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There are a number of key things to remember when planning with trusts |
Trusts offer flexibility in both tax and financial planning. The main advantage of a trust is that it allows you to separate the control and management of an asset from its ownership, which makes a trust a powerful tool.
There are different types of trusts. Commercial trusts are used for business and investment purposes (such as mutual fund trusts), whereas a personal trust is one where the beneficiaries receive their interest in the trust’s assets as a gift. Personal trusts are set up in one of two ways. First, there are testamentary trusts, which are created on the death of an individual. The second type of personal trust is an inter-vivos trust, or “trust of the living”, and it is particularly useful in accomplishing family tax and financial objectives. These trusts are set up during the lifetime of the individual who settles the trust (i.e. the settlor). Usually the purpose of setting up an inter-vivos trust is to transfer the benefit of owning assets to certain individuals, such as children, without actually passing control of the assets to them. In many cases, the settlor may not feel the beneficiaries are ready for the responsibility of taking on control. If the assets are in trust, the trustee(s) will retain control over the assets and will ensure they are managed in accordance with the settlor’s wishes. As most inter-vivos trusts are discretionary in terms of who will receive trust property, these trusts allow beneficiaries to share in the benefits of ownership, including tax benefits such as income splitting and sharing the capital gains exemption, without turning over ownership of the property.
There are a number of key things to remember when planning with trusts. A well-drafted trust agreement is important for trust management and recent Canada Revenue Agency (CRA) audit activity has emphasized the need for proper trust documentation. As well, recent court decisions have dealt with trust creation, use and management, so it is necessary to keep current on these decisions when planning with trusts. Note that these topics have been covered in more detail in recent issues of our Tax Factor publication.
Not only is it important to ensure a trust is properly formed from the outset, but it is also critical to keep in mind the deemed disposition rules for trusts. The terms of dissolution of a trust can be drafted in such a way as to effectively give a trust an unlimited life. With this possibility in mind, deemed disposition rules for trusts were introduced to prevent an indefinite capital gains deferral. Remember that individuals are deemed to dispose of property on death and a trust with an indefinite life could bypass this rule.
Generally speaking, trusts are deemed to dispose of certain properties at fair market value 21 years after the day the trust was created (and every 21 years thereafter), and are deemed to reacquire such properties at that same fair market value amount. The result is that where trust property has appreciated in value, any income and/or gains will be taxed in the trust. Losses can also result if the value of trust property has declined. In the latter situation, it may be desirable in some cases to let the deemed disposition rules apply in order to realize the losses.
Property subject to the deemed disposition rules generally includes non-depreciable and depreciable capital property, Canadian and foreign resource property, and land included in the inventory of a business. The 21 year deemed disposition rule applies to most trusts, with certain exceptions (for example, RRSPs and unit trusts). As well, there are some modifications to the rule for certain trusts such as spousal/common-law partner trusts, alter-ego trusts and joint partner trusts.
It may be easy to forget the 21 year deemed disposition date as it approaches, given the length of time that will have passed from the creation of the trust. But significant tax liabilities could arise in the trust if the date passes by without properly planning for it. And it is important to begin planning for the deemed disposition of trust property well ahead of the 21 year deemed disposition date, as certain planning will take time to implement. In particular, where the trust property includes shares of a family business, a succession plan will generally be needed.
Planning for the 21 year deemed disposition rule will often aim to prevent the disposition of assets from being taxed in the trust at the deemed disposition date and will instead defer the tax until the actual disposition of the assets. It is not possible to simply transfer trust assets to a new trust in order to avoid the 21 year deemed disposition rule — specific rules are in place to stop this planning. However, it is possible to prevent the deemed disposition of assets by transferring out trust property directly to the capital beneficiaries on a tax-deferred basis. Of course, as discussed previously, a primary concern when planning with trusts is maintaining control. So transferring property directly to the beneficiaries may not be a preferred option due to the loss of control that will result. Some planning options may be available that could allow the trustee(s) to maintain some control, while still allowing for a deferral of the tax that would otherwise arise on a deemed disposition in the trust. Note that it will still be necessary to distribute property to beneficiaries in most situations.
Planning for the 21 year deemed disposition can be complex depending on the situation. And, there may be many family issues, such as a succession plan, that need to be resolved before trust property can be distributed from the trust. We believe that this planning should generally start 2 to 5 years before the deemed disposition, depending on the nature of the property held and the complexity of the issues that need to be resolved.
Your BDO advisor will work with you to consider all options, taking into account your needs, and to ensure an optimal plan is implemented.
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