Formalizing informal trusts

By Teresa Gombita
Illustration: Jason Schnieder

Formal trust planning can spare parents sleepless nights worrying about what the kids will do with their money

Many parents set up in-trust accounts to implement income splitting with their minor children only to realize when these children turn 18, the parents can’t maintain control of the assets in these informal trusts. If a trust was formally established from the start, there would be a documented plan of intention as to what happens to the assets when the child reaches 18. Often in-trust accounts are chosen because they seem easier, less time-consuming and less expensive than a formal arrangement.

If properly established, an in-trust account will allow funds to be set aside for a minor beneficiary with only income, not capital gains, from the funds being attributed to the person who established the account until the child turns 18. Second-generation income, or income on income, should also not attribute. Such planning is implemented to minimize tax without consideration as to whether or not the child will be ready to manage such funds when he or she turns 18.

Where significant growth in assets has occurred under an informal ar- rangement, the question for parents is, can anything be done to formalize the informal arrangements before the children have the legal right to deal with their assets on their own? There are options available, but they may be legally challenged as ineffective, therefore legal counsel should be consulted prior to implementing any fix.

Trust law issues in general
The existence of a trust is determined by the relationship between the settlor (the original contributor of trust property), the trustees and the beneficiaries. The relationship may or may not be defined by a formal written document but is codified by applicable trust legislation and common law. To effectively create a trust we need to understand what is necessary to establish a trust, commonly referred to as the three certainties. A trust will not be established unless it is certain that the settlor intended to create a trust relationship and both the property and the beneficiaries are described with sufficient certainty. The best evidence that the three certainties for establishing a trust exist is a written trust agreement that deals with:

• Intention: the certainty of intention is evident where it is clear that a trust relationship was the intention of the settlor, as opposed to some other relationship such as an agency, a transfer or a gift of property.
• Existence of the trust property: property or substituted property must be clearly identifiable.
• Existence of beneficiary: the beneficiary must be identifiable.

In-trust accounts may not always meet all the criteria, or certainties, to establish a trust. Specifically, the required certainty of intention is difficult to prove without a formal, signed trust agreement. In the past, Canada Revenue Agency has stated that without a formal trust document, the arrangement is more akin to an agency than a trust. This may not be a valid description of the relationship as the minor would not have the ability to enter into an agency arrangement, and the child would not be instructing the parent or agent. While the original intention of parents setting up an in-trust account may have been to establish a trust, there are situations where the parents’ actions, including the tax filings subsequent to the initial gift, contradict the existence of the trust such that it could be disregarded.

Ability of parents to act for children
Each province has a government body that acts as the public trustee (Children’s Lawyer), who represents the interests of minors and unborn contingent beneficiaries. In the Infants Act (RSBC 1996 c. 233), Section 40 states that a guardian (usually a parent) may make agreements for an infant with the public trustees’ approval if the agreement is for consideration less than $10,000, or with court approval if the consideration amount is more than $10,000. (In Quebec, this is $25,000.) The understanding is that a parent does not have the legal authority to deal with their children’s assets greater than $10,000, therefore legal counsel should be consulted before such a transaction is undertaken. Experience shows that the Children’s Lawyer is not usually consulted formally if the risks of transacting the minor’s assets are low.

Usually the Children’s Lawyer is informed if an existing trust agreement or the terms of a will are being varied and minor or unborn children have an interest in the trust or will. As well, if an individual feels the financial interests of a minor are not being properly handled, the Children’s Lawyer can investigate.

Options before minor becomes a major

Retain informal trust
While the child will have legal rights and therefore access to the assets when he or she reaches the age of majority, it may be possible to set limits on the withdrawal of funds from the brokerage/bank account by giving parents signing authority on the accounts. This may not provide absolute security (control of funds) if the child is aware of the rule detailed in the case of Saunders v Vautier, which provides that if all persons who have an interest in the trust are of legal age and are competent, they may agree to terminate the trust, without the consent of the court or the trustees. The children could therefore override the conditions included on the brokerage/bank account and demand the trust property be released to them.

Document original trust intention
A trust agreement could be subsequently drafted to document the parent’s original intentions. To prove these intentions, it would be helpful if notes exist to provide evidence of the original intention. Experience shows that such documents usually do not exist. If a trust was created, there would have been a requirement to file T3 Trust income tax returns. It is likely if the trust was not formalized that theparents would not have incurred the cost associated with the preparation of annual T3 Trust income tax returns. If no T3 Trust income tax returns have previously been prepared, returns should be filed for at least three years to correct the situation. There is a penalty for each failure to comply with the requirement to file the information return and distribute the relat-ed slips to the beneficiaries. For each year this failure occurs, there is a penalty of $25 a day, to a maximum of $2,500, for late returns.

If the gains realized on the in-trust assets prior to the child turning 18 were reported by the child, the gain’s taxable portion must have been made payable to the child. So even if the original trust intention is documented, the child at 18 can call upon the value of the demand promissory note theoretically issued to ensure the gain is taxable on the child’s personal income tax return (the income splitting).

Incorporate a private holding company
This option involves incorporating a Holdco with the parents subscribing for nom- inal value, nonparticipating voting control preference shares. The parents would transfer assets from the informal trust, before the child turns 18, on a tax-deferred basis to the Holdco for the common shares. As common shareholders cannot request their shares be retracted, holders of the vot- ing control shares (the parents) would have control over when children can get access to this value.

If the assets include a significant amount of cash, the funds could be contributed to Holdco in the form of long-term debt, payable in 10 years. Market-rate interest should be payable on the note to offset the perceived disadvantage of the long-term repayment terms. Any interest paid to the children should be deductible by the company. As attribution applies to income generated on the original gifted funds, any interest or dividends paid on the debt and shares of Holdco received by the children would be taxable by the parent who made the original gift until the year the children turn 18.

It should be noted that there is generally a lack of integration in the Canadian tax system. Currently, investment income earned in a corporation is taxed at a slightly higher rate than if the same investment income was reported by an individual.

Settlement of a new formal trust prior to children turning 18
Currently, a trust can be settled with the parents as trustees. The children and potentially others, including future grandchildren, can be named as income and capital beneficiaries. The children could sell their investment accounts to the formal trust at fair-market value; any gain or loss on the securities in the account would be realized. Consideration will be a note with restrictions on repayment–payable in 10 years for example. Market-rate interest  moved to the end of People management should be payable on the note to offset the perceived disadvantage of the long repayment. This interest would attribute to the parent who made the original gift until the child turns 18. Any interest paid should be deductible by the trust.

Purchase life insurance
Funds in the informal trust could be used to purchase a prepaid insurance policy on the life of the parents or the child. The premiums for such a policy will reflect the age and health of the individual to be insured. All investment income realized within the policy would be exempt from income tax. After the child turns 18, he or she, as the owner of the policy, would be able to borrow against the policy by using it as collateral. In addition, the owner of the policy can cancel it and cash out. It may be possible to purchase a policy that has high surrender charges in the early years to discourage the child from cashing out for a couple of years. If the policy was originally purchased by the parents, with the parents’ funds, they could be the owners of the policy and continue to control it until ownership is transferred to the child.

Conclusion
Informal trust planning is usually implemented when a child is sweet and innocent and his or her 18th birthday seems a lifetime away. As a child gets closer to the age of majority, parents start worrying about what he or she will use the funds for. Another concern is whether the children will discontinue their education because they have won the “trust fund lottery.” A formal trust can provide inexpensive insurance against sleepless nights worrying where the money will end up.