TRUSTS & ESTATES: How your Beneficiaries are taxed
Taxation of Beneficiaries
Under subsection 104(13) of the Canadian Income Tax Act (“ITA”), the income of a trust or estate that is paid or payable to a beneficiary is taxed in the hands of that beneficiary. In order to avoid double taxation, the trust or estate is allowed a deduction for an equivalent amount. This amount is considered to be payable to a beneficiary when the beneficiary is entitled in that year to enforce payment thereof, ITA, subsection 104(24). One reason for not paying is that the beneficiary has not attained a specific age and where the trust is not a discretionary trust. In addition, subsection 104(18) states that the income is to be considered payable to the minor, thereby allowing a deduction to the trust and an income inclusion to the minor.
In view of this, a beneficiary will be required to pay tax on trust income that is not actually received so long as he or she has a legally enforceable right to the income. Of course, no tax should be imposed when he or she actually receives income that has already been notionally included in his or her income in a prior year, since it was payable to him or her. To this effect, subsection 104(13) rules that this income can be subsequently paid to the beneficiary tax free.
If an amount is included in a beneficiary’s income because it was paid or was payable by the trust or estate, the CRA considers the beneficiary to have earned the income on the last day of the taxation year of the trust, ITA, subsection 104(23) and CRA, Interpretation Bulletin IT-342R, “Trusts – Income Payable to Beneficiaries”. Assuming that a testamentary trust has a taxation year ending on January 31; and on March 1, 2003, the testamentary trust pays the beneficiary $10,000 of trust income. In his or her 2004 taxation year, the beneficiary will include the payment and report the income on his or her 2004 personal tax return that is to be filed on or before April 30, 2005. Thus, the choice of a non-calendar year by a testamentary trust may result in a deferral of the beneficiary’s tax liability for amounts paid or payable to him or her.
There is a distinction between capital and income transactions of a trust. Generally, trusts distinguish between beneficiaries entitled to distributions from the capital of the trust and those entitled to distributions from the income of the trust. Capital gains are not taken as income for trust purposes, but net income for tax purposes includes taxable capital gains. There are instances when a trust has separate capital and income beneficiaries and is required to pay the income out every year. Considering that capital gains are usually not taken as income for trust purposes, the taxable portion of the capital gains cannot be paid out to the income beneficiaries and is to remain behind to be taxed in the trust unless there is a preferred beneficiary election.
Instead of reporting it in the hands of beneficiaries, a trust can choose to retain income in the trust. To do this, the trust has to be resident in Canada throughout the year. The designation option applies only to income paid or payable to beneficiaries. Subsection 104(13.1) of the ITA authorizes this choice of retaining income in the trust for tax purposes and is commonly referred to as a “104(13.1) designation”. Such designated amount is not deductible by the trust, and is not taxable to the beneficiary. When taxable capital gains are included in the income for retention in the trust, a similar designation can be made under subsection 104(13.2). Taxable capital gains of the beneficiary are reduced by the beneficiary’s proportionate share of taxable capital gains retained in the trust.
The ITA does not permit net capital losses of a trust to be passed through to the beneficiary. Consequently, such losses are likely to remain uncompensated. Under a subsection 104(13.2) designation, there is a provision to absorb these losses in the trust by allowing the trustee to deduct under subsection 104(6) less than the full amount of taxable capital gains which are payable to the beneficiaries. Such un-deducted capital gains are included in the trust’s income and the allowable capital loss or net capital loss carried forward can be used to offset such gains. Therefore, subsection 104(13.2) designation deems taxable capital gains otherwise included in the beneficiaries’ income under subsection 104(21) not to be payable to the beneficiary.
21-Year Deemed Disposition of Trust Property
A trust is prevented by section 104 of the ITA from holding property for an indefinite period, thereby deferring the taxation of capital gains and recapture. Subject to certain exceptions, there is a deemed disposition and reacquisition by the trust of capital property every 21 years for notional proceeds equal to fair market value. When the property owned by the trust has appreciated in value, it is to be distributed among the beneficiaries before the 21-year period has elapsed. When the trust is a personal trust, this can be done on a tax-free basis. Twenty one years after the creation of the trust, the first deemed realization occurs. Even though there were trusts in existence on January 1, 1972, all such trusts would have their first realization 21 years after that date.
To beat the 21-year deemed disposition rules, the trust instrument should ensure that the trust assets can be distributed to the beneficiaries before the 21-year realization, and can be done on a tax-deferred basis provided the trust qualifies as a “personal trust”.
A “personal trust” according to subsection 248(1) of the ITA means:
1) A testamentary trust; or
2) An inter vivos trust, where no beneficial interest in which was acquired for consideration payable directly or indirectly to:
a) the trust; or
b) any person who has made a contribution to the trust.
Normally, trusts other than personal trusts are known as “commercial trusts”.
Testamentary/Inter vivos Spousal Trusts
Some spousal trusts, however, dispose of their property at the date of the spouse’s death. These spousal trusts are to satisfy the basic requirements of a spousal trust, that is, the spouse must be entitled to receive all of the income of the trust arising during his or her lifetime and nobody except the spouse can, before the spouse’s death, receive or otherwise use the income or capital of the trust. Besides, these trusts should be created in either of the following manners:
1) By the will of a taxpayer who died after December 31, 1971; or
2) By a taxpayer during his lifetime (other than a pre-June 18, 1971 inter vivos trust taxed at the graduated rates applicable to individuals).
For all your Tax Law matters and how best to resolve your estate and succession issues or that with a spouse and your children contact the lawyers at Levy Zavet PC (Levy Zavet).