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tax matters

My friend Allan gave me a call this week. "Tim, I just got an e-mail letting me know about my high-school reunion in the fall," he said.

"Sounds like fun, Al," I replied.

"Tim, I graduated 25 years ago, and I feel like I've been wasting time. The reunion is coming up fast. I only have four months to make something of myself. Got any ideas?"

Then it hit me. "Al, why don't you set up a family trust?" I suggested. "It really doesn't matter how successful you've actually been – most successful people have a family trust. "

"Tim, I like it! So, when people at the reunion ask what I'm doing today, I can just tell them the truth – I play video games – but mostly I watch over my family trust. Wow, that sounds great. Uh, Tim, what am I going to do with this family trust once it's set up?"

I then shared with Allan a primer on how a trust can save a family significant tax dollars. Here are the highlights.

Trust defined

A trust is actually a legal relationship between the settlor (the person who transfers the assets to be held in trust), the trustee (the person(s) who holds the assets that were transferred), and the beneficiary (the person(s) for whom the assets are being held).

Now, from a tax perspective think of a trust as a vehicle to hold certain assets you choose to place in the trust. The trust is treated as a separate individual for tax purposes, and any income earned by the trust will be subject to tax.

The trust can pay the tax, or the trustees may choose to distribute the income to the beneficiaries, in which case the trust claims a deduction for the amount distributed and the beneficiaries face the tax on that income instead (the beneficiaries will receive a T3 slip showing the amount of income they must report). So, it's possible to sprinkle income to various family members (beneficiaries) who might pay tax at lower rates than you might face.

You should know that there are two types of trusts: An inter vivos trust, which is a trust you might establish during your lifetime, and a testamentary trust, which is established by your will after your death. I'm talking today about inter vivos trusts. These trusts are taxed at the highest possible marginal tax rate – which is not a good thing, obviously. So, you'll generally want to distribute the income of the trust to beneficiaries to face tax in their hands at lower rates.

Trust example

Consider my friend Allan. He has children and regularly pays for many things for them. What if Allan could pay for these things using dollars that have been taxed in the kids hands rather than his own? The tax savings could be huge.

To make this possible, Allan is going to lend money to a family trust that will be established. Now, there's no hard and fast rule around how much he should advance to the trust. In my view, it should be at least $500,000 over time in order to gain sufficient benefit.

If Allan lent, say, $500,000 to his family trust, the trust could invest those dollars. Let's assume the trust earns 5 per cent annually on those funds. This would result in $25,000 of income annually. If this income were taxed in Allan's hands, he'd pay $11,600 in taxes (in the highest tax bracket in Ontario this year).

In this case, however, the trustee of the family trust – Allan in this case – can distribute the $25,000 of income to Allan's three kids. The result? Each of his kids reports one-third of the income ($8,333 each) and pays little or no tax since these kids have little or no other income and they each have a basic personal tax credit that will shelter the first $10,527 of income from tax in 2011.

Here's the problem: Allan doesn't really want to distribute cash to each of his kids directly. No problem. Allan can simply use the income in the trust to pay for expenses related to the kids. He could, for example, pay for their tuition, sports, travel, and other costs. The taxman will generally consider these amounts to have been distributed to the kids even when paid directly to third parties, provided the costs are clearly for the benefit of the kids.

There's more to say here. Next week I'll talk about some of the finer points to keep in mind with family trusts.