The right way to build a family trust

Planning benefits should trump tax savings when you build a family trust. But that doesn’t stop some people from placing assets into trusts expressly to trim their tax bills.

CRA doesn’t like that.

And to push back it’s created attribution rules, including Section 75(2) of the Tax Act.

Whenever that section’s invoked, all income and capital gains from trust property are attributed back to the person who contributed the property; rather than the trust itself.

That didn’t stop some family trusts from using it to create tax-free inter-corporate dividends. Unfortunately for those trust holders, CRA invalidated the strategy.

And, it gets worse, because even people who aren’t trying to pull one over on CRA can accidentally trigger 75(2), also known as the reversionary trust rule, and wind up with unexpected tax consequences.

Here’s how to make sure family trusts operate as intended.

Trusts are meant to hold property for the benefit of someone other than the person who puts property in that trust (settlor). So once someone settles, or transfers, something into a trust, he or she technically doesn’t own it anymore.

If a loophole lets the settlor get any property back as a beneficiary, then Section 75(2) kicks in. And any income, capital gains or losses become his problem.

Essentially, it means that for tax purposes, the property was never transferred. And the trust loses its ability to roll out assets at cost.

So if an asset went into the trust at $50,000, and it’s now worth $100,000, the trust has to report the extra $50,000 and pay tax on it.

But, if Rule 75(2) isn’t invoked, the trust “can transfer the asset out at the $50,000 cost base. The beneficiary gets the asset and doesn’t pay tax.” If he sells it five years later, when it’s worth $150,000, he pays the tax at that time—the trust doesn’t, and neither does the settlor.

The best defence is to settle the trust and have no further involvement with contributed assets.

But you have to prove to CRA that you’re really not involved.

A client who both settles a trust and tries to be its sole trustee will trigger 75(2).

To avoid this, appoint two other trustees. This prevents you from having a controlling interest but you still have a say in how trust assets are managed.

A majority rule clause goes a long way to ensuring CRA doesn’t suspect the settlor-trustee of trying to overrule the other two.

And, name alternate trustees in case anyone dies or becomes incapacitated.

The best way for a beneficiary to contribute property to a trust is to loan it at fair market value.

Or borrow the money that buys the property from a bank. That way no trustee actually contributes the funds that buy the property.

Say a company’s owner wants to place 100 new common stock shares, worth $1 each, into a trust. The trust can open an empty bank account with overdraft protection – no point taking out a loan for this sum.

The trustee then writes a cheque for $100 to the operating company to buy the common shares.

By triggering the overdraft you technically create a bank loan. Then, the dividend from the operating company goes to pay off the overdraft. Or, in the case of a larger contributed amount, it pays off the bank loan.

Section 75(2) can also be avoided by selling property to the trust. But that sale must be at fair market value, otherwise CRA will declare it a gift and that triggers tax consequences.

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.