Income Splitting with a Trust (Strategy & Tax Concerns)
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A discretionary family trust can serve as a sophisticated legal means for income splitting by allowing a high-income individual, typically the settlor, to shift the tax burden of investment returns to beneficiaries in lower tax brackets. By transferring assets to a trust, the income and capital gains generated by those assets can be allocated and paid to beneficiaries, such as children or a spouse, who then report that income on their personal tax returns. Because Canada utilizes a progressive tax system, this strategy effectively utilizes the lower marginal rates and personal tax credits of family members, thereby reducing the household's aggregate tax liability. This arrangement is particularly effective for funding a beneficiary's specific expenses, such as post-secondary tuition or certain extracurricular activities, using pre-tax dollars from the perspective of the high-earning parent.
Despite the potential for significant savings, the primary obstacle to trust-based income splitting is the set of attribution rules within the Income Tax Act (Canada). These rules generally mandate that if property is gifted or loaned at a low interest rate to a trust for the benefit of a spouse or minor child, any resulting income (and in the case of a spouse, capital gains) is attributed back to the person who provided the funds and taxed at their higher rate [more on attribution rules]. To legally conform to these legal requirements, legal practitioners often employ a prescribed rate loan strategy, where the high-income earner loans capital to the trust at the Canada Revenue Agency (CRA) interest rate in effect at the time of the loan. As long as the trust pays this interest to the lender annually by January 30th, any investment return earned in excess of that prescribed rate can be taxed in the hands of the lower-income beneficiaries without being attributed back to the lender (more on prescribed rate loan strategies).
A second major hurdle is the Tax on Split Income (TOSI) regime, which was significantly expanded nearly a decade ago to curb the prior approach of income sprinkling from private corporations. TOSI applies the highest marginal tax rate (currently 33% at the federal level) to certain types of income received by individuals from a related business, effectively neutralizing any benefit of splitting dividends or trust distributions. While TOSI is a formidable barrier, various exceptions exist, such as for beneficiaries who are actively engaged in the business for at least 20 hours per week or for spouses of business owners who are 65 or older. Furthermore, TOSI generally does not apply to income derived from non-business sources, such as interest or dividends from a portfolio of publicly traded securities, provided the initial funding of the trust was structured to avoid the basic attribution rules (more on tax on split income strategies).
Implementing a trust also introduces administrative complexities and specific timing risks that must be managed to avoid punitive tax consequences. For instance, the 21-year rule, under the Income Tax Act (Canada), deems most trusts to have disposed of their capital property at fair market value every 21 years, potentially triggering massive unrealized capital gains. To prevent this, trustees must often plan to distribute the trust assets to beneficiaries on a tax-deferred roll-out basis before the anniversary date (more on trust roll-out strategies). Additionally, recent enhanced transparency rules require most Canadian trusts to file annual T3 returns and disclose detailed information about settlors, trustees, and beneficiaries, increasing the compliance burden and the risk of penalties for non-disclosure (more on trust documentation and transparency).
Finally, the legal validity of the trust and its transactions must be meticulously documented to withstand CRA scrutiny. If a trust is found to be a sham or if the income is not truly made payable to the beneficiaries (meaning they must have a legal right to enforce payment or the funds must be used for their direct benefit), the CRA may disregard the structure entirely. Effective record-keeping is essential, especially when trust income is used to pay for a minor's expenses; the taxpayer must be able to prove that the funds were actually applied for the child's benefit rather than simply returning to the parent's pocket. Failure to adhere to these strict legal and accounting formalities can result in the reassessment of all split income back to the settlor, along with associated interest and penalties.
Contact our law firm today to learn how our legal team can help you plan for the future, including wills, trusts, powers of attorney, personal directives and other estate planning documents, or deal with the legal demands associated with the passing of a loved one. Contact our law firm at 403-400-4092 or via email at Chris@NeufeldLegal.com to schedule a confidential initial consultation.
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