The Use of a Family Trust as an Estate Planning Tool
When preparing an estate plan, a person should consider how they are best able to protect their assets and manage their wealth during their lifetime, while also planning for a tax-efficient transfer of certain assets to their beneficiaries. The use of a family trust may provide a considerable benefit to a person in optimizing their estate planning objectives as it can facilitate the transfer of wealth to future generations while maintaining flexibility over the management of the trust’s assets.
What is a Family Trust?
A family trust is a legal relationship between three parties: the settlor, the trustee(s), and the beneficiaries. To establish the trust, the settlor transfers properties to the trustee(s) who holds the properties for the benefit of the beneficiaries. A document called a Trust Deed or a Trust Agreement specifies how the trust’s assets are to be used or distributed and gives the trustee(s) certain discretion and authority.
Benefits of a Family Trust
The following key benefits can be realized by establishing a family trust as part of a person’s overall estate plan.
Estate Planning and Wealth Transfer
One of the primary reasons for establishing a family trust is to facilitate the transfer of wealth to future generations. This may be particularly advantageous when an individual holds private company shares. In a typical estate freeze, the current value of private company shares held by the individual are generally exchanged, on a tax-deferred basis, for fixed value preferred shares (“freeze shares”) and new future growth shares are issued to the family trust. This can help to “freeze” the value of the individual’s estate on their passing, setting a cap on their death tax exposure, and allow the individual to pass future growth to the next generation. You can read more about this process in our previous blog, Tax Consequences When a Person Passes Away in Canada.
Lifetime Capital Gains Exemption (LCGE)
Where certain criteria are met, an individual can shelter approximately $1,250,000 of capital gains on the sale of shares of a qualified small business corporation (“QSBC”) using the LCGE. Where the LCGE is applied, the individual is not subject to personal income tax on a capital gain. This can be a powerful planning tool for small business owners. Holding shares of a QSBC through a family trust may allow for the multiplication of the LCGE on a future sale of the company’s shares, as the LCGE of each beneficiary may, subject to certain criteria, be applied in respect of the sale. Alternative minimum tax may apply on the use of LCGE and will need to be carefully considered.
Management of Assets
A family trust can offer flexibility in managing assets while still providing for a high level of control over how an individual’s assets are managed during their lifetime, and ultimately distributed to the beneficiaries of the trust. The Trust Deed or Trust Agreement can set specific conditions for distributions, and the trustee has the authority to make decisions with respect to how the trust’s assets are managed and invested.
Confidentiality
Unlike a will, which becomes a public document during the probate process, a family trust is a private arrangement. This means that the details of a family trust and its assets remain confidential.
Considerations When Establishing a Family Trust
The following should be considered when establishing a family trust:
Transfer of Assets into the Trust
To ensure the future appreciation of assets accrue to the family trust, assets will need to be transferred to it. A straightforward transfer of assets can have significant adverse tax implications. The method by which the family trust acquires assets must be carefully considered to avoid inadvertent tax implications.
21-Year Deemed Disposition Rule
The 21-year deemed disposition rule deems a family trust to have disposed of its assets at their fair market value every 21 years from the trust settlement date, potentially triggering a capital gains tax liability. This rule aims to prevent the indefinite deferral of income taxes. Planning is generally done in advance of the 21st anniversary to mitigate the impact of this deemed disposition.
Taxation of Trust Income
Income earned within a family trust is generally taxed at the highest marginal personal income tax rate. While the trust’s net income may be allocated to a beneficiary and taxed in their personal hands at their effective marginal tax rate, there are specific income tax rules related to income splitting that must be considered.
Regular Review and Updates
A family trust should be reviewed and updated regularly to ensure it continues to meet a person’s goals and objectives and complies with current laws. Changes in family circumstances, financial situations, or tax legislation may necessitate updates to overall estate planning, including the family trust.
Reach out to one of Smythe’s estate planning experts today to discuss how the use of a family trust can be of benefit to your overall estate plan.
