My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Tuesday, February 5, 2013

Prescribed Rate Loans Using a Family Trust

In July 2011, I wrote about the income tax savings that may be derived by using a 1% prescribed interest rate loan to income split with your spouse and children. As the world economies would have it, interest rates have not moved very much over the last eighteen months; consequently, the Canada Revenue Agency (“CRA”) prescribed interest rate is still 1% for this quarter. I would therefore suggest that the use of a prescribed interest rate loan is still an attractive tax planning alternative, however, today I will expand the use of these types of loans to include a loan to a family trust for purposes of income splitting.

To recap the above blog post. The Income Tax Act contains income attribution rules that typically reallocate income to the higher income earner when he or she tries to income split with his or her spouse or children. However, there is an exception to the above attribution rules where an individual makes a loan to a spouse or minor child and interest is charged on the loan at a rate at least equal to the CRA’s prescribed interest rate at the time the loan was made. Where the loan carries interest at a rate no less than the prescribed interest rate, the attribution rules will not apply. For the loan to avoid the income attribution rules, the interest owing must be paid each year within 30 days after the end of the year (i.e. January 30th).

As I noted at the end of the blog post, income splitting with minors can be problematic because minors generally cannot enter into an enforceable contract. Thus, I suggested the use of a family trust to navigate the enforceability issues. Today, I want to expand on the use of a family trust for these type loans.

Using a Family Trust


Where a family trust is a shareholder in your company, the kiddie tax rules make income splitting with beneficiaries problematic and typically the trusts are only beneficial for children once they turn 18 or where the company is sold and you can "sprinkle" the $750,000 capital gains exemption amongst your family members.

Shockingly, for once, individuals have a planning advantage over corporations. Where you do not have a corporation or the circumstances don’t allow for the introduction of a family trust as a shareholder of a corporation, a family trust can still be utilized to income split, by utilizing a prescribed interest rate loan to a family trust. The beauty of making a prescribed loan to a trust is that the kiddie tax will not be applicable and if structured properly, children under 18 who are beneficiaries of the trust can be used to income split. 

To prevent any confusion, let me clarify. A family trust is not an “in trust” account that some institutions allow. What I am talking about here is a formal discretionary family trust governed by a trust agreement or trust deed drafted by a lawyer and properly settled, often by a grandparent. The beneficiaries of a family trust in the case of a prescribed loan trust would include both minor children and children 18 years of age and over and the trustees would typically include at least mom or dad, if not both, and an arm’s length third party.

Once the family trust is settled, mom or dad makes a loan to the trust at the prescribed interest rate in effect at the time of the loan (i.e. 1% if the loan was made this quarter). It is very important to understand that the Income Tax Act requires that the loan carry an interest rate at least equal to the prescribed rate at the time of the loan and that this interest rate remains in effect the entire time the loan is outstanding. Thus, the 1% interest rate will not change as long as the loan is in existence, even if the CRA’s prescribed interest rate increases in the future. I cannot emphasize what a huge benefit the low permanent interest rate is in our current low rate environment. If rates begin to rise, the trust will continue to only pay 1% interest, yet the family trust can earn say 7% interest without the risk that would be required today to try and achieve a 7% return.  

Once the trust receives the loan proceeds, it will then invest the funds, but must  pay mom or dad the 1% interest by January 30th of the following year. Mom or dad must report the interest earned on the loan in their personal income tax return and the trust is entitled to an interest expense deduction for the interest paid.

The income earned by the trust less the interest expense paid is then allocated out to the children and is taxed in their hands, which in most cases will result in no income tax.

The trust can be used to pay the children’s school costs, camp costs, etc.

So why isn't there a proliferation of family trusts used for income splitting of investment income? Well, the legal and accounting costs of setting up the trust can range from $4,000 to $8,000 give or take and there are also annual T3 Trust filing costs charged by an accountant. In addition, as noted yesterday, in order to make this worthwhile, the parents would typically need to advance at least $500,000, but probably closer to $1,000,000 in this low rate environment to make the additional income tax filings and administration costs worthwhile. However, you could establish or settle a trust and loan it, say $100,000 today, to lock in the 1% rate, if you believe the compounding effect of the invested money will provide you with significant investment income down the road or you expect the stock market is going to go gangbusters in the near future. Remember though, any loans advanced to the trust in the future will need to carry an interest rate at least equal to the prescribed rate at that time, so if you loan the trust more money in the future and the prescribed rate increases to say 5%, the additional loan will be subject to the higher interest rate.

Where you have funds available for investing and have children with significant private school or university costs, then you should consider the creation of a family trust and the use of a prescribed interest rate loan for income splitting purposes. Alternatively, you can just use the trust to build up funds in your child's name to help them buy a car or a house.

Tax planning of this nature is very complicated as you must navigate several income tax and trust law provisions to ensure compliance. Before considering tax planning of this nature, you must consult with an accountant and/or lawyer.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

28 comments:

  1. I was really enjoying this possibility until I hit the part about $500k. Ah well, maybe it will be something to consider in a few more years. : )

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    1. Bet, can be done for less, but lots of costs and admin so you would need some excellent returns.

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  2. What was the final step for the trust? Can the trust continue forever or is it triggered to end by some event (e.g. child turns 18, trustees resign)? If the trust must end, who defines what ends it (is the trustees, CRA etc)? What happens to the funds in the trust at that point?

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    1. Hi Bruce:

      The trust has a 21 year life. If there was a loan, the loan will be repaid at that time and if there are any remaining assets, they would be distributed to the beneficiaries in their personal name as the trust must be wound up.

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    2. If I may, it is incorrect to equate the 21-year deemed disposition at the Trust level with the need to wind up the Trust. Indeed, the Trust need not be wound up on/by its 21st anniversary.

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    3. Bruce, you are correct. The trust need not be wound up, however, there will be a deemed disposition at the end of the 21st year. Since every trust I have dealt with has ended by the 21st year, I sort of assume the trust will be wound up, but u r technically correct, the trust can continue,but it will still have the deemed disposition.

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    4. BBC, if I may continue, I'm not Bruce, but rather a CA in western Canada.

      In my practice, the 21-yr anniversaries will arrive over the next 5-8 years, hence client discusssions are ensuing. In short, shares in private companies aside, it has been my observation that if clients are turning over their portfolios an average of 3-4 yrs or less, the appetite to pay deemed dispositions tax is generally considered to be acceptable, considering that a second 21-yr period ensues (and the ACB bump also goes a long way to salve the 21-yr tax wound).

      For private companies, depending on circumstances, an estate freeze, with a new Trust being the common share subscriber, is generally appealing. There then remain choices regarding the freeze shares, including redemptions over time, their distribution from the Trust before the 21-st anniversary, etc.

      BBC, I (re)discovered your website recently and I commend you for your well-considered and instructive articles.

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    5. Sorry, you continued under Bruce's question. Some great points, want to write a guest blog on the topic?

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  3. Our family trust owns shares of my wife's dental company. We have holdco as a beneficiary of the trust. My wife and I are trustees and our kids beneficiaries. Can we as trustees lend funds to our family trust at 1% rate and pay out investment income to our kids ? if I used my home line account to lend these funds would the interest be tax deductible on my personal return?

    Thx - Raj

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    1. Hi Raj, as someone with high end tax planning, I suggest you ask your accountant to review the situation. A prescribed loan should work for you in some form, however, your accountant needs to do the planning based on your personal details and corporate structure.

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  4. What are the tax implications if the Trust's capital is less than the original loan, and the therefore the repayment of the loan is less than the original loan?

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    1. Anon,

      Great question. I have never had to look at this so actually not sure if it would just be a capital loss to the lender and whether there could be debt forgiveness issues to the trust. Sorry, don't know off the top of my head and don't have time to research it.

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  5. BBC,

    When the kids are distributed the investment income, administratively, how do you suggest that this is separated?

    Also, do you think the trust could spend money on the kids such as normal living expenses (eg: food, clothes, etc)?

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    1. Hi Anon:

      My firm likes to have our clients open an account for the child and distribute the money first from the trust to the child's account and then the child's account pays for the expenses. It provides a clean trail.

      I dont have my clients reimburse for the basic necessities of living, although I would ask your accountant/lawyer their opinion.

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    2. Thanks.

      Assuming in the child's bank account, they have excess funds or cannot use all the investment income that is distributed to them, for a discretionary family trust, does the child (or any other beneficiary) have the option of contributed that cash back into the trust?

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    3. I personally keep the funds separate and do not loan them back to the trust.

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  6. I recently received funds from a family trust in which I'm named (from my parents) on Aug. 19th, 2015. I took the funds as a loan, and plan to re-pay the loan plus the prescribed interest. My question is, when do I have to repay this loan to avoid having the funds count as my personal income for 2015? Is the deadline Jan. 31, 2016? Thanks!

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    1. Hi Anon

      Loans from a trust can sometimes be problematic. You should get some professional advice on this transaction. I do not provide such on this blog.

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  7. Hoping it's not too late to ask a question on this post. I established a Trust for my family years ago and the trust has earned foreign (US) business income every year but 2016 (bad year for the business that the trust owns part of). Typically I allocate what income I can to the kids and the balance to my wife. My question is, can I "carry forward" the 2016 expenses for the kids into 2017? There will be income in 2017.

    Thanks.

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    1. Hi 3waller

      This article seems to be what you are asking
      https://www.marcil-lavallee.ca/en/resources-tools/monthly-newsletters/list-per-month/81-taxation-of-trusts

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    2. Thank you for the article BBC. I might have missed something in there, but I don't think it addresses my question. Let me use an example:

      Trust 2016 income - $0
      Kids 2016 expenses (i.e. sport camps, toys, etc) - $10k

      Trust 2017 income - $25k
      Kids 2016 expenses - $12k

      If I could carry those 2016 expenses forward to the 2017 return, then the trust would allocate 22k of expenses to the kids, and 3k to my wife. If not, then the trust would allocate 12k to the kids and 13k to my wife, resulting in higher taxes paid is she is at or near highest marginal tax rate and kids would be zero.

      Thanks if you can help/opine!

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    3. I would suggest you cannot carry forward expenses paid on behalf of the children (as per the article, u can carryforward losses), but your accountant my have a different opinion.

      Also speak to your accountant about allocating the $22k to your kids anyways if this is a prescribed rate trust and kiddie tax is not applicable. The money would belong to them, but they can pay other future expenses. I dont know the details of your trust, so speak with your accountant,u may have options. If you dont have one, engage one.

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  8. Hello.

    Thank you for your blog.

    If a trust owns all of the participating shares of a corporation, Would there be any fiscal problems if a loan is made from the corporation to the trust using the prescribed interest rate loan? There are minors that are beneficiaries in the trust...

    Thank you

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    1. Hi Anon:

      Sorry I dont know the answer off the top of my head as there are many complicated rules with trusts that can cause them to be tainted. Ask your accountant.

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  9. YOu mention.
    "The trust can be used to pay the children’s school costs, camp costs, etc."

    Can you increase your examples of what the trust can be used for that is much more extensive? For example if the funds are going to grandchildren under 5. Could the money go for a higher end daycare with learning etc...vs a cheaper alternative? Can the kids put the money into their RESP? ...How about toys , clothing, food?
    Thank you.

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    1. Hi Chris

      This quote comes from an Assante Wealth Group document:

      The current position of the Canada Revenue Agency (CRA) is that expenditure may be considered paid or payable, and therefore deductible by a trust, if it was made for the beneficiary’s benefit. This may include an amount paid out of the trust for the support, maintenance, care, education, enjoyment and advancement of the beneficiary, including the beneficiary’s necessities of life. For example, it may be acceptable for the trust to pay third parties or to reimburse the parents for specific expenses attributable to the children (or grandchildren) such as clothing, tuition, day or summer camp, day care, airline tickets (for the children or grandchildren), sports lessons and equipment, computers, furniture (for a child’s or grandchild’s room), music lessons and music equipment, and gifts. The key is to maintain proper documentation and to be able to demonstrate that the money was used for the benefit of the beneficiary.

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  10. Hi BBC,

    I have a standard opco+holdco setup. I have lots of retained earnings sitting in the holdco. If I set up a standalone family trust, with my kids as beneficiaries, could we lend money from our holdco to the trust?

    The plan would be to invest the money inside the trust and distribute any earnings to our kids.

    Or would the holdco and trust be deemed to be 'connected' somehow, meaning that the loan would need to be repaid by the end of the next tax year?

    Many thanks for all your insightful posts!!
    N

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    1. Hi N

      Off the top of my head it may be problematic. Speak to your accountant to review the details

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