I work with many new immigrants and small business owners and I find that many people have similar questions and misunderstandings of the Canadian tax system. This post will be part of a series which addresses some of these common questions.
We have all heard the term “trust fund kid”, but what exactly is a trust fund and is it something only the ultra wealthy can take advantage of?
There are many types of trusts. A trust describes a relationship between several parties where a person, the settlor, gives another person, the trustee, the right to hold title to assets (ie. real estate, corporate stocks, bonds, cash, etc) for the benefit of beneficiaries. There are many types of trusts but this article will focus on the family trust, the type of trust that most people are referring to when talking about “trust fund kids”.
To create a family trust, legal ownership of assets must be transferred into the trust by the settlor. The people who stand to benefit from the trust fund are the beneficiaries.
There is also a separate person(s) who manage the trust, called the trustee(s). The trustee must be a separate person from the settlor and have a certain level of autonomy from the settlor. The trustee must act in the best interests of the beneficiaries and in accordance with the trust agreement. The trust agreement is the formal agreement which establishes the trust. The trust agreement is created by the settlor and his lawyer to ensure that the trust is valid and that it will carry out the intentions of the settlor*.
Furthermore, the settlor no longer has the legal right of ownership and control over the transferred assets, that right of ownership and control now belongs to the trustee. Depending on the asset and the objective of the settlor, this loss of control can be prevented. I will discuss this in a future post on estate freezes.
The main uses of a family trust
1. Reduce the total tax payable on an asset
The settlor can reduce the amount of tax he must pay on the sale of an asset in the future by setting up a family trust. The transfer of the asset “freezes” the value of the asset at the time of transfer for the settlor. That means that all future accumulation of value in the asset will not be taxed in the settlor’s hands, but instead distributed between the beneficiaries who presumably are in a lower tax bracket.**
The use of a family trust also allows other members of your family to take advantage of the Lifetime Capital Gains Exemption (LCGE). Every individual has a LCGE where $883,384 (as of 2020) of any gain from the disposition of a qualified small business corporation (QSBC) is exempt from taxation. If the QSBC shares are held by the trust, the beneficiaries can each exempt their portion of the shares thus shielding more of the shares from capital gains compared to the situation where the shares were all held by one person.
2. Plan the transfer of wealth
A family trust is an estate planning tool to transfer wealth to other family members. A family trust is an alternative to giving the assets directly to the intended beneficiaries; something that might not be possible or desired if the intended beneficiary is a minor or not responsible enough to directly own the asset. By using a family trust, the trustee is the person who manages the asset for the benefit of the beneficiary. Since the settlor chooses who the trustee will be, they can put control of the assets in the hands of someone who the settlor knows will manage the asset responsibly.
3. Protection of assets
The assets transferred to a trust are generally protected from the claims by the settlor for any lawsuits or bankruptcies, similar to the protection of assets transferred to a corporation.
The drawbacks of a family trust
1. Deemed disposition every 21 years
There is a deemed disposition every 21 years after the establishment of the trust. This means that every 21 years, the assets in the trust are considered sold and any capital gains must be taxed and paid accordingly. This is to prevent deferring taxes definitely. To plan around this, usually the assets are transferred to beneficiaries before the 21 year anniversary.
2. High tax rate
The trust is taxed like an individual tax payer. Any income the trust retains is taxed at the highest marginal rate. It is generally more tax efficient to pay out proceeds of the trust to the beneficiaries, who have a progressive tax rate, and usually a lower tax rate.
3. Cost
There is significant cost in setting up and maintaining a trust.
- Legal fees in drafting the trust agreement and setting up the trust
- Transaction costs is transferring assets to the trust
- Compensation for Trustee to manage assets (could be significant if the trust is large and complicated)
- Annual tax filings
- Additional record keeping and administrative costs
Recent changes to trusts
There have been recent changes to income that is subject to tax on split income (TOSI) that has affected the ways in which trusts can be used. The TOSI rules are fairly complicated but basically, if the income does not fall under certain exemptions, it is taxed at the highest marginal tax rate thus eliminating any tax advantage of splitting income among family members. One of the new changes requires that to qualify for the exemption, family members must directly hold at least 10% of the shares. Remember that in a trust, the Trustee directly holds the shares and the family members are only the beneficiaries.
The remaining exclusions from the highest marginal tax rate require a certain level of involvement with the business. Therefore, this change will affect beneficiaries who were never involved in the business and only took in the passive income stream from the shares or the so called “trust fund kids”.***
Conclusion
With these new changes on TOSI that affect the use of trusts for tax splitting among family members, you can expect fewer corporate structures that include a family trust to produce so called “trust fund kids”.
A family trust has some specific use cases but many of the uses of a family trust can be accomplished through holding corporations. The main advantage of a trust is the idea of indirect beneficial ownership which gives family trusts greater flexibility for certain scenarios for tax and estate planning.
If you are considering a tax and estate plan, please contact us as each case is different and the details matter in choosing the best structure.
* There are legal requirements that a trust must meet to be considered a valid trust. Failing to meet these requirements could result in a finding that the trust is invalid leading to unintended consequences.
** There is no benefit in setting up an estate freeze and subsequently selling the transferred assets; the increase in value of the asset, if any, would be small therefore the tax savings would be minimal and negated by the cost of setting up the trust. This type of transaction also assumes that the value of the asset will increase.
*** This is essentially an expansion of the “kiddie tax” rule exacted in 2000 which taxed income distributed to individuals below the age of 18 at the highest marginal tax rate.