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tax matters

Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.

Have you set up a trust yet? Lots of people have. Consider Margaret Layne from London, who died in 2003 and left about $775,000 in trust for her cat. Then there's a parrot named Greeny who inherited half a million dollars in the form of a property left in trust when its owners died. Crazy.

As for my family, my sister doesn't have kids, but she does own a very large llama. It told her not to bother with a trust for him. Before we get into the question of whether a trust makes sense for your family, here's a primer on how they work.

Trust defined

A trust is a legal relationship between three people: the settlor, trustee and beneficiary. When a trust is created, the settlor (who owns an asset of some type – called the "property") transfers property to the trustee who holds legal title to the property. But the trustee holds title not for his or her own benefit, but for the benefit of others – the beneficiaries.

Trusts are one of the great inventions of English common law because of the dual ownership that is created: The trustee has legal ownership while the beneficiary has beneficial ownership.

Once the settlor has transferred the property to the trustee, he or she no longer has any ownership in the property. The trustee is responsible for management of the property over which he or she holds title, but isn't entitled to benefit from the property in his or her capacity as trustee.

Now, for a valid trust to exist, three requirements must be met (in legal vernacular, these are called the three "certainties"):

  • There must be an intention to create a trust;
  • The property to be held in trust must be identifiable and actually transferred to the trustee;
  • The beneficiaries must be identifiable.

Trust agreement

It's not absolutely necessary for a written trust agreement to exist for a valid trust to exist – but it's wise to create one in most cases. Without a formal agreement, the trust would generally be considered a "bare trust," in which case the trustee would be obligated to transfer the property to the beneficiary on demand, and to deal with the property as the beneficiary directs. (There are really no duties or powers of the trustee other than acting as an agent of the beneficiary.)

These trusts can often give rise to more problems than you'll care to face.

A written trust agreement will spell out how the trust property is to be held, to whom and when the property should be distributed, and in what amounts. There might also be terms or conditions that must be met before distributions can be made. The agreement also details the obligations and powers of the trustee.

The agreement can provide broad discretion to the trustee in how the property is to be managed and distributed (often called a "discretionary trust") or can be restrictive, requiring the trustee to manage and distribute the property according to specific instructions.

Be sure to speak to a lawyer in your province before using bare trusts or to create a written trust agreement.

Types of trusts

There are two broad types of trusts: inter vivos and testamentary. An inter vivos trust is one that is created by a settlor during his or her lifetime. A testamentary trust is created by the settlor at the time of his or her death, through proper wording in the will.

Taxation of trusts

A trust, regardless of whether it's an inter vivos or testamentary trust, is treated as a separate person under our tax law, which means the trust could pay tax on any income.

It's possible for the trustee to pay, or make payable, income of a trust to the beneficiaries.

In this case, the beneficiaries will face the tax on the income, not the trust itself. The beneficiaries will receive a T3 slip in this case, detailing the income to report.

If the income of an inter vivos trusts is taxed in the trust itself, it's taxed at the highest marginal tax rate, rather than facing graduated rates of tax as you and I would face. Testamentary trusts are different – for now – in that income is taxed at the same graduated rates as you and I would be (this is being reviewed by the government and may be changed).

Next time, we'll get practical and I'll share some common uses of trusts in tax and estate planning.

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