Tim Cestnick is managing director at WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.
I can remember when I was young, my Uncle Bob came to stay with us for a while when he was in Toronto on business. During that visit, he handed me $10.
"Be careful with that money, Tim" he told me, "because a fool and his money are soon parted."
"I know Uncle Bob," I replied, "but thanks for parting with this money anyway."
Actually, my uncle has always been good with his money. Years ago, he set up a family trust to save tax. You see, a family trust can be a valuable tool for saving tax dollars if you use it properly. Today I want to tell you about an uncommon way to use a trust that can save a family potentially thousands of tax dollars.
THE BASICS
First, let me share the basics about trusts. Under our tax law, a trust is considered to be an individual - just like you and me. So, any income earned by a trust will be subject to income tax.
A key difference between a trust and other individuals is that a trust can distribute its income to the beneficiaries of the trust so that the income is taxed in the hands of the beneficiaries rather than in the hands of the trust itself.
The trust is entitled to a deduction for any income distributed to beneficiaries.
And so, it's possible for the trust to sprinkle its income into the hands of other family members (beneficiaries) who might pay tax at lower rates than you might face.
Now, the type of trust I'm going to talk about today is an inter vivos trust, which is a trust you might create during your lifetime, as opposed to one that is established by your will after your death (which is called a testamentary trust).
An inter vivos trust is itself taxed at the highest possible marginal tax rate - which is not good, obviously. But if the trustees (who make decisions around the trust and its assets) distribute the trust income to certain beneficiaries, the trust's high rate of tax can be avoided and the lower tax rate of the beneficiaries can be utilized.
THE IDEA
Now, our tax law is designed to prevent you from moving certain types of income into the hands of certain trust beneficiaries to save tax. Still, there are types of income that won't be subject to these rules. I'm talking about service income, for example.
You see, it's possible to flow service income through a trust and for that income to be taxed in the hands of beneficiaries, including minors, who may be in a lower tax bracket.
The total taxes paid could be much less than if the person providing the services - perhaps you - were taxed on that service income.
Here's how it would work: You would enter into an employment agreement with the trust whereby you would provide services to the trust.
The trust would then enter into a consulting agreement with a third party (note, if you own more than 10 per cent of any class of shares in that third party, you are a "specified shareholder" and the strategy may not work).
In this case, the trust will earn the income for the services provided, and would then distribute that income to the beneficiaries of the trust who will be taxed at a lower rate than you.
There was a court decision in the case Ferrel v. The Queen (1999) which affirms this strategy.
In that case, there was a valid agreement between the trust and a corporation for the provision of management services.
The actual services were being performed by Mr. Ferrel on behalf of the trust.
In that decision, the judge said: "It follows that other structures, including trusts, may also be used to save tax, as long as proper legal documentation is prepared to accomplish the purpose desired."
A trust can also be used by an executive who isn't a specified shareholder, who may have a spouse and minor children, to provide services to the end employer for a portion of his income.
Alternatively, a trust can be used to carry on a business directly so that the sale of inventory or other property that results in net income can give rise to a splitting of that income with beneficiaries.
Be sure to visit a tax pro to set this up properly so as to avoid the rules in our tax law that can throw a wrinkle into this tax planning.
© The Globe and Mail
