A trust is a “person” and a taxpayer for income tax purposes. As a result, it will be subject to income tax on its taxable income for a taxation year. In turn, if some or all of the trust income for the year is “paid or payable” to a beneficiary of the trust, the trust can generally deduct that amount from income and the beneficiary will normally be taxed on the income instead.
For most purposes, a trust is considered an “individual” under the Income Tax Act, like a human being. However, there are some important exceptions.
Taxation of trust on retained income
Income earned and retained in the trust for taxation year − that is, the income is not paid or payable to a beneficiary in the year − is normally taxed to the trust.
Most trusts are subject to tax on their taxable income at a flat rate equal to the highest marginal rate that applies to individuals. Currently, the federal rate is 33%; the provincial rate depends on the province. Typically, the combined federal+provincial rate is about 50% or higher.
The rationale for the high flat rate is to prevent individuals from setting up numerous trusts and attempting to split income at graduated rates that otherwise apply to individuals.
There are two exceptions, where trusts are subject to the same graduated tax rates that apply to individuals. First, the graduated rates apply to a “graduated rate estate”, which is generally a deceased’s estate for up to 36 months after the death (certain conditions must be met). Second, the graduated rates apply to a “qualified disability trust”. Generally, this is a testamentary trust (one that arises upon your death, normally created by your Will), where the beneficiary is disabled and eligible for the disability tax credit.
Taxation of beneficiaries on retained income of the trust
There are a couple of instances where income retained by the trust is taxed to a beneficiary rather than the trust.
First, this can occur where there is a “preferred beneficiary” under the trust and the trust makes a preferred beneficiary election. In such case, the elected amount is subject to tax in the hands of the beneficiary rather than the trust. This election can save tax if the beneficiary’s rate of tax is lower than the tax rate of the trust (as noted, the trust usually pays the highest marginal rate of tax).
A preferred beneficiary must either be eligible for the disability tax credit, or dependent on another individual by reason of physical or mental infirmity and have income less than the basic personal credit amount ($12,069 for 2019). Other conditions apply.
Second, a beneficiary will be taxed on income retained by the trust that is not otherwise paid or payable to a beneficiary under the age of 21. The beneficiary must have an unconditional right to the income in the year (which will typically be paid out in the future), although the right may be conditional upon the beneficiary reaching a certain age that is 40 years or younger.
In either case, where the income is taxed to the beneficiary in a current year, it can be paid out in a future year on a tax-free basis.
Taxation of beneficiaries on distributed income
To the extent income of a trust is payable to a beneficiary in a taxation year, it is normally deductible for the trust and included in the income of the beneficiary. As a result, there is typically only one level of taxation − either at the trust level or the beneficiary level.
Income is considered “payable” in a year if it is paid to the beneficiary in the year or if the beneficiary has the right in the year to enforce payment of the income. This latter point will often depend on the terms of the trust.
The trust can designate some types of income paid or payable to a beneficiary to preserve or “flow through” the nature of the income.
For example, the trust can designate that its dividends from Canadian corporations that are paid to a beneficiary flow through as dividends in the hands of the beneficiary. An individual beneficiary can then benefit from the dividend tax credit, since such income from the trust is considered to be dividend income.
A trust can also designate that its net taxable capital gains flow through to the beneficiary, which will be useful if the beneficiary has capital losses (since capital losses can only offset capital gains). If the capital gains result from dispositions of property eligible for the capital gains exemption, such as qualified small business corporation shares and family farm or fishing property, the availability of the exemption will flow out to the beneficiary to the extent of his or her remaining lifetime exemption.
Inclusion for trust where income is distributed to beneficiary
There is a rule that allows the trust to designate its income paid or payable to a beneficiary − that would otherwise be included in the beneficiary’s income as discussed above − to be included in the trust’s income and not the beneficiary’s income. This rule can be useful if the trust has loss carryforwards available to offset the income inclusion, as the income can than be paid out tax-free to the beneficiary.
Example
A trust has $50,000 of income this year, and $30,000 of unused non-capital losses from previous years. It pays out $50,000 to its beneficiary.
The trust can deduct $20,000 of the income paid to the beneficiary, leaving the trust with $30,000 of income. The $20,000 amount is included in the beneficiary’s income.
The trust can designate the remaining $30,000 to be included in the trust’s (and not the beneficiary’s) income, which can be offset by the $30,000 non-capital loss carryforward, resulting in no tax for the trust. The $30,000 amount is received tax-free by the beneficiary.
Deemed disposition rules
Most personal trusts are subject to the so-called “21-year deemed disposition” rule. This rule provides a deemed disposition and reacquisition of almost all trust property at its fair market value every 21 years. The deemed disposition ensures that accrued capital gains cannot be deferred indefinitely, although the rules can also trigger capital losses.
There are some exceptions where the deemed disposition occurs at a different time. For example, under certain spousal (or common-law partner) trusts, the first deemed disposition occurs on the death of the spouse beneficiary. Similarly, for an alter ego trust (generally, a trust in which you are the settlor and sole beneficiary during your lifetime), the first deemed disposition occurs on your death.
Income and gains that result from the deemed disposition rules are subject to tax in the trust and are not taxed to the beneficiary.