Family Trusts for Income Splitting

Introduction
Understanding family trusts for income splitting is essential for business owners, high-income professionals, investors, and families who want to build generational wealth while reducing taxes legally. A family trust is a flexible structure that allows income and capital to be distributed among family members in a tax-efficient way. When used correctly, a family trust can help lower overall tax burdens, protect assets, control succession planning, and manage how wealth flows to beneficiaries. However, CRA and Revenu Québec closely monitor trust arrangements and have strict attribution rules, filing requirements, and audit procedures. This guide explains everything you need to know about family trusts for income splitting and how they are taxed.

Legal and Regulatory Framework
Family trusts for income splitting are governed by the Income Tax Act, attribution rules, tax on split income (TOSI) legislation, CRA’s T3 Trust Guide, Québec’s Taxation Act, trust reporting rules, and the 21-year deemed disposition rule. A family trust is considered a separate taxpayer that must file a T3 return federally, and a TP-646 in Québec, reporting all trust income, deductions, and distributions. Trusts allow income to flow through to beneficiaries, but only if rules are followed precisely. Misuse can result in income being reassessed back to the settlor, denial of deductions, TOSI reclassification, or penalties.

Purpose and Benefits of Family Trusts
Family trusts for income splitting are used for several key goals. They enable shifting income to beneficiaries in lower tax brackets, allowing families to reduce overall tax payable legally. Trusts also allow for asset protection, since assets inside a trust are not owned directly by beneficiaries, reducing exposure to creditors, divorces, and lawsuits. Trusts provide long-term flexibility for estate and succession planning because the trustee manages assets on behalf of beneficiaries based on trust deed instructions. Family trusts also allow business owners to freeze the value of their corporation and pass future growth to beneficiaries through the trust. These benefits make family trusts a central tool in Canadian tax and wealth planning.

Who Can Benefit from a Family Trust
Family trusts for income splitting are useful for incorporated business owners, professionals using corporate structures, investors with holding companies, parents planning to transfer wealth to children, and families running multi-generational businesses. Trusts are also beneficial for families with disabled or vulnerable beneficiaries, providing controlled access to assets. Real estate investors use trusts to split rental or capital gain income. Families with private corporations commonly use trusts to allocate dividends, when permissible, to reduce overall tax. In Québec, trust structures are especially useful for multi-property ownership and estate protection.

How Income Splitting Works Through a Family Trust
A family trust earns income from business income, interest, dividends, rental income, or capital gains. That income may be allocated to beneficiaries, who then report it on their own tax returns. The trust deducts the distributed amount, avoiding taxation at the trust’s high default rate. Beneficiaries pay tax at their personal marginal rates, often much lower than the trust rate. For example, if a business owner’s corporation pays dividends to a family trust, the trust can distribute those dividends to lower-income family members where permitted, resulting in significant tax savings. This mechanism is central to family trusts for income splitting.

Restrictions: TOSI (Tax on Split Income)
TOSI rules limit income splitting for certain family members. TOSI applies to dividend income, business income, and certain trust allocations to individuals who do not meet specific involvement or age tests. If TOSI applies, income is taxed at the highest marginal rate regardless of the beneficiary’s income. Exceptions apply for spouses over age 65, adults engaged in the business (“excluded business”), owners with meaningful shareholdings (“excluded shares”), and capital gains on qualified small business shares. Understanding TOSI is critical when using family trusts for income splitting.

Attribution Rules
Attribution rules prevent tax avoidance by shifting income to minor children or related individuals artificially. Income or capital gains may be attributed back to the settlor if the trust is funded improperly or without consideration. Loans to trusts must carry market interest rates to avoid attribution. When attribution applies, income is treated as though earned by the person who contributed assets, cancelling tax benefits. Proper structuring ensures family trusts for income splitting comply with attribution rules.

21-Year Deemed Disposition Rule
Every 21 years, a trust is deemed to dispose of its assets at fair market value, potentially triggering capital gains. To avoid this tax event, assets are often distributed to beneficiaries or transferred strategically before the 21-year deadline. Families must track this timeline carefully. Québec trusts must also comply with the TP-646 deemed disposition rules, which mirror federal requirements. Proper planning ensures long-term tax efficiency.

Québec-Specific Trust Rules
Revenu Québec imposes additional filing obligations. Québec trusts must file TP-646 and additional disclosure forms including beneficiary information, trustee residency, and asset details. Québec does not automatically follow federal trust exemptions and conducts aggressive audits of income splitting and attribution. Québec also applies unique penalties for unfiled trust returns, even if no income exists. Anyone using family trusts for income splitting in Québec must ensure dual compliance with CRA and ARQ rules.

Documentation Requirements
To remain compliant, a trust must maintain a trust deed, trustee resolutions, annual minutes, asset registers, T3 slips for beneficiaries, bank statements, proof of income earned, distribution records, and beneficiary loan documents if applicable. CRA requires trusts to maintain books for at least six years; however, trust documents are generally kept indefinitely. Québec requires additional records for TP-646 and may request detailed beneficiary information during audits.

Key Court Decisions
Canadian courts have confirmed that trusts are valid separate entities when structured correctly. Courts have upheld TOSI reclassifications when beneficiaries were not genuinely involved in the business. Attribution cases emphasize that gifts to minors through trusts must follow the law carefully. Courts also confirm that trustees must act independently and cannot simply follow instructions from the settlor. These cases highlight why proper structuring is essential when using family trusts for income splitting.

Why CRA and Revenu Québec Audit Family Trusts
Family trust audits are triggered by unexplained distributions, payments to minors, business income flowing through a trust, corporate shareholdings owned by trusts, and large capital gains allocated to beneficiaries. CRA and ARQ also review attribution, TOSI exposure, and whether the settlor indirectly controls the trust. Non-resident beneficiaries and real estate ownership inside trusts are also major audit triggers. Proper documentation is essential to avoid reassessment.

Mackisen Strategy
Mackisen CPA provides complete trust-planning and income-splitting support. We establish family trusts with your legal team, determine optimal allocation strategies, prepare annual T3 and TP-646 returns, analyze TOSI exposure, ensure attribution compliance, manage corporate share freezes, prepare trust resolutions, structure dividend flows, and defend trusts during CRA and ARQ audits. Our planning protects family wealth and ensures every income-splitting step is compliant and tax-efficient.

Real Client Experience
A business owner used a family trust to distribute dividends to adult children. CRA questioned involvement. Mackisen proved excluded business status and preserved tax savings. A Québec family failed to file trust returns for several years. We reconstructed all records and eliminated penalties. Another client used a trust to hold multiple rental properties. ARQ challenged attribution. Mackisen provided tracing and upheld the trust structure. We have also managed 21-year planning for families with multi-million-dollar estates, ensuring tax-free rollouts.

Common Questions
Is a family trust legal for income splitting? Yes—when structured properly.
Do minors receive income through trusts? Yes, but attribution and TOSI rules may apply.
Does a family trust file its own return? Yes—a T3 and, in Québec, a TP-646.
Can a family trust own company shares? Yes—commonly used in small business tax planning.
Does the 21-year rule tax the trust automatically? Yes unless assets are distributed earlier.
Can a trust reduce capital gains tax? Yes—through capital gains allocation to beneficiaries.

Why Mackisen
With more than 35 years of combined CPA experience, Mackisen CPA Montreal helps families and business owners use family trusts for income splitting safely and effectively. We design trust strategies that minimize tax, protect assets, and withstand CRA and Revenu Québec scrutiny. Whether you're creating a trust, restructuring your business, or defending a trust in an audit, our expert team ensures precision, compliance, and strong long-term tax benefits.