Reducing Your Children's Canadian Income Taxes with Trusts

[The Federal Government in its 2014 Budget announced changes to tax law that will with some limited exceptions treat testamentary trusts similarly to other trusts, with income earned and retained in the trust taxed at the top marginal rate, instead of graduated rates beginning in 2016. Accordingly, the article below will no longer be accurate. There may still, however, be some tax-planning opportunities available using trusts, but these are more limited than when this article was written.]

There can be significant long term Canadian income tax savings for your children and their families if you create discretionary trusts for each of your children and their families in your will, instead of leaving them their inheritances outright.

A trust involves having one or more persons, called trustees, hold the assets for the benefit of others, called the beneficiaries. You can appoint one or more trustees to hold the assets for the life of your child. The trust would have several beneficiaries, including your child. You might include your child’s spouse, children and grandchildren. You can give the trustee control over when to make distributions from the trust of income or capital to any of the beneficiaries. The trustee could distribute to one or more beneficiaries to the exclusion of the others at the trustee’s discretion. If you have more than one child, you can set up a separate trust for each child, and that child’s family.

There are a couple of ways that this can save taxes for your children.

Canadian income tax law treat a testamentary trust, which includes a trust created by a will, as a separate taxpayer from the beneficiaries. Trustees must pay income taxes from the trust on income earned the trust’s investments, unless the trustees pay the income to the beneficiaries, and claim a deduction for the income paid or payable to the beneficiaries. If the trustees claim a deduction for the income paid or payable to the beneficiaries, then the beneficiaries are required to report the income, and pay income tax on the income deducted by the trustees. (See Canada Revenue Agency's Interpretation Bulletin "IT-342R Trusts - Income Payable to Beneficiaries" for a more detailed and technical description.)

Testamentary trusts are taxed at graduated marginal rates of tax. In other words, the rate of tax is relatively low for the first $33,000 earned by the trust in a year, and the rate then increases at various higher levels of income.

Where the trust’s rate of income tax is lower than a beneficiary’s marginal rate of income tax, the trustees can save taxes by claiming the income in the trust and paying the tax at the trust’s rate of tax. On the other hand, if some of the beneficiaries have little or no income, the trustees can distribute some of the income to those beneficiaries, who may have to pay little or no tax.

Lets take a simple example. Supposing you leave your daughter $400,000 out right in your will. She is a resident of British Columbia. She invests the money and in a year, she receives interest income of $16,000 on the $400,000 investment. Her other income is employment income of $60,000 per year. Therefore, her total income is $76,000. According to the Ernst & Young tax calculator for 2005, her combined Canadian and British Columbian income taxes would be about $19,000. (No doubt, it would be a little different depending on her specific circumstances, and what credits and deductions are available to her, but these numbers should be fair for comparison purposes.)

If, on the other hand, you leave the $400,000 in a British Columbia resident trust created in your will, and the trustees invest it at the same return, earning $16,000 investment income, the total income tax will be less. Your daughter would pay income tax of about $13,700 (using the Ernst & Young tax calculator.) The trust would pay income taxes at a tax rate of about 22.05%, or about $3, 500. The amount of tax paid by your daughter and the trustees combined would be about $17,200 instead of about $19,000 if your daughter invested the income and paid all of the taxes. The tax saving in that year would then be about $1,800. Over a long period of time the tax savings would be significant.

If your daughter had children in college with little or no income, the trustees could distribute the income to your daughter’s low income children, and the tax savings to your daughter’s family would be greater. This is because your children can claim personal tax credits that are not available to the trust.