Setting up an "in-trust" account is an excellent way for a parent or grandparent to split investment income with a child or grandchild and therefore increase a family's disposable income. This income-splitting technique has become extremely popular over the last several years as Canadians search for innovative and legitimate ways to reduce their tax bills. In fact, we get more questions on a day-to-day basis on this topic than any other tax-related issue.
The unfortunate side to this story is that, while many clients are setting up these accounts, very few understand their legal or tax implications.
Adults are presented with a dilemma when they want to give money to a minor (i.e. children under 18 years of age); the minor cannot enter into a legally binding contract. Because of this, most financial institutions and mutual fund companies will not accept a minor as an account-holder.
By setting up an in-trust account, a parent or grandparent can transfer cash to and make investment decisions on behalf of a minor. Essentially, the minor is the beneficial "owner" of the account and the adult has given up all rights to use the investments in the account for his or her own benefit. From the moment funds are transferred to the minor's account, all investment decisions must be made for the benefit of the minor.
Setting up an account is fairly simple. The parent/grandparent is the one who signs the application and provides instructions for the account. Typically, the name of the account identifies the adult and the child as follows: "Name of adult" in trust for "name of child"
Capital gains earned in the account could be taxed in the hands of the minor. This provides an excellent opportunity to split investment income with the minor.
For example, if the money in the account is used to purchase equity mutual funds that are expected to distribute mainly capital gains, these gains and any gains realized on the sale of the funds will remain with the child.
Since most children will not have any other income, approximately $14,824 in capital gains can be reported by the child without incurring a tax liability. If the parent who transferred the funds to the account is in the top tax bracket, the tax savings realized annually would be approximately $3,500. (The actual saving will depend on which province the parent resides in.) With the impact of compounding, this saving could be substantial by the time the child turns 18 years of age.
If the investment provides dividend or interest income, this income will be attributed back to the parent or grandparent unless certain income-splitting strategies are implemented (see "The more you make, the more you pay"). Any income earned on the income attributed back to the parent or grandparent however, would remain with the child.
There is also no attribution of any type where the parent or grandparent is a non-resident of Canada. For example, grandparents living outside of Canada can contribute money to an in-trust account and have one of the child's parents as trustee
Probate fees are generally levied on the transfer of estate property on the death of an individual. They do not apply to property that is transferred prior to the date of death. If investments held in-trust for a child represent amounts legally transferred from an adult to the child, they do not form part of a deceased adult's estate, thus avoiding probate fees.
If structured properly, investments held in trust may avoid the grasp of creditors, as they belong to the child and not the parent/grandparent.
While there are many benefits to setting up an in-trust account, the benefits can only be realized if the account is properly set up, meets all of legal requirements and complies with tax law. Therefore, before anyone rushes out and opens an account in trust for a child, the following criteria must be considered to ensure the account is properly structured.
To properly set up an in-trust account, you must ensure that (1) the minor is the beneficial owner of the account; and (2) a legal transfer of cash or other investments has taken place.
How is this done? When setting up an in-trust account, it is usually registered as follows: "trustee" in trust for "beneficiary". The in-trust account should always name the beneficiary. If the beneficiary's name is missing, it raises doubts as to who is the true owner of the account.
Has a transfer really taken place? This may seem like a simple question but you must be able to prove that the cash or investment has been transferred, with no conditions, from the adult to the child. There can be no strings attached that would allow any of the cash or investments to be returned to the adult. Otherwise, the Canada Customs and Revenue Agency (CCRA, formerly Revenue Canada) may ignore the legal form of the account and attribute all of the income, including gains, back to the adult.
The best way to avoid these problems is to make sure that proper documentation exists showing the transfer of the cash or investments to the account for the benefit of the minor. It is also a good idea to ensure that the trustee and donor (person contributing cash or investments to the child) are not the same person.
For example, one spouse may donate cash to the trust while the other spouse is the trustee. In a more typical situation, a grandparent is the donor while the parent is the trustee. Attention to this small detail could help avoid an unfavorable tax issue.
When the size of the investment is significant or the in-trust account is part of a more complicated estate plan, a formal trust may be required.
In a formal trust, there are usually three separate interested parties:
- The Donor: This is the person who establishes and contributes cash or investments to the trust.
- The Trustee: This is the decision-maker. Unless other specific instructions are provided, the trustee has full discretion as to the investment of the trust property on behalf of the beneficiary.
- The Beneficiary: This is the person for whom the money is being invested and who will ultimately benefit from any growth or suffer any loss in the investment.
All three of these individuals must be identified in order for legal trust to exist.
A formal trust is usually created by a legal document, which the help of a lawyer and spells out, in detail, the following types of information:
As an example of where a formal trust would be beneficial, consider the situation where parents want to set aside funds to be used for a child's education. The trust can provide that, until the child is 25 years of age, the money can only be used for tuition fees and related costs. In this way, for the specified time, the trust funds can only be used for that specific purpose.
It is important to ensure that the person contributing money to the trust provides clear instructions as to the intended use of funds. If specific instructions are not provided, the trust document should be very clear on how amounts contributed to the trust are to be handled
In addition to being more complicated, formal trusts are required to file annual tax and information returns. The costs of setting up a trust as well as the cost of these annual filings should be carefully considered.
Notice: Clarington Mutual Funds nor Fiscal Agents Financial Services Group are not engaged in rendering accounting, legal or other professional services or advice. The comments in this Tax Tip are not intended, nor should they be relied upon, to replace specific professional advice. Before acting on material contained herein. readers should seek advice that is appropriate to their personal circumstances from a professional advisor.
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