Planning with Discretionary Family Trusts
In our Winter 2011 Tax Alert, we commented on some of the potential benefits that can be achieved through the use of discretionary family trusts. It is important that subsequent actions and decisions by trustees and beneficiaries do not undermine the effectiveness of the trust structure. In this article, we discuss a number of the more common administrative traps to avoid.
Allocations must be paid or payable to the recipient-beneficiary
Trustees generally have discretion to allocate all or a portion of a trust's income to one or more beneficiaries. The amount allocated to a beneficiary in a particular year is deductible in computing the trust's taxable income, and is included in computing the recipient beneficiary's income for that year (watch the "kiddie tax" where minors receive allocations). However, one of the prerequisites for the trust to obtain a deduction against income earned in a particular year is that the allocated amount must be "paid or payable" to the beneficiary in the same year. If the amount is not paid or payable in the year, the Canada Revenue Agency (CRA) likely will disallow the deduction to the trust.
The best way to satisfy the "paid or payable" requirement is to distribute monies to the recipient-beneficiaries by way of cheques deposited into the recipients' own bank accounts.
If an allocated amount is not, or cannot be, paid in a particular year, the trust can still obtain a deduction if the amount becomes payable to a beneficiary in the year. The CRA will consider the amount to be payable only if the recipient-beneficiary has a legally enforceable right to collect the amount either immediately or, where the recipient is a minor, when that minor attains legal age. Generally, the recipient must be aware of the trust allocation and must be in possession of legally enforceable documentation by the end of the year in which the allocation is made. If these conditions are not met, the CRA likely will deny the trust a deduction for the allocated amount.
However, the mere exercise of trustee discretion to allocate income to a particular beneficiary and evidencing such discretion with a trustee resolution are not sufficient to consider an amount to be payable. The missing ingredient here is the ability of the beneficiary to enforce payment.
A beneficiary's legal right to enforce payment can be established by having the trustee issue a demand promissory note to the recipient before the end of the year, or as soon as the amount becomes known, in which the allocation is made. However, there is a caveat to this method. Certain provisions of the Ontario Limitations Act (2002) may restrict the rights of the holder of a demand promissory note. In particular, the note-holder may be prevented from enforcing payment on a note more than two years after a default by the debtor (i.e. a missed interest payment, failure to pay upon demand, etc.). In such cases, the CRA may seek to deny the trust a deduction for the allocated amount, as the recipient would no longer have a legally enforceable right to collect on the note.
Payments made to beneficiaries must be used for their benefit
Parents often take possession of funds allocated from a trust to a child-beneficiary. In some cases, the parents do not maintain sufficient documentation to prove that subsequent disbursements of the funds were made for the benefit of that particular child. Such practices can have negative tax consequences. Where the parents cannot demonstrate that the funds were used for the benefit of the child, the CRA likely will deny the trust a deduction for the amounts allocated to the child. In addition, the CRA may seek to apply a benefit to the parents, to be included in their income, equal to the amount received.
The CRA will treat payments to a minor child's parents (or to third parties) for the benefit of the child as having been paid to that child in circumstances where:
- the trustees have exercised their discretion and made an allocation payable to the child;
- the trustees notify the parents of the discretionary allocation and the payment is made in accordance with the parents' request or direction; and
- it is reasonable to consider that the payment was made to benefit the child directly. Acceptable payments include those paid for the support, maintenance, care, education, enjoyment and advancement of the child, including necessities of life.
It is most prudent, however, to have trustees make cash distributions of allocated amounts by way of cheque directly to the beneficiary's bank account in the year in which the allocation is made. Payments to any third party on account of acceptable expenses can then be made directly from the beneficiary's bank account. This strategy is particularly important when dealing with adult beneficiaries.
Maintaining accurate records
In order to support a review by the CRA, trustees are required to maintain accounting and other records to document their decisions, including:
- separate trust bank accounts with statements and cancelled cheques for all material payments, including payment of income allocated to beneficiaries;
- annual resolutions and/or minutes of trustee meetings documenting all material decisions made by the trustees, including allocation of income to beneficiaries;
- copies of all promissory notes issued to beneficiaries for allocated amounts payable; and
- accurate bookkeeping and accounting records, including proper receipts for all deposits and disbursements, and entries to record allocations of income to beneficiaries.
In the event of a CRA review, the absence of such records will tend to result in the CRA disallowing many expenses, including allocations made to beneficiaries. In one particular case (The Howard Langer Family Trust v. M.N.R., 92 DTC 1055), the Tax Court of Canada considered a trust that kept no formal records, did not maintain a bank account, and provided no credible evidence that income was specifically allocated and paid to the beneficiaries. In the face of this lack of proper documentation, the Court denied the deductions for amounts the trust had allocated to the beneficiaries.
Save the original trust settlement property
A number of essential, prerequisite conditions must be satisfied to establish an effective trust. One such condition requires the settlor to identify and transfer some specific property to the trust. Often, a gold or silver coin or a $10 bill is used.
If the CRA does conduct an audit, it may request a review of that original settlement property. If that property is not produced, the CRA might deny the bona fide existence of the trust and seek to attribute all income earned by the trust to the settlor him/herself.
Remember the 21-year deemed disposition rule
A discretionary family trust is deemed to dispose of capital assets at the end of its 21st taxation year and every 21 years thereafter. Income tax is payable by the trust at those points to the extent that the fair market value of each capital asset, determined at the deemed disposition date, exceeds the trust's adjusted cost base in that particular asset. However, this income tax can be deferred if the trust property is distributed to one or more Canadian resident beneficiaries prior to the 21-year deemed disposition date. In order to defer the tax otherwise payable on each 21st anniversary date, trustees should implement careful advance planning. If these dates are missed, any deferral of the income tax otherwise available will be lost.
A number of specific technical requirements and anti-avoidance provisions must be satisfied for a trust to be effective. Look for discussion of these issues in future editions of Tax Alert.
Contact your Collins Barrow advisor for more information on the use of trusts in family and business planning.
Bill Crowther, CA, is a Tax Partner in the Peterborough office of Collins Barrow.
Information is current to April 5, 2011. The information contained in this release is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.