THE DISCRETIONARY FAMILY TRUST
This edition of Landry,McGillivray “ Advisor” is intended
as general information only, with respect to a discretionary family
trust. A lawyer in our firm should be consulted prior to proceeding
with a discretionary family trust.
1. GENERAL ASPECTS
A trust is a relationship in which one person (known as the settlor)
transfers property to another person or persons (the trustees) for
the benefit of certain other persons (the beneficiaries).
Discretionary family trusts are used in corporate reorganizations
and estate freezing to transfer future income and wealth to a taxpayer’s
family. Those family members then use their lower marginal tax rates
to effect overall savings and the potential for making multiple
use of the super capital gains exemption is enhanced.
Interests in trust include income and capital interests. An income
interest entitles a beneficiary to a share of the income earned
by the trust property. A capital interest entitles a beneficiary
to a share in the trust property, the capital, when it is distributed.
A trust is flexible. A settlor can name any persons as beneficiaries
of the trust. In the discretionary trust, the income and the capital
interests of a beneficiary are contingent on the discretion of the
trustees to allocate income or capital to the beneficiary. Thus,
the principal can maintain control over the underlying shares held
by the trust and the income attributable to it.
The income beneficiaries of a discretionary family trust are usually
the principal and the spouse, children, children’s spouses,
grandchildren and their spouses. The capital beneficiaries are usually
the same persons.
2. BENEFITS OF A TRUST AS A SHAREHOLDER
There are additional advantageous aspects of having shares owned
by a trust:
|| a principal can undo the arrangement easily by
distributing the assets to himself or in any proportion to the
|| the trust does not pay tax if it allocates and pays its income
||with a discretionary trust, the allocation of income can change
from year to year;
||dividends maintain their character as they flow through a
trust. Therefore, individuals without income from other sources
can earn about $30,000 of dividends without any tax costs; and
||capital gains retain their identity as they flow through the
trust, and may be eligible for the enhanced capital gains exemption.
3. ANCILLARY BENEFITS OF DISCRETIONARY FAMILY TRUSTS
a) Estate Planning
A discretionary family trust survives the death of an individual.
Therefore, the shares in the trust are not subject to estate proceedings
nor probate fees. The deceased would be replaced as a trustee and
the trust would continue.
b) Creditor Protection
Each principal controls the underlying assets, those assets are
subject to the rights of the other beneficiaries. Therefore, the
underlying assets should be safe from the
c) Estate Freezing
There is merit in being able to pass future appreciation in the
value of the shares to family members. The most important reason
is to provide an opportunity to “tax”future capital
gains in their hands. Those beneficiaries could use their capital
gains exemption to reduce or eliminate future income tax.
In the past, the potential disadvantage of estate freezing has
been loss of control. A freeze in favour of a discretionary family
trust does not suffer from this disadvantage.
4. INSTITUTING A DISCRETIONARY FAMILY TRUST
The principal will arrange for a friendly settlor to establish
the trust. The settlor is someone who has reason to benefit the
principal and his family. The settlor will give the principal an
amount of money in trust.
The principal trustee will coincidentally appoint two co-trustee
or additional trustees. The principal trustee can remove the co-trustees
or additional trustees. Any trustee’s decision will be by
way of a majority decision of those trustees.
The beneficiaries of the trust will typically be the principal,
his wife, his children, his children’s spouses, and the children’s
children or any desired combination thereof.
5. THE PARTIES
(a) settlor - the person who establishes the trust
by transferring property to other persons to hold in accordance
with his instructions for the benefit of certain other persons.
(b) trustees - persons who receive property to
hold on behalf of certain other persons and to deal with in accordance
with the instructions of the settlor.
(c) beneficiaries - those persons entitled to
benefit from the property.
6. TYPES OF TRUSTS
To fully understand the use and operation of a trust, it will be
necessary for you to become familiar with the differences between
certain types of trusts:
(a) Testamentary Trust v. Inter Vivos Trust
A testamentary trust arises upon the death of an individual; all
other trusts are inter vivos (or living) trusts.
(b) Discretionary vs. Non-Discretionary Trust
Where the terms of the trust Indenture require the trustees to
decide which beneficiaries will receive income of the trust and
how much of the income each will receive, the trust is a discretionary
trust. A non-discretionary trust is one under which a beneficiary’s
entitlement to income does not depend on the exercise of any discretion
by the trustees.
(c) Revocable Trust v. Irrevocable Trust
Where the property of the trust is to revert to the settlor or
someone appointed by the settlor (subsequent to the creation of
the trust), the trust is a revocable trust. Where the property of
the trust is divested of unconditionally by the settlor (that is,
the settlor can never reacquire the property), the trust is an irrevocable
trust. A trust must be irrevocable to avoid attribution of income
or loss from trust property or taxable capital gains or allowable
capital losses from the disposition of trust property to the settlor.
(d) Spousal Trust
A spousal trust contained in a will is a trust under which all
the income is for the benefit of the taxpayer’s spouse and
no person except the spouse may, before the spouse’s death,
receive or otherwise obtain the use of any of the income or capital
of the trust. The spouse need not be a capital beneficiary. Tax-free
rollover of property may be made by a taxpayer to a testamentary
or inter vivos spousal trust although in an inter vivos transfer,
income or loss and gain or loss are attributed back to the taxpayer.
(e) Bare Trust
A bare trust is often used in situations where there are many
investors and it is expedient to have the property registered in
the same name of one person as nominee or, in the case of real property,
to have a corporation as registered owner of the property and liable
under the mortgage in order to limit the exposure of the investors.
There are many other types of trusts, such as units trusts and
mutual trusts, etc.
7. A trust can arise in one of two different ways:
(1) by intention of the parties evidenced by the transfer of property
by one person to another for the benefit of certain other persons;
(2) by one person declaring that he holds the property for and
on behalf of another (declaration of trust).
There are three requirements in establishing a valid trust. These
(1) certainty of intention: the intention of the
settlor to transfer the property to the trustee for the beneficiaries
and not the trustees themselves;
(2) certainty of subject matter: the subject matter
of the trust must be certain (it must be clear what property the
trustee is holding for the beneficiaries). Legal ownership Of the
property must vest in the trustees;
(3) certainty of objects: the objects of the trust
must be clear; that is, who is the benefit from the trust.
If any of these certainties is not fully complied with, then the
trust will not be properly constituted and the desired purposes
of establishing the trust, including tax and estate planning, will
also fail. The courts have required strict compliance to trust law
in the establishment of trusts and Canada Revenue Agency has successfully
attacked family trusts simply on the basis of poor and sloppy documentation
(or the lack thereof).
8. APPOINTMENT OF INDIVIDUALS
(a) Who Should be the Settlor?
Any individual over the age of 18 years can be the settlor of the
trust. The trust can be created by the individual (the settlor)
gifting an appropriate amount of cash to the trustee to benefit
certain persons on the terms and conditions set forth in the Trust
Indenture. However, because it may be desirable to take advantage
of the preferred beneficiary election and because the taxpayer and
his spouse normally wish to be income beneficiaries of the trust,
it is recommended that a parent of the taxpayer (grandparent of
the children) be the settlor of the trust. In the event that there
are no surviving grandparents, the settlor should be a relative
or friend. This will result in loss of the preferred beneficiary
election but will allow the taxpayer and his spouse to remain income
beneficiaries of the trust without affecting the income-splitting
advantages of the discretionary family trust.
Under the Income Tax Act, a reference to a trust is read as a reference
to the trustees having ownership or control of the trust property.
Therefore, for many situations, it is recommended that a trust
have three trustees. One may be the taxpayer and the remaining trustees
may be persons knowledgeable about taxpayer’s affairs and
kindly to his way of thinking. However, the trustees must be advised
that they are in a fiduciary capacity (position of trust) and must
exercise their discretion with regards to the interest of the beneficiaries
and not of the taxpayers.
The Trust Indenture should contain additional or substitute trustees
in the event of the death or withdrawal of any of the trustees.
Trustees should automatically be withdrawn in the event that they
are no longer residents in Canada. This is to avoid the possibility
of the trust becoming non-resident (the residence of a trust for
tax purposes is considered to be residence of the majority of its
trustees) and being deemed to dispose of its property at that time.
(b) Who Should be the Beneficiaries?
In a discretionary family trust, the income and capital interests
of a beneficiary are contingent interests only. An income interest
is contingent on the discretion of the trustees to allocate income
to that beneficiary; a capital interest is contingent on a beneficiary
meeting the conditions of the trust.
Trust income may be allocated to beneficiaries with lower marginal
tax rates and as a result the total amount of taxes paid will likely
be less than if the income were taxed in the trust itself.
The income beneficiaries of a discretionary family trust will usually
be the taxpayer and his spouse, children, children’s spouses,
grandchildren and their spouses and any registered charity; the
capital beneficiaries are often the same persons.
The preferred beneficiary election may be neither appropriate nor
available in all situations. However, where income of a trust was
not payable in the year but was held in trust for an infant or minor
whose right to such income had vested and the only reason that it
was not payable was that the beneficiary was an infant or a minor,
the income allocated to that beneficiary is considered to have been
Therefore, the trust will be entitled to deduct the amount of such
income and it will be taxed in the hands of the infant beneficiary(or,
more accurately, his/her legal guardian) to be used in paying such
child’s share of the family vacation, his/her clothes and
his/her share of family expenses.
9. TAXATION OF THE TRUST
For purposes of income tax, a trust is considered to be an individual
but is not entitled to personal exemptions. The taxation year of
the trust is the calendar year. Inter vivos trusts are subject to
income tax at the highest marginal rate. The effective minimum rate
of tax applicable to inter vivos trust is approximately 50 %. Therefore,
there is no tax advantage where income is left and taxed in a trust
rather than in the hands of the taxpayer.
A trust is entitled to deduct amounts paid or payable to a beneficiary.
Any remaining income not otherwise payable to beneficiaries will
be taxed in the trust itself. Therefore, trustees should allocate
and pay all income of the trust prior to the year-end of the trust.
A trust is generally considered to be a conduit for tax purpose;
that is, the income of the trust distributed to beneficiaries and
certain deductions made by the trust retain their character in the
hands of the beneficiaries. Categories of income that retain their
characters when flowed through are dividends, taxable capital gains,
foreign source income, eligible interest from Canadian sources,
superannuation or pension benefits and amounts received upon or
after death of an employee in recognition of services..
It is important that trustees monitor the sources of the trust
income so that they can pay or allocate the particular type of income
to a beneficiary.
In cases where property is transferred to a trust, there is a possibility
that such property may never be disposed of and , consequently,
capital gains tax may be deferred indefinitely. To overcome this
result, the Act deems the property of a trust to be disposed of
every 21 years (the so-called rule against perpetuities). The tax
ramifications of this 21-year rule must be carefully considered,
particularly in cases where trust property is held until the death
of the survivor of the settlor and his spouse or in cases where
trust property is to be held until the death of the survivor of
the settlor and his spouse or in cases where trust property is not
to vest in infant beneficiaries until they reach 25 or 30 years
In order to avoid the 21- year deemed disposition rule, the Trust
Indenture should include a provision to eliminate the trust prior
to the 21st anniversary date of the creation of the trust. Capital
property of a trust can generally be rolled out at its adjusted
cost base or undepreciated capital cost and, as a result, would
be a tax-free distribution to the capital beneficiaries.
10. PLANNING WITH TRUSTS
Discretionary family trusts are extremely useful vehicles in many
estate planning circumstances. They can be used to provide income
to maintain children or handicapped members of one’s family.
Discretionary family trusts are often used on corporate reorganizations
and estate freezing arrangements as a means to transfer income and
wealth to a taxpayer’s family (and thereby use the lower marginal
tax rates of family members) without losing control of the assets
benefitting the trust.
The discretionary aspect of the family trust allows trustees to
pay trust income based on the individual needs of each beneficiary.
A taxpayer must throughly consider the tax and financial implications
of using a discretionary family trust as part of a corporate reorganization
or estate freeze. To be of any tax advantage, discretionary family
trusts must be irrevocable and once constituted, it may be difficult
to vary the trust. However, in many cases a trust can be dissolved
by simply distributing all the assets to the capital beneficiaries
on a tax-free basis.
11. PUTTING IT TOGETHER
A trust is not a legal entity. It is not capable of being registered
in a government office like a corporation or partnership, so there
is no third-party evidence of its existence. As a result, it is
important to properly constitute and document the creation of the
trust to withstand the scrutiny of Revenue Canada or the courts.
The following steps serve as a guideline to the creation of a trust,
but no action should be taken without prior consultation with you
(a) Intention to create trust - the settlor must
evidence his intentions to create the trust by gifting an amount
($500 to $1000) to the trustees to be used in accordance with his
instructions for the benefits of the beneficiaries. This is normally
done by the settlor issuing a cheque to the trustees(payable to
“The Family Trust”).
(b) Trust Indenture - the Trust Indenture should
grant sufficiently broad and flexible powers to the trustee in order
to enable them carry out their functions. Unless specifically otherwise
provided, a trustee’s power will governed and limited by the
particular provincial legislation or the common law. For instance,
a trustee is restricted by statute to certain qualified investments,
which do not include shares in private corporations. Therefore,
if the intention of trust is to hold shares in a private corporation,
this must be specifically set out.
The Trust Indenture then should be dated and signed by the settlor
and each of the trustees.
(c) The settled funds - might be deposited in
a non-interest-bearing chequing account from which no transaction
would take place. A second bank account could be opened from which
the trustee s could transact the business of the trust.
(d) Borrowed funds - the trust now duly constituted
can borrow the funds necessary to purchase investments. This loan
should only be repaid from income earned by investment of borrowed
funds to avoid attributions of income to the settlor.
(e) Affairs of the Trust - the organization of
the trust(the Trust Indenture and banking documentation) and the
day to day affairs should be recorded in a manner similar to that
of a corporation. Minutes and Resolutions should be kept of trustee’s
meetings and decisions, and should be dated and signed by the trustees.