both trustees and beneficiaries which effectively allows them to control the money now and potentially take it back later. As for the settlor, it is usually a family friend who owes you big-time, or another relative who won’t be included as a beneficiary. The settlor’s only role in this case is essentially to be a figurehead — he or she merely provides a silver coin or ingot and signs the document creating the trust, then fades into the sunset. The trust is drafted according to mom and dad’s instructions and names themselves, their children and potentially other lower-income family members (such as potentially their parents) as beneficiaries. It also usually gives the trustee complete discretion each year to decide how any income or capital gains earned inside the trust are to be distributed among the beneficiaries. In other words, it is the trustee, not the settlor, who really controls the trust, and he can decide exactly who (including himself) gets how much each year, with an eye to getting the best tax results and ensuring the best use of the money.
Now that trust is in place, it’s time to get down to the business of investing. The parent in the highest tax bracket then lends the trust money at the prescribed government rate — currently 1% per year and which can be locked in for the life of the loan. It is vital that the loan be documented, that each year’s interest be paid to the lending spouse prior to January 30 of the next year, and that the lending spouse declares this as interest income on his tax return; one missed year is enough to disqualify the trust from any future income splitting. Instead, it would lead to the income being taxed in the hands of — and at the rates of — the spouse we were trying to get it out of in the first place!
Provided the i’s get dotted and t’s get crossed, the trustees can now allocate any of the income and capital gains earned on the trust’s investments as they desire each year among the various beneficiaries, effectively taxing it at the latter’s rates. When allocating the money to minors, however, mom and dad as trustees can then turn around and pay it to themselves in their other role as the legal guardians of their children. They are required, however, to spend the money for that beneficiary’s benefit, and it is important to keep a clear record, including receipts, of where the money goes. If not all of the money allocated to a beneficiary is going to be used that year, the trust can write that beneficiary a demand promissory note prior to year-end and keep the money in the trust without causing problems. Since the beneficiary is now entitled to immediate payment of the money upon demand, however, some parents may be reluctant to run up too large an “IOU” to the child who, when he becomes an adult, can demand immediate payment of the balance owing at that time.
Mom and dad can theoretically continue to operate the trust for decades, although these types of trusts are often wound up far sooner — such as when the lender spouse dies or when the children are finished university and are no longer in a low tax bracket. Moreover, every 21 years, any unrealized capital gains on assets owned by the trust are taxed, which leads to many trusts being wrapped up at this point if the bill is going to be a large one. When the trustee wishes to wind up the trust, the trust repays the loan by liquidating enough of the investments to do so, and the trustee decides how to divide the remainder among the beneficiaries.
There could be a significant capital gains tax bill at that time, although the gains may be allocated to low-income beneficiaries provided there is enough additional money left to repay the loan. Noting that this day of reckoning may come, some trustees start periodically realizing the gains many years prior to the 21st anniversary or the planned windup date of the trust, allocating them to beneficiaries in low tax brackets along the way. This can ensure that the tax issues at the time of the 21st anniversary or windup are a non-event. In fact, if there isn’t going to be a big tax bill at that time, the parents may decide to keep the trust operating, such as if there are still tax savings to be had. In fact, in some cases, mom and dad are now grandparents and may want to help their children with the grandchildren’s costs in a tax-efficient way by using the trust to pay these expenses. If there are any assets in the trust with unrealized gains that haven’t been liquidated, the trustee can transfer them to any of the beneficiaries without triggering tax at any time prior to the next 21st anniversary of the trust’s creation, so that person would now own such assets with the same cost and unrealized capital gain as was the case when owned by the trust.
Additional Steps To Get And Keep The Trust Up And Running
Other than handling the investment portfolio directly or consulting with the person hired to do this for the trust, the trustee has other administrative tasks to attend to from time to time. Your lawyer and accountant can help the trustee with these — particularly for the first year or so, after which you may be more comfortable doing more of this on your own. Usually, the first order of business will be applying for a trust number from the CRA, as many investment institutions and banks won’t allow you to open an account for the trust until this has been done. This may take several months, so it generally makes sense to delay selling assets and loaning money to the trust until the number has arrived and the relevant accounts are ready to go.
The trustees will also need to keep clear records and receipts of the trust’s activities, expenses and payouts. Generally, most trustee decisions are documented through “Trustee Resolutions” that are usually rather brief documents signed by the trustees. Perhaps the most common is an annual resolution each December declaring how any income or capital is to be allocated among the beneficiaries that year (by dollar amounts or percentages of income received, depending on what makes the most sense at that time). The trustees will also need to prepare new loan documents and additional directors’ resolutions if mom or dad ever decides to loan the trust additional money in the future.
The trustee will also need to work with a tax preparer to file a return for the trust showing the realized capital gains and earned income, although most trusts seldom have to pay any taxes directly, since it is more tax efficient to have the income taxed in beneficiaries’ hands most of the time. All of the beneficiaries will have to report taxable income received by the trust on their own returns. For minor beneficiaries receiving no other income, it might be the difference between them having to file a return or not.
Finally, the trustee must account to the beneficiaries from time to time about how the trust is operated. This essentially requires showing the trust’s income and expenses. This should be done within the first two years of the trust’s existence, and then more sporadically thereafter. It’s been suggested that this be done every three to five years. If a beneficiary disputes the charges, he can get the trustee to do a formal passing of accounts before a court officer (although this is extremely uncommon in the case of trusts set up for this purpose).
Tax Savings And An Example
Since I’m B.C.-based, this example uses the tax rates that apply to most of my clients, although the potential tax savings can be a lot higher in most other provinces, where the highest tax brackets are higher than those on the “left coast.” As well, B.C. is one of the provinces that offers a higher dividend tax credit, meaning that taxpayers in some other provinces potentially lose twice — once through higher tax brackets and a second time through a lower enhanced dividend tax credit that effectively means a higher tax rate on dividend income. For example, in B.C., the highest tax bracket is 47.7% and the effective tax rate when earning dividends in this tax bracket is 31.3%, whereas Ontarians earning more than $220,000 pay income tax at 53.53% and are taxed at 39.34% on enhanced dividends, including all surcharges.
Also, dollar for dollar, the most potential savings apply when transferring interest from the wealthy parent to a starving child, at least until the child is earning enough money to actually pay tax on any of it. On the other hand, using investments with eligible dividends instead of interest income can save clients with larger portfolios more money in total. For example, while a child in B.C. can earn over $10,000 in interest tax-free if that is his only source of income, he can actually make more than $50,000 solely in dividend income tax-free. The same generally holds true in other provinces, although someone earning only dividends may not be able to earn quite as much tax-free as a British Columbian. Accordingly, for larger portfolios, the real savings may be achieved through allocating dividend income to those in the family with lower incomes.
Let’s assume that John and Jane spend $20,000 per year on their son Michael’s education and activities, that Jane is a stay-at-home spouse, and that John is in the highest tax bracket. John receives an inheritance of $400,000 from his mother and would have invested it in blue chip stocks that pay 5% per year in dividends ($20,000). If taxed in his own name, he would owe $6,260 in taxes on the dividends. By using a trust instead, he would report $4,000 in interest (1% of $400,000), on which he would pay $1,908 in taxes. After paying the interest expense, the trust would be able to allocate the remaining $16,000 to Michael and use this money toward his expenses. Since Michael isn’t earning any other income, this money will be tax-free. As a result, the family saves $4,352 each year even if the dividend payments don’t increase and the investments don’t grow in value. If there are any future gains, the savings are even higher since any capital gains can be reported on either Jane or Michael’s returns, and thus taxed at their rates, rather than John’s.
Conclusion
Although there is definitely a hassle factor involved in setting up and maintaining a family trust — as well as a legal bill of probably $3,000 or so — the potential yearly savings may be too much to ignore, particularly since the annual costs of running the trust will be far lower than the set-up fees. Accordingly, if you have a significant non-registered portfolio, and either children or grandchildren that you want to help financially in lower tax brackets, it may be worth sitting down with your accountant and lawyer with a calculator and your investment portfolio to see if this might work for you. For those of you doing leveraged investing who don’t mind the risk, using the trust for the leveraged portfolio may make your money go further, although this strategy would probably mean lending the trust money at your own borrowing rate rather than the lower prescribed government rate. This would mean that the interest paid to you by the trust would now cancel out your own borrowing costs for tax purposes and would also provide a higher tax deduction to the trust as well. In any event, the next step is to crunch the numbers. One day, your family and the companies owning family vacation resorts the world over may thank you!
Colin S. Ritchie, BA.H. LL.B., CFP, CLU, TEP and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com.