Many business and property owners, rely on family trusts to achieve a variety of financial and tax goals. In fact, as Canadians accumulate business assets and personal wealth, these trusts have become so popular that the Canada Revenue Agency (CRA) is increasingly scrutinizing them. Unfortunately, trusts that aren’t properly established and maintained could be penalized or disallowed.

If you have already established a family trust, be sure to review its “trustworthiness” before the CRA does. For those who are contemplating establishing a trust, there are a number of important considerations to ensure the trust achieves your objectives and also meets the government’s expectations.

First some background. Individuals establish family trusts, which are “inter-vivos trusts” or “trusts of the living,” to transfer the benefits of owning assets (such as shares of a corporation, a building, land, etc.) to others while retaining control of those assets.

Business and property owners often use trusts to assist with managing assets, succession planning, optimizing tax exemptions, reducing probate fees, income splitting with family members, providing for disabled family members, asset protection, charitable gifting and supporting a will.

For example, trusts can be used in an estate freeze to allow future growth in the value of your company to accrue to beneficiaries, such as your children, while you retain control of the company. One way to accomplish this is to transfer the shares of the corporation to a new holding company, in exchange for preferred and common shares of the new company. As the owner, you would hold the voting preferred shares and control of the company while your beneficiaries would hold the common or growth shares. All future growth in the company would accrue to these common shares held by the beneficiaries, which would be held in trust.

When the trust eventually sells these common shares, the capital gain can be allocated to the beneficiaries. Since there is an enhanced capital gains exemption available on the sale of shares of privately owned Canadian small businesses, each beneficiary can shelter in year 2020 up to $883,000 of the gain from tax if the conditions for the exemption are met.

Inter-vivos trusts must calculate income, file a tax return and pay taxes. Since trust income, however, can be allocated to beneficiaries and taxed in their hands, this arrangement produces most of the tax benefits of trusts – and receives most of the focus of CRA audits.

The CRA is not fond of income splitting because this reduces government revenues. Thus CRA audits often target trusts that are established primarily to enable income splitting with lower income spouses and children. The Canada Revenue Agency generally looks at three key issues.

1. Has the trust been properly formed?

The CRA may request the original signed trust document, including a description of the beneficiaries and the property that was settled in the trust. If your trust was set up by a lawyer, this should not be a concern. The CRA will also expect to see evidence of trustee decisions, such as minutes. If the CRA determines the trust was not formed properly, there may be adverse tax consequences.

2. Where trust income has been allocated to beneficiaries:
– was the income actually paid; or
– is there a genuine obligation to pay that income to a particular beneficiary?

To answer these questions, the CRA will review documentation to substantiate payments. These documents may include trustee resolutions that allocate the trust’s income, proof of payment for income paid during the year and promissory notes or other evidence that the trust has made the income payable to specific beneficiaries. If these documents are not available or are inadequate, then the income may still belong to the trust and will be taxed at top rates.

3. Where trustees make payments to third parties, did they benefit the beneficiary?

Another way to pay income to a beneficiary is to make payments to third parties for their benefit. The CRA wants to ensure that trust funds paid by the trustees are benefiting the beneficiaries and not someone else. Thus the CRA wants to see documentation of payments and evidence that the payments benefit a particular beneficiary. If, for example, a trustee is the parent of a child beneficiary and the parent is reimbursed for expenses incurred on behalf of the child, there should be expense receipts to prove the funds were spent for the child’s benefit, and not the parent. If the CRA finds expenses or beneficiary allocations that are not supported, the trust may again be taxed on the income.

It seems the Canada Revenue Agency’s intensive scrutiny of trusts is here to stay and, along with addressing these three issues, the CRA will be reviewing trust records to determine whether income has been calculated and reported properly for tax purposes. Auditors will expect to see relevant bank and investment accounts and appropriate maintenance of records.

Family trusts can provide owners of companies and property owners with valuable benefits — but only if properly established and administered. If you are unsure whether your family trust will stand up to CRA scrutiny, ask a tax professional for guidance regarding the necessary strategies and records. After all, you need to be able to trust that your family trust will achieve your goals.