Family Trust in Canada: How It Works, Income Splitting, TOSI and the 21-Year Rule

What Is a Family Trust?

This guide covers how a family trust works, what it costs to set up, how income splitting is limited by the tax on split income (TOSI) and the 21-year deemed disposition rule. It is part of the corporate, trust and estate tax guides.

A family trust is a legal arrangement with three parties:

The trust holds assets separately from the settlor’s estate, with income and capital distributed according to the trust agreement.

Types of Family Trusts

Most family trusts used for tax planning are inter vivos trusts, set up during the settlor’s lifetime; a testamentary trust is created by a will on death. Both pay tax at the top marginal rate on income they keep, with narrow exceptions, and both face the 21-year rule; the differences are covered in testamentary vs inter vivos trusts.

Benefits of Family Trusts

Tax Planning

Asset Protection

Estate Planning

Tax on Split Income (TOSI) Rules

The tax on split income (sometimes called the “kiddie tax”) is the main limit on splitting income through a trust or a private corporation. Income that a minor receives from a family business through a trust is split income unless a narrow exclusion applies, such as property inherited from a parent. For adults, the rule and its exclusions are:

• Split income generally includes dividends or interest (not salary) paid, directly or indirectly, by a private corporation from a business related to the person, and certain capital gains.
• Split income is taxed at the top marginal rate unless it is an excluded amount.
• Excluded business (any adult): the person is actively engaged in the business on a regular, continuous and substantial basis in the year or in any five earlier years; working on average at least 20 hours a week while the business operates counts, and the five years don't have to be consecutive.
• Excluded shares (age 25 or older): shares with 10% or more of the votes and value of a corporation that isn't a professional corporation, earns less than 90% of its business income from services, and doesn't get all or substantially all of its income from another business related to the person.
• Reasonable return (age 25 or older): an amount that is reasonable given the work the person performed, the property they contributed, the risks they assumed and what they have already been paid from the business.
• From age 18 to 24, outside an excluded business, only a safe harbour capital return on property the person contributed, or a reasonable return on arm's-length capital they contributed, is excluded.
• An amount is also excluded if it would be an excluded amount for the person's spouse or common-law partner who was 65 or older at the end of the year, or who died during the year.
• At any age, taxable capital gains realized on death, or on qualified farm or fishing property or qualified small business corporation shares, are excluded.

Impact of TOSI

TOSI makes income splitting through trusts much less effective than before 2018. A related set of rules, the attribution rules, can tax income from property given or lent to a spouse, or to a minor who is a niece, nephew or not at arm’s length, back to the person who transferred it.

Setting Up a Family Trust

Steps

1. Determine objectives: Income splitting? Estate planning? Asset protection?
2. Choose trustees: Family members? Professional trustee?
3. Select beneficiaries: Who can receive income/capital?
4. Draft trust deed: Lawyer prepares legal document
5. Settle the trust: Transfer initial asset (often $1)
6. Fund the trust: Transfer assets or have trust subscribe for shares

Costs

21-Year Deemed Disposition

What Happens

For most trusts, there’s a deemed disposition every 21 years from the trust’s creation (a spousal trust, for example, is deemed to dispose when the beneficiary spouse dies):

Example

Planning Strategies

Family Trust for Business Owners

Holding Company Shares

A trust often holds the shares of a holding company or, after an estate freeze, the new growth shares of the business.

Lifetime Capital Gains Exemption

When a trust sells qualified small business corporation shares and allocates the gain to beneficiaries, each eligible beneficiary can claim their own lifetime capital gains exemption. Example: with an exemption of $1,275,000 each, a family of 4 beneficiaries could shelter $5.1M+ in gains.

Restrictions

Trust Taxation

Income Retained in Trust

Income Distributed to Beneficiaries

Trusts generally want to distribute income to avoid top-rate taxation.

Attribution Rules

Transferring property to a trust for a spouse or minor child can make the income attribute back to the settlor, unless an exception applies, such as a loan charging at least CRA’s prescribed rate with each year’s interest paid within 30 days after year-end. The rules and the prescribed-rate loan are explained in attribution rules in Canada.

Trust Return Filing

T3 Trust Income Tax Return

Penalties

When a Family Trust Makes Sense

Good Candidates

Not Worth It If

Key Takeaways

• Family trusts can reduce taxes and protect assets
• TOSI rules limit income splitting with minors and many adults
• For most trusts, the 21-year rule deems the trust to sell its capital gains property, so any gain is taxed unless the assets are dealt with before then
• Setting one up has legal costs for the deed, plus yearly accounting and trustee costs
• Most often used by business owners, for cottage succession and for large estates
• Setting one up involves a tax lawyer and an accountant

Related Reading

• Bare trust filing rules
• Management companies and income splitting
• Estate planning guides

→ Back to: Complete Canadian Tax Guide