Trust Flow-Through Strategies to Minimize Tax
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The taxation of trusts is designed around a conduit principle, which allows income to be taxed either at the trust level or in the hands of the beneficiaries. By default, most inter vivos (living) trusts and non-qualified testamentary trusts are taxed on any retained income at the highest marginal tax rate for individuals (which in Alberta would be approximately 48%). To avoid this heavy tax burden, the most common strategy is to flow the income through to beneficiaries under Subsections 104(6) and 104(13) of the Income Tax Act (Canada). This mechanism allows the trust to claim a deduction for the income it distributes, while the beneficiary includes that same amount in their personal tax return, potentially benefiting from their lower personal marginal tax brackets.
For this flow-through to be legally effective, the income must be "paid or payable" to the beneficiary within the same taxation year it was earned. Under Subsection 104(24) of the Income Tax Act, an amount is considered "payable" if the beneficiary has a legal right to enforce payment, even if the actual cash has not changed hands. In practice, trustees often satisfy this requirement by issuing a demand promissory note to the beneficiary. This creates a legally binding obligation that allows the trust to deduct the amount from its own taxable income, effectively shifting the tax liability to a beneficiary who may have a much lower effective tax rate due to the graduated nature of personal income tax.
Another sophisticated way to optimize this flow-through is by utilizing the "character" of the income. When income flows through a trust, it generally retains its original nature (such as eligible dividends or capital gains), provided the trustees make the appropriate designations in the trust's tax return (T3). For instance, if a trust realizes a capital gain and allocates it to a beneficiary, the beneficiary only includes the taxable portion (currently 50% for individuals on the first $250,000 annually, though rules for 2026 are more stringent for higher amounts) in their income. This allows the family unit to utilize the beneficiary’s lower tax rates and specific tax credits, such as the dividend tax credit, which would be wasted if the income were taxed at the top flat rate within the trust.
While most trusts are taxed at the top rate, there are two significant exceptions: the Graduated Rate Estate (GRE) and the Qualified Disability Trust (QDT). A GRE can exist for up to 36 months following an individual's death and is taxed at the same graduated rates as a living person [more on the Graduated Rate Estate]. Similarly, a QDT is a testamentary trust for a beneficiary who qualifies for the Disability Tax Credit and can also access graduated tax rates [more on Qualified Disability Trusts]. If your trust qualifies as one of these entities, it may be more tax-efficient to retain some income within the trust to take advantage of its own lower tax brackets before flowing the remainder out to beneficiaries, thereby doubling up on the available graduated tax buckets.
It is also vital to navigate the Tax On Split Income (TOSI) rules, which were significantly expanded in recent years to prevent income sprinkling. If TOSI applies, income flowed through to certain beneficiaries (typically family members of a business owner) is automatically taxed at the highest marginal rate regardless of their other income. To avoid this, trustees must ensure that the distributions fall under specific exclusions, such as the excluded business or excluded shares exceptions. Without careful planning to meet these criteria, the attempt to flow-through income to lower-income family members may be neutralized by the TOSI hammer, resulting in the very high-tax outcome you were trying to avoid.
Finally, proper documentation and timing are the pillars of a successful flow-through strategy. The Canada Revenue Agency (CRA) requires that all allocations be clearly documented in the minutes of the trust and reported on T3 slips issued to beneficiaries within 90 days of the trust's year-end. If the trustees fail to make the income "payable" by December 31st, or if the trust’s deed does not grant the power to distribute income, the CRA may deny the deduction at the trust level.
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.comd to schedule a confidential initial consultation.
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