Parents who want to create a financially secure future for their children — while simultaneously reaping the benefits of income-splitting — sometimes set up in-trust accounts. But if a client is considering such a move, you might want to point out that these accounts are likely to cause headaches down the road.

“It’s not a great way to run your affairs,” says Mike McIntosh, a chartered accountant and investment advisor in the Calgary office of Vancouver-based Phillips Hager & North Investment Management Ltd.

Tax experts agree: the biggest problem is that once a child reaches the age of majority, power over the account must be handed over to the child.

“When a child turns 18, we as a company have to notify him about the account,” McIntosh says. “The parents get upset.”

Most parents who open in-trust accounts want to place equity investments in the account and engage in income-splitting. Under the Income Tax Act, capital gains from assets placed in an in-trust account can be reported by the child, as opposed to the parent. (This does not apply to interest or dividends; both these are taxed in the hands of the parent.)

For example, says McIntosh, parents might want to place shares of a start-up oil company in trust for their child. But what happens if the oil company experiences superior growth and the value of the account balloons to, say, $250,000? When the child turns 18, he or she has access to a lot of cash. And some parents don’t want that, McIntosh says.

As a result, some investment firms are even refusing to set up in-trust accounts, says Siân Matthews, a tax lawyer with Bennett Jones LLP in Calgary. The resulting tension between parents and the child can lead to “a potentially nasty lawsuit. Brokers don’t want that problem.”

Another problem a parent may face is a challenge from the Canada Revenue Agency. An in-trust account would be considered an inter vivos trust (a trust created between living people), which is taxed at the highest marginal rate. Obtaining a tax advantage by having the capital gains taxed at the child’s lower rate means the trust would have allocate the gains to the child in cash or the form of a promissory note.

But people rarely file trust tax returns for in-trust accounts, McIntosh says. And if the gains are shown on the child’s tax return — but the money hasn’t actually been allocated to the child — the parent could be in for a harsh tax hit. The parent would be “offside” by not filing a trust return, says McIntosh. Worse, the gains probably would be attributed back to the parent and taxed with interest and penalties.

Further, the CRA will challenge whether the account is a real trust. Even though an account opening form may state the account has been opened by a John Smith “in trust” for Susie Smith, this is not always sufficient evidence of a trust.

While a trust can be made orally or in writing, says Matthews, courts favour the latter. With actual trust documents, it is easier to establish the required “three certainties” to have a trust. These are:

> The certainty of the settlor’s intention. The “settlor” is the person who sets up the trust. Determining that person’s intention is difficult to establish without a trust document, says Matthews.

> The certainty of property. If a parent makes withdrawals from the account, says McIntosh, it looks as though they are trying to benefit from the tax shelter aspect without respecting the trust. “If there is no settlement property, there is no valid trust,” adds Matthews.

> The certainty of objects. This refers to whom will benefit from the trust and how. Again, this is most easily proven when there is a trust document.

However, says Matthews, in situations in which there is “an actual trust but no written deed,” there is a planning strategy available to “formalize” the trust, thereby fending off fights with the child and attacks from the CRA.

In simple terms, it will mean converting the in-trust account into a formal trust prior to the child reaching the age of majority, which is established by the child’s province of residence.

Establishing a formal trust will give the parents the opportunity to determine when the trustees should distribute trust assets to the child.

@page_break@Matthews’ firm also makes a court application to “vary the trust.” Because the child will be a minor, the provincial Children’s Trustee represents him or her.

All this costs money — about $30,000, Matthews says. Therefore, it’s not a recommended strategy when small amounts of money are at stake. In her experience, this strategy is most commonly used when an in-trust account is valued at $2 million-$25 million.

Another strategy that can be used to protect the assets in the trust is for a parent to set up a private holding corporation and transfer the assets through a tax-deferred rollover into non-voting common shares.

Generally, a common shareholder cannot request retraction of their shares from the company — giving the parent, who has voting shares, a measure of control. However, notes Matthews, if the child can argue validly that there was no legal trust in the first place, he or she could still call for the shares. “In certain provinces, such as British Columbia and Ontario, adult children can call for trust property to be conveyed directly to them,” she says.

A third strategy to put a layer of control between the child and the in-trust assets is using the funds to buy a universal life insurance policy. The investment proceeds would be protected from taxes and the child could borrow against the policy, as collateral, when he or she turns 18. However, once the child reaches the age of majority, he or she could cash out the policy for its surrender value, if willing to pay the high surrender fees applicable in the early years of the policy.

Looking on the bright side, Matthews says, your client may have kids who won’t try to get at the money. But the client still needs to keep the CRA happy. In-trust accounts certainly have been challenged, she says, especially if significant second-generation income or significant capital gains taxes are at stake. IE