This is the third of a four-part series. In this article we will outline the benefits and applications of a trust.
A trust is a legal arrangement where legal title of property is transferred to trustees who control and administer the property on behalf of beneficiaries. Since it is a distinct tax entity, trusts are required to file annual tax returns. Let’s review how inter-vivos and testamentary trusts can reduce your tax bill.
An inter-vivos trust is between living persons. Establishing an inter-vivos discretionary family trust while you are alive may protect your assets (e.g., house, cottage and hygiene goodwill of your dental practice) from creditors and lawsuits and at the same time income-split with your family. Although you no longer own the assets, you can direct who gets what if you are one of the trustees.
A discretionary family trust provides flexibility in distributing income amongst beneficiaries in different tax brackets. In addition, by restructuring the shareholdings of your company using a family trust, you can cap or freeze your future tax bill. All future growth of the business can be channeled into the shares held by the family trust. This is ideal for estate planning purposes as your tax bill, upon death, can be minimized.
As income of an inter-vivos trust is always taxed at the highest personal tax bracket, it is best to distribute all income to beneficiaries. A practical example in using an inter-vivos trust is to transfer your hygiene/technical goodwill to a hygiene or technical corporation (H/TSC). The common shares of this H/TSC are then owned by a trust. The trust would receive dividends from the H/TSC and then pay the same to its beneficiaries (spouse, children, parents, cousins, nephews, aunt and uncle) who are at a lower tax bracket. Beneficiaries could be anyone selected by you. The bottom line is to achieve tax savings.
In addition to dividends, when you sell shares of your H/TSC, any capital gains realized can be channeled to the hands of the beneficiaries. Beneficiaries can utilize their lifetime capital gains exemption to shelter any possible taxes from the sale. It is no longer beneficial to pay dividends to children under 18. Hence, income splitting works best with individuals 18 or over. Beneficiaries can receive up to $35,000 of dividends from the trust virtually tax-free if they have no other income. With the new dividend rule proposed by the federal government in November 2005, an individual with little or no income may receive approximately $49,000 of dividends and pay virtually no tax.
Another use of the trust is to transfer properties (for example, a house or cottage or investments) to a trust to eliminate or minimize the probate fees levied on your death. However, the initial transfer might result in a tax bill unless you are 65 or over. In Ontario, the probate fees are $5 on each $1,000 for the first $50,000 and $15 per $1,000 thereafter. That means, if you have assets of $1M, your probate fee could be $14,500.
A testamentary trust is incorporated into your will and takes effect upon your death. It ensures that property is held and managed for your beneficiaries long after your death. A testamentary trust saves taxes as it is taxed in the same way as an individual, unlike an inter-vivos trust whereevery dollar is taxed at the top rate. Each dollar is taxed at the graduated tax rates starting with the lowest tax rate and going up. You might achieve a tax saving by creating multiple testamentary trusts. Consult with your legal advisor when drafting/updating your will.Other tax saving ideas will be covered in the final installment of this four-part series in the next issue.