What Is a Trust and How It’s Taxed

Introduction
Understanding what is a trust and how it’s taxed is essential for business owners, families, investors, and anyone involved in estate planning or asset protection. A trust is a powerful legal structure used to hold and manage assets for beneficiaries. Trusts are widely used in Canada for tax planning, wealth preservation, real estate ownership, and transferring assets between generations. But trusts also come with strict tax rules, mandatory filings, penalties for non-compliance, and complex reporting—especially after recent federal and Québec legislative changes. This guide explains everything you need to know about what is a trust and how it’s taxed.

Legal and Regulatory Framework
What is a trust and how it’s taxed is governed by:

• the Income Tax Act
• CRA T3 Trust Guide
• T3RET – Trust Income Tax and Information Return
• Schedule 9 – Income Allocation
• Québec’s TP-646 Trust Return
• Québec’s new trust reporting rules (effective 2023 onward)
• trust law (common law & civil law in Québec)
• attribution rules
• 21-year deemed disposition rule

Canada treats trusts as separate taxpayers, with unique obligations and deadlines.

1. What Is a Trust? (Simple Explanation)

A trust is a legal relationship, not a corporation, formed when:

• a settlor contributes property
• a trustee manages property
• for the benefit of beneficiaries

Three key components:

1. Settlor – creates the trust

2. Trustee – administers property and manages decisions

3. Beneficiaries – receive income or capital from the trust

A trust separates control and benefit, making it a powerful tax and estate-planning tool.

2. Types of Trusts in Canada

Understanding what is a trust and how it’s taxed requires knowing the main trust categories:

A. Personal & Family Trusts

• inter vivos trusts (created during lifetime)
• testamentary trusts (created by will)
• discretionary family trusts
• spousal trusts

B. Business & Investment Trusts

• holding trusts
• real estate trusts
• bare trusts (nominee arrangements)
• partnership trusts

C. Special-Purpose Trusts

• alter ego trusts
• joint spousal trusts
• Henson trusts (for disabled beneficiaries)
• insurance trusts

Each trust type has specific tax rules.

3. How Trusts Are Taxed

A trust is a separate taxpayer that must:

• file an annual T3 return (CRA)
• file TP-646 (Québec) if applicable
• report all income (interest, dividends, rent, capital gains)
• pay tax on retained income
• issue T3 slips to beneficiaries for distributed income

Tax rates for trusts:

Most inter vivos trusts are taxed at the highest marginal tax rate
(unless income is flowed to beneficiaries).

Thus, proper distribution planning is essential.

4. Income Allocation to Beneficiaries

Trusts may:

• retain income and pay tax at the highest rate
OR
• allocate income to beneficiaries (who pay tax at their own rates)

Types of distributions:

• income distributions
• capital gains distributions
• return of capital
• discretionary distributions (trustee decides)

When income is allocated:

• trust deducts the amount
• beneficiaries receive T3 slips
• beneficiaries report income on personal returns

This “flow-through” mechanism is central to what is a trust and how it’s taxed.

5. Attribution Rules (Important for Families)

Attribution rules prevent using trusts to split income improperly.

CRA may attribute income back to:

• the settlor
• a parent
• a spouse

Attribution applies when:

• the settlor keeps control
• beneficiaries are minors
• trust loans have no interest
• transfers are not made at fair market value

Proper structuring avoids attribution.

6. 21-Year Deemed Disposition Rule

Every 21 years, a trust is deemed to sell all its assets at fair market value.

This triggers:

• capital gains
• taxable events
• potential tax planning requirements

To avoid the 21-year tax hit, families often:

• distribute assets to beneficiaries prior to year 21
• freeze or restructure the trust
• roll assets into new trusts (advanced planning)

This is a crucial part of what is a trust and how it’s taxed.

7. GST/HST and QST Considerations

Trusts may be required to:

• register for GST/HST
• register for QST
• collect sales tax on rental or business activities
• file periodic returns

Bare trusts (nominee arrangements) must now file returns even with no tax.

8. Québec Trust Tax Rules (Stricter Reporting)

Québec requires:

• TP-646 filing for many trusts
• detailed disclosure of trust assets
• beneficial ownership information
• residency information
• expanded reporting under anti-avoidance rules

Unfiled Québec trust returns lead to heavy penalties.

9. Documentation Required for Trust Compliance

Trusts must maintain:

• trust deed
• minute book
• resolutions
• investment records
• income statements
• T3 slips issued
• bank statements
• proof of distributions
• beneficiary designations
• real estate documents
• capital gain calculations

CRA requires trusts to keep records for six years, though many are kept permanently.

10. Penalties for Not Filing Trust Returns

Penalties for failing to file T3 or TP-646 include:

• $25/day (minimum $100, maximum $2,500)
• penalties for failing to issue T3 slips
• interest on unpaid taxes
• gross negligence penalties
• audit expansion into beneficiary returns

Bare trust penalties also apply (introduced 2023+).

Key Court Decisions

Canadian courts have ruled:

• trusts are valid even without formal registration
• CRA can apply attribution rules where intent is tax avoidance
• discretionary trusts give broad trustee powers
• failure to file trust returns leads to harsh penalties
• bare trusts must meet disclosure rules
• trust residency is determined by control, not legal registration

These rulings shape the modern taxation of trusts.

Why CRA and Revenu Québec Audit Trusts

Trust audits are common due to:

• income-splitting concerns
• undisclosed beneficiaries
• real estate held through trusts
• non-resident trusts
• attribution-rule violations
• failure to file T3 and TP-646
• unexplained distributions

Understanding what is a trust and how it’s taxed helps prevent audit exposure.

Mackisen Strategy

Mackisen CPA provides full trust-taxation support:

• trust creation guidance with legal partners
• preparing T3 and TP-646 trust returns
• determining taxable vs non-taxable distributions
• ensuring compliance with attribution rules
• planning before 21-year deemed dispositions
• preparing T3 slips for beneficiaries
• managing CRA or ARQ trust audits
• tax planning for family trusts and estate freezes
• analysis of trust residency and non-resident implications

We ensure full compliance with both federal and Québec trust laws.

Real Client Experience

Examples of trust cases Mackisen handled:

• A family trust missed 5 years of T3 filings. We corrected all returns and avoided major penalties.
• A Québec real estate trust failed to issue T3 slips. We reconstructed distribution records and filed compliant returns.
• A business owner’s trust faced attribution-rule reassessment. Mackisen prepared a strong objection and reversed most penalties.
• A non-resident trust incorrectly claimed exemptions. We restructured the trust and ensured proper reporting.
• A family nearing the 21-year deadline needed asset distribution planning. We executed a tax-efficient rollover.

Common Questions

• Do all trusts need to file a T3?
Most do, especially after new reporting rules.

• Do family trusts pay tax?
Yes—at the highest rate, unless income is distributed.

• Can a trustee also be a beneficiary?
Yes—common in family trusts.

• Does Québec require separate trust filings?
Yes—TP-646 is mandatory for Québec trusts.

• Is a bare trust required to file?
Yes—new rules require full disclosure.

• What happens after 21 years?
A deemed disposition occurs unless assets are distributed.

Why Mackisen

With more than 35 years of combined CPA experience, Mackisen CPA Montreal helps families, businesses, and investors understand what is a trust and how it’s taxed. Whether you’re setting up a trust, filing trust returns, or defending against a CRA or ARQ audit, our expert team provides full trust planning, compliance, and protection.