Income generated by children through trusts or investments can be subject to complex tax rules in Canada. As more families explore wealth management and legacy planning, it’s increasingly common for parents or guardians to set up trusts or investment accounts for their children. These financial structures help safeguard assets for the future but come with tax implications that need careful consideration.
Understanding how a child’s income from trusts and investments is taxed is crucial to avoiding pitfalls, maximizing benefits, and ensuring tax compliance. Canadian tax laws surrounding minors are designed to prevent income splitting and abuse of lower tax brackets, but there are also legitimate strategies that can be employed to minimize tax burdens. This article aims to break down the key taxation rules and strategies for handling a child’s income from trusts or investments, using the latest 2024 information and practical case studies to provide actionable insights.
Understanding Child Income from Trusts and Investments
Income earned by a child from trusts or investments can come from a variety of sources. Parents or relatives may gift money to a child, or it could come through an inheritance. When this money is placed into an investment or trust account, it has the potential to generate interest, dividends, or capital gains. Each of these income types is taxed differently, and when minors are involved, there are additional tax rules to consider.
A common setup is for parents to create family trusts or investment accounts in the child’s name, often as a way to save for future education, such as through Registered Education Savings Plans (RESPs), or simply to transfer wealth more efficiently. These vehicles can help a child grow their wealth tax-efficiently over time, but it’s important to understand the tax implications.
In Canada, the income that a child earns from trusts or investments is generally taxed in a similar way to adults, but there are several exceptions and attribution rules that apply specifically to minors. Certain income earned by children may be attributed back to the parents and taxed at the parents’ marginal tax rate, making it crucial to structure these investments properly.
Taxation Rules for Minor Children in Canada
General Taxation Rules for Minors
In most cases, minors are subject to the same tax rates as adults. Income from employment, scholarships, or investment accounts is generally taxed in the hands of the child. However, minors are entitled to claim basic personal tax credits, just like adults. As a result, if the income earned falls below the personal exemption limit, the child may not owe any taxes.
Attribution Rules for Parental Income
When a parent gifts money to a child to invest, any income (interest or dividends) generated from those funds is subject to attribution rules. The Canada Revenue Agency (CRA) requires that income earned by a minor through a parent’s financial gift be attributed back to the parent for taxation. However, this rule does not apply to capital gains; capital gains from such investments remain taxable in the hands of the child.
For example, if a parent gives $10,000 to their child to invest in stocks, any dividends or interest generated from that $10,000 will be taxed as if it were earned by the parent. If the investment appreciates and the child sells it, any capital gains will be taxed in the child’s name.
Exceptions to Attribution Rules
Certain types of income, such as scholarships, bursaries, or income from child benefits, are not subject to attribution rules. Additionally, the income earned within specific accounts, such as RESPs, follows its own set of tax rules, which provide tax-sheltered growth opportunities until withdrawals are made.
The attribution rules are designed to prevent families from taking advantage of the lower tax rates available to children, ensuring that income derived from parental funds is taxed appropriately.
Trust Income: How It’s Taxed
Overview of Trust Types: Revocable, Irrevocable, and Discretionary Trusts
- Revocable Trusts: In a revocable trust, the trust creator (also known as the settlor) can change or revoke the trust at any time. Income from revocable trusts is taxed in the hands of the settlor, meaning that any income generated for a child beneficiary will still be attributed back to the parent or grandparent who created the trust.
- Irrevocable Trusts: Once an irrevocable trust is created, it cannot be altered or revoked. For tax purposes, income from an irrevocable trust is typically taxed in the hands of the beneficiary. This means that if a minor receives income from an irrevocable trust, the child is responsible for paying the tax on that income, subject to the attribution rules discussed earlier.
- Discretionary Trusts: In a discretionary trust, trustees have the authority to decide how and when beneficiaries will receive income or capital from the trust. Income distributed to a child from a discretionary trust may be taxed either in the trust or in the hands of the beneficiary, depending on the trust structure. This type of trust is commonly used in family wealth planning.
Taxation of Income from Family Trusts
In family trusts, income generated and distributed to minors may include interest, dividends, or capital gains. Family trusts often use a discretionary structure, allowing trustees to distribute income in a tax-efficient manner. However, the “kiddie tax” (discussed later) may apply to certain types of income, such as dividends from family businesses, which can complicate tax planning.
Taxation of Capital Gains and Dividends
For minors receiving capital gains from a trust, the income is generally taxed in the child’s hands, as capital gains are not subject to the attribution rules. Dividends, however, may be subject to special taxation rules, including the kiddie tax. Careful planning is required to structure trust distributions in a way that minimizes the tax burden on the family.
Investment Income: Taxation Overview
Taxation of Interest Income
Interest income is earned from savings accounts, GICs (Guaranteed Investment Certificates), or bonds. In Canada, interest income earned by a child is taxed at the full marginal tax rate, with no preferential treatment. Additionally, if the funds used to generate interest were gifted by a parent, the attribution rules apply, and the interest income will be taxed in the parent’s hands, not the child’s.
For instance, if a child earns $500 in interest income from a savings account funded by a parent’s gift, that $500 will be taxed at the parent’s marginal tax rate.
Taxation of Dividends
Dividends are typically paid out by corporations to shareholders. In Canada, dividends are subject to a “gross-up” and dividend tax credit system, designed to avoid double taxation. If a child receives dividend income from a Canadian corporation, that income may be taxed in the child’s hands. However, as with interest income, if the funds used to purchase the shares were provided by a parent, the dividend income may be attributed back to the parent.
It’s also important to note that dividends from private family corporations are subject to the kiddie tax, which significantly increases the tax rate on that income.
Taxation of Capital Gains
Capital gains arise when an investment, such as stocks or mutual funds, is sold for more than the purchase price. In Canada, only 50% of capital gains are taxable. When minors earn capital gains, the taxation of these gains depends on the source of the initial investment.
Unlike interest and dividend income, capital gains earned by a minor are not subject to attribution rules. This means that capital gains are taxed in the child’s hands, regardless of whether the investment was funded by a parent. As a result, capital gains can be an effective way for families to transfer wealth to their children without triggering a higher tax burden.
Tax-Sheltered Accounts for Children
- Registered Education Savings Plan (RESP): Contributions to an RESP grow tax-free until the funds are withdrawn for educational purposes. When the child eventually uses the funds, the withdrawals are taxed at the child’s marginal tax rate, which is typically lower.
- Tax-Free Savings Account (TFSA): While children under 18 cannot open a TFSA, once they reach 18, they can contribute to a TFSA, and any income earned in the account (interest, dividends, or capital gains) is not taxed.
The Kiddie Tax and Split Income
Introduction to the Kiddie Tax
The kiddie tax, formally known as the Tax on Split Income (TOSI) in Canada, is a tax mechanism designed to prevent income splitting between parents and children to take advantage of the child’s lower tax rates. Under the kiddie tax rules, specific types of income earned by minors are taxed at the highest marginal rate, ensuring that families cannot use their children as a means to reduce their overall tax burden.
Types of Income Subject to the Kiddie Tax
- Dividends from Family Businesses: If a child receives dividends from shares in a family-owned corporation, that income is subject to the kiddie tax and will be taxed at the highest marginal rate.
- Income from Family Trusts: Any trust income directed to a child from a family business or partnership may also be subject to the kiddie tax. If the trust is designed to split income between family members, the CRA may apply TOSI rules.
- Partnership or Rental Income: Income earned by minors from family partnerships or rental properties is also subject to the kiddie tax.
How the Kiddie Tax Impacts Income from Family Businesses, Trusts, or Investments
The kiddie tax can significantly increase the tax burden on a child’s income from family businesses or trusts. For example, if a minor receives $5,000 in dividends from a family corporation, this income will be taxed at the highest rate, reducing the overall tax savings that might have been anticipated through income splitting. Families need to be aware of the kiddie tax and how it may affect their wealth transfer strategies.
Exceptions to the Kiddie Tax
Not all income earned by minors is subject to the kiddie tax. Certain types of income, such as wages earned from legitimate employment or capital gains from non-attributable investments, are exempt from TOSI rules. Additionally, income earned through specific tax-sheltered accounts, such as RESPs, is not subject to the kiddie tax.
Real-Life Scenarios and Case Studies
Scenario 1: A Child Receiving Income from a Family Trust
The Smith family set up a discretionary family trust for their two children, ages 12 and 15. The trust holds shares in the family’s privately owned business, and every year, dividends are distributed to the beneficiaries, including the two minors.
Under the kiddie tax rules, the dividend income that the children receive from the trust is considered split income and is subject to the highest marginal tax rate. The dividends, originally meant to provide some tax relief by utilizing the children’s lower tax brackets, end up being heavily taxed under TOSI rules.
Had the trust been structured differently or invested in assets that generate capital gains instead of dividends, the children could have benefited from the more favorable tax treatment of capital gains, which are not subject to the kiddie tax.
Scenario 2: A Child Earning Investment Income from a GIC
John, 16, received a gift of $10,000 from his grandparents, which was invested in a GIC (Guaranteed Investment Certificate). Over the course of the year, the GIC earned $400 in interest income.
Because this gift was not made by John’s parents, the interest income is not subject to attribution rules, meaning it will be taxed in John’s hands. As his total income for the year is below the personal tax exemption threshold, John does not owe any taxes on the interest income earned from the GIC.
This scenario highlights how gifts from non-parental sources can benefit minors, as the income earned is not subject to attribution back to the parents.
Scenario 3: Capital Gains on Stocks Held by a Minor
Emma, age 17, received a monetary gift from her parents, which was used to purchase shares of a publicly traded company. Over two years, the shares appreciated, and Emma decided to sell them, generating $3,000 in capital gains.
Since capital gains are not subject to attribution rules, the $3,000 is taxed in Emma’s hands, and only 50% of the gain is taxable. Emma benefits from a lower tax rate on her capital gains, as the gains are not subject to TOSI, and her overall taxable income is within a low tax bracket.
This scenario shows how capital gains are often a tax-efficient way to transfer wealth to minors without triggering the kiddie tax.
Steps to Minimize Taxation on Child’s Income
1. Structuring Trusts for Tax Efficiency
When setting up a trust for a child, it’s important to consider the type of income that the trust will generate. Capital gains, for example, are not subject to attribution rules and can be taxed in the child’s hands, often at a lower rate. By focusing on investments that generate capital gains rather than dividends or interest, families can reduce the overall tax burden on the child’s income.
Additionally, discretionary trusts can be structured to provide flexibility in income distribution. Trustees can choose when and how to distribute income, potentially delaying distributions until the child reaches the age of majority, when attribution rules no longer apply. However, care must be taken to avoid the kiddie tax on certain types of income, such as dividends from family businesses.
2. Utilizing Capital Gains Over Interest and Dividends
As previously mentioned, capital gains offer a tax advantage over other forms of income because they are not subject to attribution rules and only 50% of the gain is taxable. Families can encourage long-term investments in stocks or mutual funds that have the potential for capital appreciation, rather than short-term investments that generate interest income or dividends, which are more heavily taxed.
3. Leveraging Tax-Sheltered Accounts
Registered accounts such as RESPs and TFSAs can be powerful tools for tax-sheltered growth of a child’s investments. Contributions to an RESP grow tax-free, and when the funds are withdrawn for educational purposes, they are taxed in the hands of the child, who is likely to have little or no other income, resulting in minimal tax liability.
Although minors cannot open TFSAs, once they turn 18, they can contribute to their own TFSA, allowing investment income to grow tax-free. Parents can help their children understand the benefits of these accounts and encourage their use once the child is eligible.
4. Avoiding Attribution by Using Non-Parental Gifts
Income earned from gifts provided by non-parental sources, such as grandparents or other relatives, is not subject to the attribution rules. By having extended family members contribute to a child’s investment account or trust, families can bypass the attribution of income to the parents. However, this requires coordination within the family and careful documentation of the source of funds.
5. Income Splitting Through Employment
One way to avoid the kiddie tax and attribution rules is for minors to earn income through legitimate employment. Income earned by a child from a job is taxed in the child’s hands, and they can claim personal tax credits to reduce or eliminate the tax liability. Encouraging children to earn their own income through part-time work is not only a tax-efficient strategy but also a valuable financial learning experience.
By carefully selecting the types of income generated and understanding the nuances of Canadian tax law, families can minimize the tax burden on a child’s income from trusts or investments while remaining compliant with the law.
Authoritative Resources for Further Guidance
1. Canada Revenue Agency (CRA) – Tax on Split Income (TOSI)
The CRA provides comprehensive information on the Tax on Split Income (kiddie tax) and how it applies to minors. This resource explains the types of income subject to TOSI and the specific rules surrounding its application to children. Visit the official CRA website for up-to-date guidelines:
CRA TOSI Guidelines
2. CRA – Income Attribution Rules
The CRA also offers detailed resources on how income attribution works for gifts and loans provided by parents to minors. These rules are crucial in understanding how investment income is taxed when parents contribute to a child’s investment account or trust. Access the full guidelines here:
CRA Income Attribution Rules
3. Financial Advisors and Estate Planners
Consulting a financial advisor or estate planner with experience in family trusts and investment income for minors is essential for structuring these accounts in a tax-efficient manner. These professionals can provide personalized strategies tailored to the specific needs of your family.
4. Legal Advisors Specializing in Trust Law
Legal experts who specialize in trust law can offer valuable advice on setting up trusts in compliance with Canadian tax laws. They can ensure that the trust structure aligns with your family’s wealth transfer goals while minimizing tax liabilities.
5. Government Publications and Tax Guides
The Canadian government regularly publishes tax guides and official publications that provide detailed information on the taxation of trusts, investments, and minor income. These publications are updated annually to reflect changes in tax law and can be accessed through the CRA or other government platforms.
6. Financial Literacy Resources for Children
Encouraging financial literacy in children is important as they begin to earn income from investments. Many organizations offer resources and educational tools that can help children understand how taxes work and the importance of financial planning.
Frequently Asked Questions (FAQ)
Q1: What is the Kiddie Tax, and how does it affect my child’s income?
The kiddie tax, officially known as the Tax on Split Income (TOSI), applies to certain types of income earned by minors, such as dividends from family-owned corporations, income from family trusts, or partnership income. This tax is designed to prevent income splitting, where parents shift income to their children to take advantage of the child’s lower tax bracket. Income subject to the kiddie tax is taxed at the highest marginal rate, which can significantly increase the tax burden on the child’s income.
Q2: Can my child receive tax-free income from investments or trusts?
Yes, in certain cases, your child can receive tax-free income. For example, if the total income falls below the basic personal exemption limit, your child may not owe any taxes. Additionally, income earned from non-parental gifts or capital gains may not be subject to attribution rules, allowing it to be taxed at the child’s rate. Tax-sheltered accounts like RESPs also allow investments to grow tax-free until withdrawals are made for education.
Q3: How can I avoid the attribution rules when investing on behalf of my child?
Attribution rules apply to income earned from funds gifted by parents. To avoid these rules, you can explore options such as investing in capital gains, which are not subject to attribution, or structuring investments using non-parental gifts (e.g., from grandparents). Additionally, investments held within tax-sheltered accounts like RESPs are not subject to attribution.
Q4: Are capital gains taxed differently for minors?
Yes, capital gains are treated differently from other types of income, such as interest and dividends. In Canada, only 50% of capital gains are taxable, and these gains are not subject to the attribution rules when earned by minors. This makes capital gains a tax-efficient option for children’s investments.
Q5: What happens if my child earns employment income?
Employment income earned by a child is not subject to attribution rules or the kiddie tax. It is taxed in the child’s hands, and the child can use personal tax credits to reduce or eliminate the tax liability. Encouraging children to earn their own income through employment is a great way to avoid complicated tax rules and provide valuable financial experience.
Q6: Can I use trusts to reduce the tax burden on my child’s income?
Yes, trusts can be used as part of a family’s tax planning strategy, but careful structuring is required to avoid the kiddie tax and attribution rules. Family trusts can be beneficial if they focus on capital gains or are designed to distribute income at a time when the child is no longer a minor.
Q7: How are RESP withdrawals taxed for my child’s education?
When funds are withdrawn from an RESP for educational purposes, they are taxed in the hands of the beneficiary (the child). Because the child often has little or no other income, the tax liability on these withdrawals is typically very low, making RESPs a tax-efficient savings vehicle for education.
Q8: Can my child have a TFSA?
Children under 18 cannot open a Tax-Free Savings Account (TFSA). However, once they reach the age of 18, they can contribute to a TFSA, and any income earned within the account, whether from interest, dividends, or capital gains, is not subject to taxation.
Q9: Is dividend income from family businesses always subject to the kiddie tax?
Yes, in most cases, dividends from family businesses are considered split income and are subject to the kiddie tax. This means that the income will be taxed at the highest marginal rate, regardless of the child’s personal tax situation.
