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A family trust can be a very useful tool for income tax planning purposes. A trust can allow income to be split with between the various beneficiaries, thereby utilizing the lower tax brackets of the beneficiaries. It also allows for the multiplication of the capital gains exemption. However, when using a family trust, care must be taken to ensure that the trust is not subject to reversionary trust rules in subsection 75(2) of the Income Tax Act.
In order to ensure that a trust is not subject to the reversionary trust rules, careful consideration must be given to the settlement of the trust and the types of transactions that take place with the trust. It is generally understood that when settling a trust, the settlor can not be a beneficiary of the trust, nor should the settlor have any discretion or influence on how the trust property is to be distributed.
Even if the trust has been settled properly and the settlor has no discretion or influence on how the trust property is distributed, it is possible for the trust to become a reversionary trust. One such way would be to have a beneficiary sell an asset to the trust. Even if the transaction takes place at fair market value, the trust would be considered a reversionary trust, as the property could revert back to the person from whom it was received. Another potential way that a trust can become a reversionary trust is through beneficiary making a contribution to the trust. If the beneficiary is deemed to be a settlor of the trust as a result of the contribution, the trust would be subject to the reversionary trust rules.
If a trust is subject to the reversionary trust rules in subsection 75(2), it can result in significant adverse income tax consequences. Any income earned from the trust property may be taxed in the hands of the person who transferred the property to the trust, thereby eliminating the benefits which come from income splitting. In addition, and more significantly, the trust may lose its ability to distribute trust property to a beneficiary at its adjusted cost base. This may result in a disposition at fair market value of the property that is distributed to the beneficiary.
As the trust assets increase in value, this can result in a tax liability to the trust, when the property is simply distributed to a beneficiary.
It is very important that trustees be informed of the types of transactions they can enter into for tax purposes to ensure that the trust does not become a reversionary trust.
If you have any questions about family trusts or would like more information about reversionary trust rules, please contact you local MNP Tax specialist.
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