Welcome back to the blog!
In addition to working with clients on investment and wealth management, I write a blog on tax tips and tidbits and share other articles that I think will be of interest.
In this edition, I’m going to write about trusts, a common topic that I’m regularly asked about by clients that are curious about the tax or estate planning opportunities that they may present.
Now, given that trusts are a complex area of law, the discussion that follows below is intended to be a simplified overview of inter-vivos trusts and their potential application in wealth management.
What is a trust anyway?
In essence, a trust is a relationship and not a separate legal entity like a corporation, although a trust is treated as a separate taxpayer for income tax purposes.
More specifically, a trust is a relationship or legal arrangement in which one party transfers property to another party who holds the legal title to the transferred property for the benefit of another party. Okay, perhaps that sounds a bit confusing, so let’s break it down…
The parties to a trust
The party that creates the trust by making the initial transfer of property is referred to as the settlor - the settlor must own the property that is transferred and generally must make the transfer voluntarily.
Next, the party that holds legal title to the property is referred to as the trustee - the trustee has control over the property and is obliged to manage the trust property in accordance with the terms of the trust and in the best interest of the beneficial owners of the trust property.
Finally, the party that is entitled to the use, enjoyment, and advantage derived from the trust property is the beneficiary - a beneficiary is normally a person, a group of persons, or a corporation.
It is possible for the settlor, the trustee, and the beneficiary to be the same person or to otherwise have some combination of overlap in the outlined roles, however, this may result in adverse income tax implications, such as triggering the attribution rules, so careful planning is needed.
A trust can be created informally, however, it is always prudent and preferable to engage a lawyer and sign a legal document referred to as the trust agreement to outline the parties to the trust, the property being transferred, the powers and restrictions of the trustee, and last but not least, the particulars around the distribution of trust income and capital to the beneficiaries.
Common types of trusts
Okay, so now that I’ve explained some of the technicalities and particulars regarding trusts, let’s explore the two main types of trusts for tax purposes.
Inter-vivos trust, this type of trust is created and takes effect during the settlor’s lifetime, and includes a family trust or an alter-ego or joint spousal trust as examples.
Testamentary trust, in contrast, this type of trust only comes into effect as a consequence of death and it is typically created by a will or perhaps through a beneficiary designation.
In addition, a trust can be classified as either discretionary, in which case the trustee can use judgment to decide if, when, and which beneficiary to pay income and capital to, or non-discretionary, where in contrast, the trust document specifically outlines and stipulates these details.
Common uses of trusts
Okay, on to the main event!
In what follows, I’m going to focus on inter-vivos trusts, the trusts created during the settlor’s lifetime, and some common uses and benefits of these trusts.
I think the tax question that I get asked most frequently about is income splitting.
Unfortunately, the Income Tax Act contains a number of provisions that effectively limit the opportunities to selectively income split with family members including a spouse or minor child.
However, it is still possible with the right planning and the use of a trust where there is one family member in a high income tax bracket with a spouse or child in a lower income tax bracket. The high income family member can loan funds to a trust at the prescribed rate with the low income family members designated as trust beneficiaries. In the trust, the funds can be invested with the income allocated to the low income spouse or to a minor child to pay for education, sports activities, or camps etc. The allocated income is taxed at the marginal rate of the beneficiary, and where the beneficiary has little to no other income, significant annual family tax savings can be achieved.
It almost sounds too good to be true, and as such, there is a caveat - the trust must actually pay interest to the high income family member at the prescribed rate, currently set at 1 percent, and this interest is considered taxable to the high income family member while it is deductible to the trust.
A transfer of assets that are expected to increase significantly in value to a trust enables the future growth of these assets to accrue to the trust beneficiaries while also allowing the original owner to "lock in" the associated tax liability based on the assets current value.
Typically, an estate freeze is implemented when a business owners transfers shares of a private company to a trust, and where the shares are considered QSBC shares at the time of a future sale, the estate freeze can also help to multiply the capital gains exemption, sheltering approximately $915,000 in capital gains per trust beneficiary.
The trust may also enable the business owner to maintain control of the business if it is structured properly.
Control for minors or dependents with a disability
A trust is often used to make gifts to minors that have not yet reached the age of majority since a minor cannot legally manage funds. A trust allows for the benefits of ownership to pass to the minor while the legal ownership and management of the assets rests with the trustee.
Similarly, a trust may also be helpful in providing support for a dependent that is living with a disability without compromising the government benefits that might be available.
Probate and Privacy
Assets held in a trust at death do not form part of the testator’s estate, and as such, they are not subject to probate fees or the applicable lengthy probate process, which also helps to maintain privacy. The trust document does not become a public document like a will and there is therefore no public disclosure of the trust assets or the names of the trust beneficiaries.
A trust can provide protection from creditors as assets that are transferred into a trust are no longer owned by the settlor, and therefore, creditors generally cannot make a claim against the assets, provided the trust was not established just before or in anticipation of such a claim.
A spouse or child can contest the distribution of an estate by making a wills variation claim if not adequately provided for, even if they are financially independent, whereas a trust provides protection from this.
So as you can see, there are lots of potential applications in wealth management for trusts.
However, trust and tax laws are very complex and reporting requirements are becoming increasingly onerous, so it is imperative to obtain legal and tax advice from professionals before considering if a trust may be an appropriate planning option to consider.
If not structured properly, there can be significant and adverse tax and legal consequences.
If you have questions or are interested in exploring planning opportunities using trusts or otherwise, I’d be happy to chat further.
I can be reached at firstname.lastname@example.org or 604.981.6681.
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