December 1, 2004
by John McMillan, LL.B. and David Harris, MBA, TEP
You have by now learned that high income attracts high taxes. Additionally, some readers may have learned that large asset holdings can be vulnerable in the event of litigation or bankruptcy. The main issues then, are how to minimize taxes and protect assets with the underlying objective of providing for present and future generations. Towards these ends, the creation and maintenance of a Trust can be a powerful tool.
For example, income from your hygiene operations (and in several provinces, your dentistry operations) can be channeled through incorporated entities into a Trust and distributed to family members at potentially considerable tax savings. Additionally, many of your assets may be transferred to a Trust, which can provide asset protection from (future) creditors.
What is a Trust?
Trusts are unique. While they can possess all the powers of a natural person or corporation, they are neither. Significantly, Trusts are deemed to be persons for the purposes of the Income Tax Act (discussed below). Trusts are essentially a way of (among other things) separating yourself from your property while at the same time retaining control of how the property (and its fruits) will be dealt with, and ultimately distributed.
A simplistic (but sufficient) definition of a Trust is a legal arrangement whereby one person (the Settlor) gives or transfers property to another person or persons (Trustee(s)) to hold to the benefit of one or more other persons (Beneficiaries).
Requirements for Trusts
For a valid Trust to be formed, it must possess and exhibit certain essential elements. First, the Settlor must have a clear and imperative intention, which can be as broad and straightforward as “for the support, well being, maintenance, education and advancement of the Beneficiaries.” Second, the Trust must hold some type of well-defined property on a continuous and uninterrupted basis. Otherwise, the Trust will fail. Third, there must be one or more Trustees. Fourth, the beneficiaries of the Trust must be certain. It is possible to either specifically identify the beneficiaries or to include a class of individuals (provided the class is fully described, leaving absolutely no doubt as to whether any one individual belongs to that class).
All of these elements are fully described and provided for in a written Trust Agreement, which is strongly recommended.
Creating a Trust
The events contributing to the creation of a Trust will include the Settlor settling the Trust by giving a clear and express statement of intention and contributing the initial property. Property must be continuously held by the Trust. In some cases, a nominal settlement such as a silver coin is used with the intention of having the Trust hold the coin continuously, to be certain that there is no gap in property ownership. In cases where a Trust is used to protect assets from future creditors, normally, the assets being protected are used as the settlement.
The property of the Trust (and any future property contributed) will then be in the hands of the Trustees and subject to the Trustee’s powers and limitations set out in the Trust Agreement. Trusts can hold all manner of property, including tangibles (real estate, collections, valuables) and intangibles (shares, promissory notes, benefits under contracts).
A properly drafted Trust Agreement will clearly set out all of the powers (and limitations) of the Trustees. Generally, the Trustees can (and usually are) given all the powers and privileges to deal with the Trust property as if they were the owner of the Trust property, subject of course to the overriding obligation to deal with such property for the benefit of the Beneficiaries.
Taxation of Trusts
It would be impossible to provide a full treatment of the tax benefits (and disadvantages) on one short article. However, the following salient points should be noted:
The Income Tax Act treats Trusts as “taxpayers” that must file annual tax returns if they have income.
Trusts pay tax based on the difference between income received by the Trust and amounts allocated to beneficiaries.
Trust Income, once taxed, becomes “capital” of the Trust and can be distributed to beneficiaries tax-free, so there is no double taxation of Trust income. This “Trust or beneficiary” phenomenon provides some planning opportunities.
Just like individuals, Trusts only pay tax on 50 percent of capital gains and receive the “dividend tax credit” on Canadian dividends.
Income allocated to beneficiaries keeps its character–when a Trust allocates dividends, the income is taxed as dividends on the personal returns of beneficiaries. Ditto for capital gains and interest.
Since the introduction of the “Kiddie Tax”, beneficiaries under the age of 18 are now taxed at the highest marginal rate on all income distributed to them by the Trust.
The tax rate on income depends on whether a Trust is a “testamentary Trust” (settled by the will of a deceased person) or an “inter-vivos” Trust, settled by a living Settlor.
Testamentary Trusts receive preferred treatment — they pay tax at graduated tax rates like individuals. This presents an opportunity for “post-mortem income splitting” between an individual and a Trust. Normally, income on your property will become your spouse’s after your death with the tax determined by the spouse’s total income. Assume that your spouse has annual income of $100,000 and then inherits your property that produces $30,000 annually. Total income will be $130,000, with high tax applied to the inheritance.
Alternatively, with a testamentary Trust, on your death your spouse’s income remains at $100,000 with the Trust earning the other $30,000. The Trust’s income will be taxed at the lowest personal rate, saving about $10,000 annually for the rest of your spouse’s life. Testamentary Trusts also protect assets from your spouse’s present and future creditors, a topic that will be discussed more fully later.
Inter vivos Trusts
In contrast, inter vivos Trusts are taxed on all undistributed income at the top personal tax rate. The government’s intent is indifference between having tax paid by a Trust or a high-income individual. Many accountants who assist in the preparation of Trust income tax returns even force all Trust income to be distributed annually. This is not always the best approach– there may be advantages to having your Trust taxed instead of you. While the highest tax rate is applied to Trust income, federal and provincial “surtaxes” that apply to individuals are not.
Because Trusts are taxed in their province of residence, there have been uses made of Trusts domiciled in a province with tax rates lower than the beneficiaries. An Ontario resident (top tax rate 46 percent) could gain a significant advantage by having an Alberta-domiciled Trust pay 39 percent instead. There are some anti-avoidance rules designed to prevent this type of strategy that must be resolved for successful implementation.
Uses of Trusts
The number of Trusts in Canada has mushroomed in the past decade as advisors have discovered uses for this extremely flexible vehicle.
The three most relevant uses for dentists will be discussed.
Family income splitting
If the provincial regulatory body in your province permits non-dentist ownership of professional corporations, or if you have a Technical Service (dental hygiene) Corporation, a Trust provides a safe, flexible way to distribute income to family members. Some or all of a corporation’s profit may be distributed to the Trust, which then discretionarily allocates funds to beneficiaries who are taxed at their own tax rate. Allocating to a spouse and children 18 years and older, and even your parents if circumstances permit, may result in significant tax savings.
Unlike when paying salaries, there is no requirement for beneficiaries to provide services in exchange for amounts received from a Trust. Since beneficiaries only get distributions at the pleasure of the trustees, u
nlike owning shares, they have no claim against a company’s income or assets.
Protection of assets
Because beneficiaries (and therefore their creditors) do not have a claim against assets of a Trust, a growing use of Trusts is ownership of personal assets like houses, investment portfolios and cottages, and business assets such as the value of your Technical Services Corporation and, where permitted, your professional corporation.
Proper implementation of this strategy will prevent future creditors from accessing these assets. As damage awards continue to increase for things like malpractice and vehicle accidents, many professionals are using Trusts to provide additional protection for personal assets beyond what their liability insurance can.
There are tax consequences that may arise from the transfer of assets to a Trust. Further, statutory restrictions under the the Bankruptcy and Insolvency Act (Canada) and other provincial legislation can prevent or defeat the use of Trusts designed to frustrate existing creditors, so implementation requires knowledgeable professional advice.
In addition to the previously discussed tax benefits from making use of testamentary Trusts in your will, there is one other important attribute of these Trusts–assets held by them do not belong to the beneficiary of the Trust, so protection is provided from their creditors, matrimonial disputes and other claims.
Also, when a Trust is created by your will, you can determine what happens to Trust assets on the death of the initial beneficiary. For instance, you can leave assets to a Trust for your spouse, and direct that on the spouse’s death the assets will be divided between your children.
If you do not use a Trust and bequeath outright to your spouse, the spouse’s will determines what will happen on their death. There have been a number of cases where a widow or widower remarries and bequeaths assets they inherited to their next spouse.
There are also special types of Trusts available to those 65 or older that will allow them to minimize probate costs on death and liability for funding long-term care. A discussion of these “alter-ego” and “joint-partner” Trusts, is beyond the scope of this article.
As Trusts are designed to protect the user from something (such as taxes or creditors), it is essential that strategies involving Trusts be designed and implemented carefully. There are a number of traps involving Trusts that are not always properly addressed. Two of the most common from our experience are outlined here.
The Income Tax Act contains a number of anti-income splitting provisions. These rules apply to Trusts when a Trust acquires property in any way (loan, gift, sale etc) from a beneficiary of the Trust. In this case, all income from this “reversionary” property, or any property substituted for it, forever belongs to the person giving it to the Trust.
If the goal of a Trust is to split income, failure to address this rule can have disastrous consequences, especially if discovered after the fact. For example, clients who put personal funds in their Trust bank account (possibly to cover an overdraft) can permanently taint their Trust.
Many people who have Trusts erroneously believe that they must terminate after 21 years. However, for tax purposes, every 21st anniversary, a Trust is deemed to sell and reacquire all property at fair market value. If property has appreciated in value since acquisition, and if no planning was done, the Trust would experience a capital gain.
This “deemed disposition” is fairly easy to avoid–a Trust can distribute “capital property” to beneficiaries at any time without tax. Doing this before the 21st anniversary will prevent the deemed disposition.
Some Trust designers have made their Trusts “implode” just before the 21st anniversary to avoid this problem. If properly planned, there is no reason to terminate the Trust, assuming it has distributed any appreciated property. Also, there may be situations where it is better to pay the tax and keep assets in the Trust (for example if the intended beneficiary has creditors waiting to pounce).
Professional advice needed
Whether the goal of a Trust is to save taxes or protect a dentist from creditors, there is some chance that it will be scrutinized either by Canada Revenue Agency or creditors. Accordingly, it is essential that experienced professionals be consulted in the design, implementation and maintenance of a Trust. Trusts can be an effective way of dealing with the challenges that can arise from the accumulation of wealth. Given the potential advantages, it is worth investigating, with the assistance of your advisers, if this is a worthwhile strategy for you.
John McMillan is a Toronto business lawyer serving dental professionals. johnmcmillan@ bellnet.ca
David Harris is a Registered Trust and Estate Practitioner providing tax planning and strategic consulting to dentists. email@example.com.