How to Organize Bookkeeping & Accounts for Trust Accounting

 

 

Introduction

A trust is a common-law concept which dates back to medieval times.

 

In Merrie Olde England, land was typically granted by a king, owned by a lord but occupied and farmed by a serf. The ‘landlord’ (and this is the genesis of the term) was the beneficial owner of the land but was not in possession of it. The king had transferred beneficial ownership of the land to the landlord. The tenant occupied the land, used it and gave a portion of what was produced from it to the beneficial owner.

 

This relationship between the three parties formed the foundation for modern trusts. A trust is, then, a relationship between three parties:

 

• the settlor (the king) is the person who initially contributes the trust property;
• the beneficiary(ies) (the lord) is the person or group of persons who has beneficial ownership of the property but does not have physical possession of it;
• the trustee(s) (the serf) is the person or group of persons who occupy the property and have control over it, but who do not own it.

 

 

​Example - A Modern Trust Arrangement

​ Grandma wants to give $10,000 to each of her grandchildren, but she is concerned that they will squander the money. Grandma therefore gives the money to her daughter-in-law, in trust, to be held for each grandchild until he or she turns 25. Any income that is earned from investing the money is to be used by the daughter-in-law to defray a grandchild’s expenses. Grandma is the settlor. The daughter-in-law is the trustee. The grandchildren are the beneficiaries.

 

Trust Basics

A trust is a relationship, but it is treated as though it were a person for income tax purposes. A trust computes its income and pays its tax as though it were an individual resident in the province in which the majority of trustees resides, except that a trust cannot claim personal credits. An inter vivos trust (defined below) pays tax at the top marginal rate. A testamentary trust gets the benefit of graduated rates.

 

A trust is allowed a deduction in computing its income subject to tax for income that is paid or payable to its beneficiaries, so that the trustees may have flexibility in determining where the trust’s income is taxed.

 

A trust files separate income tax return (a T3) and pays tax on its taxable income. A T3 Supplementary slip is given to each beneficiary to whom income is paid or payable (which income the trust deducts in computing its own income) and the slip is used by the beneficiary to report income on his or her own tax return.

 

Accounting for a beneficiary’s equity is similar to accounting for a partnership as discussed in our Partnerships & Joint Ventures article.

 

Types of Beneficiaries

Trust law distinguishes income beneficiaries from capital beneficiaries.

 

An income beneficiary is one who has a right to share in income. A capital beneficiary is a beneficiary who has a right to share in trust capital.

 

Often the income and capital beneficiaries are the same person; sometimes they are completely distinct groups of persons; sometimes they overlap.

 

 

​Trust Beneficiaries

​ When grandma died her will provided that $100,000 was to be held by her executor. The income earned was to be used to pay for the post-secondary education of her grandchildren. On the graduation of the last grandchild, the principal remaining was to be given to the Salvation Army. The grandchildren are income beneficiaries but not capital beneficiaries, as they have a right to benefit from income but not capital. The Salvation Army is a capital beneficiary but not an income beneficiary. 

 

The distinction between income and capital beneficiaries can occasionally raise issues in the administration of a trust. The issues arise because for income tax purposes the taxable portion of a capital gain is on income account but for trust accounting purposes it is on capital account. Thus, if a trust has different income and capital beneficiaries, a capital gain must be allocated to the capital beneficiaries under trust law although the intention of the settlor is often to have the entire profit realized during the period of the trust allocated to the income beneficiaries.

 

This problem can be solved by having a provision in the trust agreement that provides that the income beneficiaries are also to share in any capital gains that are realized for income tax purposes.

 

Books & Records

Most trusts do not keep a full set of double-entry books, typically not keeping track of assets and liabilities and therefore not preparing a balance sheet.

 

The reason for this will become clear below, but this failure to maintain a full set of books is a defect in trust accounting. It is always a good idea to go the extra mile and set up a full set of books. Again, we will address this issue below when talking about the types of transactions a trust enters into and the related accounts that are needed to record these.

 

The vast majority of trusts maintain books and records primarily for the purpose of calculating income for income tax purposes and filing tax returns. Since most trusts are not engaged in a business, they need only keep track of income and expenses for income tax filings (in much the same way that an individual who only has employment income keeps track only of employment related receipts and outlays) and so need not file a balance sheet with the income tax return.

 

However, as will be seen, a trust balance sheet contains information that is very useful – the carrying value of property, amounts credited to beneficiaries but unpaid, which are useful both in day-to-day transactions and when a trust is wound up, so it is a good idea to maintain one from the outset.

 

Types of Trusts

Trusts are categorized in many different ways and you will hear all sorts of terms applied to trusts. Some of the more commonly encountered ones are described below.

 

There are basically, however, two types of trusts that a bookkeeper need be concerned about, because the way in which transactions are accounted for differ.

 

An inter vivos trust is a trust that is established during the lifetime of the settlor. A testamentary trust is a trust that is established on the death of the settlor. A sub-category of testamentary trust is a trust in which only the spouse or common-law partner of the deceased has a right to income or capital during the survivor’s life. Such a trust is called a ‘spousal trust.’

 

 

​Example - Types of Trusts

​ The investment trust that grandma set up with her daughter-in-law as trustee in our first example is an inter vivos trust as it was settled during grandma’s life. The trust set up under her will in our second example is a testamentary trust. It is not a spousal trust because someone other than grandma’s spouse has a right to income. 

 

 

The primary differences between these types of trusts relate to how contributions of property on settling the trust and withdrawals of capital are treated for income tax purposes.

 

​

* The election can be made on an asset-by-asset basis, but it is not possible to elect at an intermediary value.

 

These differences relate only to the calculation of the gain or loss for income tax purposes as property passes in to or from a trust. However, as was noted above, since most trusts only keep accounts in order to prepare tax returns, these differences are important.

 

Other Categorizations of Trusts

There are many other terms commonly used to describe trusts. Some of these are presented here so you will understand their meanings.

 

Alter ego trust – a trust under which the settlor is the sole beneficiary. Such trusts are used in certain tax plans.

 

Bare trust – a trust under which a trustee serves only to hold title to property but does not otherwise deal with the property. A bare trust is often used to hold title to real property.

 

Commercial trust – a trust whose units are traded, such as a mutual fund trust.

 

Discretionary trust – any trust in which the interests of the beneficiaries are not fixed but are subject to the determination of the trustees.

 

Estate – the trust that arises when a deceased’s property passes to the executor.

 

Family trust – a trust under which the beneficiaries are typically all members of one family.

 

Joint spousal, joint partner or joint common-law partner trust – a trust under which the settlor and his or her spouse or common-law partner are the only beneficiaries.

 

Personal trust – any testamentary trust and an inter vivos trust where no beneficiary paid to acquire an interest. Most trusts established by individuals are personal trusts.

 

Setting Up the Accounts

The structure of the accounts for a trust is very similar to that of a partnership. The primary difference is that where the income and capital beneficiaries are not the same, separate accounts should be maintained for the income beneficiaries and the capital beneficiaries. Furthermore, a separate capital account is typically needed to record the initial contribution of capital by the settlor.

 

The extract shown below is typical of the equity section of the trial balance for a trust.

 

​

​

 

The trust was initially settled with $100 of capital.

 

This trust has two income beneficiaries, Joe Smith and Sally Jones, and two capital beneficiaries, Joe Smith and the Red Cross Society.

 

The income beneficiaries have previously been allocated income that they have not drawn in full. At the beginning of the year, Joe had $15,000 of prior year allocations undrawn; Sally had $12,000.

 

The capital beneficiaries also have undrawn equity at the beginning of the year. This could represent:

 

• income retained and taxed in the trust in prior years. Unless the trust agreement provides otherwise, the after tax income of the trust is normally considered to be capital and belongs to the capital beneficiaries;
• capital gains realized in prior periods and allocated to the capital beneficiaries. As noted earlier, unless the trust agreement provides otherwise, capital gains are on capital account and accrue to the capital beneficiaries, not the income beneficiaries.

 

During the current year, the trust will have earned income. At the end of the year this will be dealt with as follows:

 

• to the extent it is paid or payable to an income beneficiary, and entry will be made to close out the account to the beneficiaries’ current allocation accounts;
• to the extent it is paid or payable to a capital beneficiary (again, generally only a capital gain and then only if the trust agreement does not provide otherwise), it will be closed out to the account of the capital beneficiaries;
• to the extent it is not so paid or payable, the trust will record the income tax it pays on the retained income as an expense, and the after-tax amount will be closed out to the accounts of the beneficiaries (typically the capital beneficiaries) to whom it belongs.

 

The following journal entry shows how this would be recorded, on the assumption that the current year’s total income is $65,000 of which $6,000 is a capital gain to be allocated equally to the capital beneficiaries and the remaining income is to be allocated equally to the income beneficiaries.

 

​

 

Account 5790 is an expense account which deducts from the trust’s income the income that is allocated to the beneficiaries.

 

Having processed this entry, the closing beneficiary equity accounts for the year are as follows in the exhibit on the next page, which would serve as a template for the presentation of the accounts in the trust’s financial statements.

 

​

 

 

At the beginning of the next fiscal period, the accounts of each beneficiary would be consolidated into the opening balance, as follows:

 

​

 

 

Trust Transactions

Trusts generally have to account for the same types of transactions that partnerships do, so the principles described in our Partnerships & Joint Ventures article apply equally to trusts.

 

The major issue the bookkeeper needs to address is whether to account for trust transactions at fair value or at tax cost.

 

There are no generally accepted accounting principles which are specific to trusts, so the general rule should apply: contributions of property to and withdrawals of property from a trust should be book-kept at fair values. However, generally it is only the tax value of the underlying property of a trust that is of interest so that keeping the books using anything other than tax values creates unnecessary work, as the tax values must be tracked in any event.

 

 

​Example - Accounting for Trust Transactions

​ When Frank died his will called for a trust to be established for his wife Wilma. Among other things, the trust received 10,000 shares of a Canadian chartered bank. The adjusted cost base of the shares was $130,000 and their fair value was $1,457,000. For income tax purposes, the transfer to the trust was accounted for at adjusted cost base and the executors did not elect otherwise. Under his will a second trust was established for his son, Allan. This trust received 3,000 shares in a public oil and gas company. The adjusted cost base of the shares was $60,000 and their fair value was $182,000. For income tax purposes, the transfer to the trust was accounted for at fair value and the accrued gain on the shares was taxed on Frank’s terminal return. The fair value of the bank shares at the time of their transfer to the trust for Wilma is not a useful piece of information, and there is little point in setting up the accounts to track it. So the trust should record this transaction as follows: ​ 

 

 

Similar ideas would apply to the accounting for the distribution of property by the trust.

 

Thus, where an inter vivos trust or non-spousal testamentary trust distributes property, the disposition would be accounted for by the trust using the tax cost as the value. Where a spousal testamentary trust distributes capital to anyone other than the spouse the transaction is accounted for at fair value.

 

21-year Rule

Because a trust can continue in existence indefinitely, the transfer of property to a trust could be used as a method of deferring the taxation of gains accrued on capital property. In order to prevent this, most inter vivos trusts are required for income tax purposes to account for a deemed disposition of all capital property owned every 21 years. This deemed disposition forces the trust or its beneficiaries to pay tax on the taxable portion of the gain and resets the adjusted cost base of the property to fair value at that time.

 

It is to avoid this deemed disposition that most such trusts wind up and distribute their capital properties to the capital beneficiaries before the 21-year period has expired.

 

It is on the wind up of a trust that its balance sheet becomes particularly important. If a balance sheet has not been maintained it may be very difficult to recreate the amounts owed by the trust to the various beneficiaries which were allocated over time but not paid.

 

Tax Reporting

As noted above a trust is treated as though it is a person for income tax purposes and a trust pays tax on income it earns and does not allocate to beneficiaries.

 

A trust computes its income and pays its tax as though it were an individual resident in the province in which the majority of trustees resides, except that a trust cannot claim personal credits. An inter vivos trust pays tax at the top marginal rate. A testamentary trust gets the benefit of graduated rates and some thought must therefore be given to retaining income in such a trust to be taxed there – if it pays tax at a lower effective rate than the beneficiaries would.

 

Generally, an inter vivos trust will allocate its income annually to the beneficiaries, as generally the rate of tax that applies to the beneficiaries will be less than that the trust experiences. There may be a marginal saving, however, in retaining income to be taxed in the trust if the trust is resident in a province (Alberta, for example) where the top rate is lower than the top rate in the province in which the beneficiary resides and to which the beneficiary would be subject.

 

An inter vivos trust is required to use a December 31 taxation year end and its return is due no later than March 31 of the following year.

 

A testamentary trust is permitted to choose any year end it likes so long as the first does not end more than one year following the death of the testator. The return is due within 90 days of that year end.

 

A trust is also a person for purposes of registering for and collecting GST/HST and provincial retail sales tax. Thus, the accounting for these taxes is done at the trust level. Very few trusts are engaged in commercial activities (unless the trust is an estate that has taken over a proprietorship carried on by the deceased) so GST accounting for trusts is generally not complex.

 

SUMMARY

• A trust is a relationship between a settlor, the trustees and the beneficiaries.
• For income tax and sales tax purposes a trust is treated as a person. A trust pays tax on its income, but is allowed a deduction for income that is paid or payable to the beneficiaries, who then pay tax on the income.
• From a bookkeeping perspective, it is the capital/ownership section of the accounts that is atypical.
• Many trusts do not keep balance sheets, which is a mistake.
• It is common to use tax values to record trust transactions rather than fair market value.

 

 

 

We can assist you with the ins and outs of accounting and bookkeeping for your Trust Accounts in Canada. Here at Green Quarter Consulting - Accounting and Bookkeeping Services for Small Businesses  in White Rock South Surrey, Vancouver, Langley and Surrey BC, we assist Small Business Owners with analyzing transactions, sources of income and your tax risks and how they relate to your business strategy. Learn more about our Greenstamp CFO Services here.

 

Contact us today at 778-791-2864 or 604-970-0658, let’s talk, or send us an email here and we will be in touch very shortly.

 

 

 

​GET YOUR FREE CONSULTATION TODAY