Use of Trust in Tax Planning

This memo provides an overview of the use of inter vivos trusts (created during one’s lifetime) for tax, estate and succession planning and summarizes the key concepts and benefits.  It also outlines some specific situations where trusts may be advantageous, as well as other important considerations.  It is intended to assist in determining whether an inter vivos trust may be an appropriate planning tool for your tax, estate, or family objectives.

Key Concepts

An inter vivos trust is a legal arrangement established by a settlor during their lifetime, whereby property is transferred to a trustee to be managed for the benefit of one or more beneficiaries. The property used to settle the trust is typically of nominal value (such as a $20 bill).  The settlor will typically have no other involvement with the trust after its creation.  The trustees of a trust administer the trust and make decisions in accordance with the terms of the trust, including with respect to the distribution of income and property to the beneficiaries.  The trust’s beneficiaries may receive income or property from the trust and can include individuals (including children/grandchildren born in the future, as well as future spouses), corporations and other entities.

The terms of a trust may provide the trustees with complete discretion over distributions to beneficiaries, or these can be fixed by the trust deed.  While it is generally preferable for the trust to be discretionary so as to provide flexibility in the event of changes to a family’s situation over time, it is possible to generally provide the trustees with this discretion, while also imposing certain parameters in the event of specific triggering events (such as upon the death of certain individuals, or immediately prior to the trust’s 21st anniversary).

Taxation

Inter vivos trusts are generally taxed as separate individuals at the highest marginal tax rate on any income retained in the trust.  Income paid or payable to beneficiaries is deductible by the trust and is instead taxed in the beneficiaries’ hands.  For this reason, all income and taxable capital gains earned by a trust is typically distributed to the beneficiaries and generally taxable at their marginal personal tax rates.

Inter vivos trusts must have a December 31st year end and are generally required to file a T3 Trust Income Tax and Information Return annually, no later than 90 days after year end.  As part of their annual tax filing, trusts are required to report certain information about all beneficiaries, trustees, and the settlor, including their names, addresses, dates of birth and Social Insurance Numbers.

Deemed Disposition on 21st Anniversary

To prevent the indefinite deferral of tax, most inter vivos trusts are generally deemed to have disposed of trust assets every 21 years, triggering tax on accrued gains for any assets held by the trust at those dates.  This deemed disposition can be avoided by distributing assets from the trust to beneficiaries prior to this 21-year anniversary.  The distribution of assets by a trust to Canadian-resident beneficiaries generally takes place on a tax-deferred basis, with the beneficiary assuming the trust’s adjusted cost base for those assets.  As a result, the beneficiary receiving the property will eventually be subject to tax in respect of those gains, whenever the assets are eventually disposed.

Where there are concerns about distributing assets to beneficiaries at the 21st anniversary, but where the plan is to ultimately distribute assets to those beneficiaries, it may be possible to distribute the assets in a way that restricts the beneficiaries’ control over those assets.  This type of planning would add complexity to the overall structure but may be feasible under the right circumstances.

Benefits of Inter Vivos Trusts

Inter vivos trusts may provide various benefits, including:

• Capital Gains Exemption Planning
  Individuals resident in Canada are entitled to a lifetime capital gains exemption of $1,275,000 in respect of the sale of shares of Canadian-controlled private corporations (“CCPCs”) that meet certain tests, effectively allowing individuals to shelter up to $1,275,000 in qualifying capital gains from tax.  The use of a trust to hold shares of a CCPC may allow a family to maximize access to this capital gains exemption and minimize taxes payable on the sale of the business.
  
  
• Facilitate Flow of Funds Between Corporations
  Using a trust to hold shares of a corporation carrying on an active business may facilitate flowing dividends from the operating company to an investment holding company without incurring additional corporate tax.  This structure, (commonly referred to as a “trust sandwich”), can thus provide additional capital that can be invested within the holding company.
  
  
• Income Splitting
  Earning investment income in a trust may allow for income splitting with family members by distributing the income from the trust to beneficiaries who are in lower tax brackets.  However, there are income attribution rules within the Income Tax Act (“the Act”) that can deny these benefits and these should be considered.

• Estate Planning
  Trusts are commonly used to implement an “estate freeze” to allow for future growth in the value of assets to be taxed in the next generation, potentially providing a significant tax deferral.
  
  
• Control and Flexibility
  The trustees can dictate how and when income and assets are distributed from the trust, such that no beneficiary has any fixed entitlement to income or property of the trust.  The provisions of the trust can also include certain parameters that may bind the trustees’ decision-making in certain situations.
  
  
• Asset Protection
  Properly structured discretionary trusts may protect assets from creditors, marital breakdown, or legal claims against beneficiaries.
  
  
• Privacy
  Trust agreements are private documents, unlike wills which become public after probate.  Accordingly, the general public cannot access information about a trust.
  
  
• Probate Avoidance
  Assets held in an inter vivos trust are not part of one’s estate, such that they are not subject to probate fees upon one’s passing.

Other Considerations

• Association of Corporations
  Corporations that are “associated” for tax purposes are required to share certain tax incentives, including entitlement to the low corporate tax rate on the first $500,000 of annual active business income, as well as access to refundable SR&ED tax credits.  The use of a trust could result in corporations that might not otherwise be associated becoming associated, thereby limiting the group’s entitlement to these benefits.
  
  
• Income Attribution Rules
  The Act contains rules that may restrict income splitting opportunities by attributing investment income back to an individual who has contributed property to the trust.  These rules are intended to prevent income splitting in some situations.
  
  
• Alternative Minimum Tax (“AMT”) and Interest Expense/Investment Management Fees
  AMT is an alternative tax calculation intended to ensure that a certain minimum amount of tax is paid where a taxpayer has certain tax preferential income or deductions.  Only 50% of interest expense incurred in connection with investments in marketable securities is deductible for AMT purposes, which will generally result in a trust being liable for AMT where it has such interest expense, even if the trust has distributed all of its net income.  The November 4, 2025 draft federal legislation also includes investment management fees incurred by a trust as an expense which is only 50% deductible for the purpose of the AMT calculation which, if enacted, will exacerbate this issue.
• Legal and Administrative Costs
  Establishing and maintaining a trust involves legal fees, annual tax filings and potentially trustee compensation.  The trustees should also maintain proper books and records of the trust’s activity, including resolutions and promissory notes with respect to distributions of income and property to beneficiaries.
  
  
• Deciding on Beneficiaries
  There are various tax and legal issues with adding beneficiaries to a trust after its creation.  For this reason, it is recommended that thought be put into deciding on the beneficiaries of the trust at the time of its creation, noting that it is possible to include beneficiaries by category (i.e., children, grandchildren, siblings, etc.) without specifically naming an individual.  Consideration should also be given to whether the information about beneficiaries that must be reported in the T3 tax return is readily available and if not, whether you are comfortable asking for this personal information.
  
  
• Choice of Trustee(s)
  The trustees’ role is essential, so they should have the ability and reliability to manage the trust in accordance with its terms and applicable laws.  Consideration should also be given to the number of trustees and how decisions can be made (i.e., requirement for the consent of the majority of trustees).
  
  
• Provincial Law
  Trust law can vary by province, particularly in Quebec.  The impact of these differences should be considered when establishing and maintaining a trust.

Conclusion

Inter vivos trusts are a versatile tool for tax, estate, and succession planning, offering flexibility, control, asset protection, and privacy.  However, they involve tax, legal, and administrative complexities and must be carefully structured and monitored to achieve the desired objectives and avoid adverse tax consequences.

Contact your Welch LLP advisor if you would like to discuss whether a trust is appropriate for your circumstances or if you require assistance with trust planning and implementation.