When my son did a project on lemmings this week, I realized that Canadians are much like lemmings. Lemmings are small rodents, usually found near the Arctic (we're as close to the Arctic as anyone). They tend to migrate in large groups, all heading in the same direction (sounds an awful lot like the caravan that was my son's hockey team on the way to a tournament a couple of weeks ago).
Yup, Canadians are like lemmings. And Canadian taxpayers even more so. When one has done some sort of advanced tax planning, everyone wants to run in the same direction -- or they feel left out. I see this all the time with trusts. I wish I had a loonie for every time someone has approached me asking for my help to set up a family trust. Most aren't even sure why they want to set one up.
Whether or not a trust makes sense depends entirely on what you're trying to achieve. As a tool, a trust is not an end in itself. You don't set one up because the wealthy seem to have trusts. You establish a trust when it helps to achieve specific objectives. I want to spend some time talking about trusts, and when they can make sense.
Trusts defined
Although a trust is considered to be an individual taxpayer under our tax law, it's not actually a legal entity. Rather, it's a relationship between three parties: The settlor (the person who transfers property to the trust), the trustee (the person who holds legal title to the property -- not for his own benefit, but for the benefit of the third party, the beneficiary), and the beneficiary (the person who is intended to benefit from the property held in trust). And there can be more than one settlor, trustee, or beneficiary.
There are two general types of trusts: Inter vivos trusts (created during the lifetime of the settlor), and testamentary trusts (which are created upon the death of an individual, by the person's will). Inter vivos trusts are taxed at the highest marginal tax rate on all income of the trust, while testamentary trusts are taxed at the same graduated rates as any individual.
Trusts used
Now, why would someone set up a trust? There are a number of common uses. I'm going to focus on a couple of these today.
Splitting Income: Trusts can be used to split income in different ways. For example, it's possible to invest in marketable securities in a trust and to have any income taxed in the hands of the beneficiaries, rather than in the settlor's hands if the trust is structured properly. Now, the attribution rules that normally apply to income in the hands of minor children or a spouse will equally apply when a trust is interposed. But earning capital gains in the trust, to be taxed in the hands of minor beneficiaries, or other income taxed in the hands of adult children, as beneficiaries, can work.
Multiplying Exemptions: It's possible to use a trust to gain access to the lifetime capital gains exemption or the principal residence exemption. For example, if a trust owns shares of a qualifying small-business corporation, it may be possible to utilize the $500,000 capital gains exemption of each beneficiary. Similarly, if the trust owns a residence, it may be possible to shelter any capital gains on a sale from tax using the principal residence exemption as long as at least one beneficiary ordinarily inhabits the home.
Now, there are many more uses of trusts. Next week, I'll share several other common uses. Stay tuned.
Tim Cestnick is managing director at WaterStreet Group Inc. and author of 101 Tax Secrets for Canadians, among other titles.
