Moore
February 2017 Newsletter

There are various tax rules that apply to trusts and their beneficiaries. Below is a summary of some of the main rules.

Tax rates for trusts

Most trusts are subject to a flat tax equal to the highest marginal tax rate – currently 33% federally plus the applicable provincial rate. As a result, there is typically no tax savings if income is earned and retained in a trust.

There are two exceptions to the high flat tax. The first applies to a “graduated rate estate”, which is a deceased individual’s estate for up to 36 months after death (certain other conditions apply). The second applies to a “qualified disability trust”, which is a testamentary trust that has a beneficiary who qualifies for the disability tax credit (again, certain other conditions apply). Generally, a testamentary trust is one that is created upon your death, such as a trust created by your will. Graduated rate estates and qualified disability trusts are subject to the same graduated tax rates that apply to individual (e.g. 15% on the first $45,916 in 2017).

When an amount of income of a trust is paid or payable to a beneficiary in a year, it can normally deduct the amount. The beneficiary in turn includes the amount in income. As a result, there is generally no double taxation of the same income.

Taxation year

All personal trusts other than graduated rate estates have a calendar year taxation year.

A graduated rate estate can have an off-calendar year taxation year for the first 36 months, after which, if it is still in existence, it will have a calendar year end. For example, if an individual died on June 30, 2016, the estate could have its first three taxation years ending on June 30 of 2017, 2018 and 2019, respectively, with the next taxation year ending on December 31, 2019. Alternatively, the estate could have calendar year ends right from the start, so that its first taxation year would be short and would end on December 31, 2016, and all subsequent taxation years would be calendar years. The decision as to the taxation year would normally be made by the executor or administrator of the estate.

Note that before 2016, all testamentary trusts could have off-calendar year taxation years.

Deemed disposition rules

Most personal trusts are subject to a deemed disposition of their property at fair market value every 21 years. The deemed disposition ensures that accrued capital gains cannot be deferred indefinitely.  At the time of the deemed disposition, the cost of the properties is also adjusted to fair market value.

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 at the death of the spouse beneficiary.

Similarly, for an alter ego trust (basically a trust in which you are the settlor and sole beneficiary during your lifetime), the first deemed disposition occurs at the time of your death.

Tax-free rollover for property distributed out of trust

A personal trust can normally distribute its properties to its beneficiaries on a tax-free “rollover” basis, at the original cost. Thus, for example, a trust can avoid the deemed disposition referred to above by transferring out its property tax-free to a beneficiary before the deemed disposition date.

The transfer of the property out of the trust takes place at the cost of the property, which also becomes the cost to the beneficiary. Therefore, accrued gains can be eventually taxed if and when the beneficiary disposes of the property.

Again, there are some exceptions to the tax-free rollover. For example, the rollover does not apply to distributions to non-resident beneficiaries. It does not apply to a spousal trust if property is distributed to someone other than the spouse beneficiary during his or her lifetime. In these cases, the distribution takes place at fair market value, and therefore will trigger accrued gains (or in some cases losses).

Taxation of beneficiary

As mentioned, when income of a trust is paid or payable to a beneficiary in a taxation year, it is included in the beneficiary’s income for the year. Most forms of income can retain their character. For example, a trust can designate that taxable capital gains and dividends of the trust paid to a beneficiary retain the same character in the hands of the beneficiary, so as to benefit from the reduced taxation that applies to these kinds of income.

Trust losses cannot be flowed out to beneficiaries and therefore always remain losses of the trust.

However, a trust with income in the current year can carry forward losses from previous years to offset the income inclusion in the current year. The trust can then pay out the income to a beneficiary in the current year, and make a special designation that has the effect of not taxing the beneficiary on that income (since it was already included in the trust’s income, although offset by the losses). The designation is valid only if the trust’s “taxable income” is nil for the year – which basically means that the income is fully offset by the loss carryforward.

Example

A trust has two beneficiaries. In the current year, it earns $20,000 of interest income. The trust has $20,000 of losses from previous years which it carries forward to the current year, resulting in nil taxable income for the trust.

The trust distributes $10,000 to each beneficiary and makes the designation. Each beneficiary receives the amount free of tax. And, of course, the trust will pay no tax because of the loss carryforward.

In some cases, income retained in the trust can be subject to tax in the beneficiary’s hands. This can be beneficial if the beneficiary is subject to lower tax rates than the trust. This rule can apply to trusts that make a “preferred beneficiary election”, which can be made in certain circumstances where the beneficiary is entitled to the disability tax credit. A similar rule can apply in respect of trust income retained in the trust, where the right to the amount of income vests in a beneficiary under the age of 21 (in general terms, this means that the beneficiary is unconditionally entitled to receive the amount at some point in time in the future, even though it is not paid or payable now).

Last modified on February 14, 2017 12:00 am