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Family Trusts are quite a respite amidst the realities of inheritance, estate, and wealth that are cumbersome and can indefinitely sow seeds of enmity and expense.
As Johann Kaspar puts it
“Say not you know another entirely ’til you have divided an inheritance with him.”
Fortunately, Trusts are there to provide some relief.
More than two-thirds of all property in Canada is tied up in some trust. Family trusts are also a prevalent phenomenon. Families that tend to be more conservative about their wealth create trusts to receive income with lower taxes for all their members, including those children who are otherwise unfortunate or are likely to be overlooked.
Such trusts are also a tool to preserve property for many generations.
Is it all that simple? Why does the government allow you to avoid taxes by simply creating a trust? What are the cons and limitations of a trust? The following discussion addresses these pertinent questions.
Key Terminologies to Understand
- What is a Trust?
A trust is an instrument that allows a person to transfer his property to another person, who then maintains it to benefit one or more persons (beneficiaries) as the first person intends.
- Family Trust
Similarly, a family trust, a powerful financial tool, is one in which the beneficiaries and the person entrusting property belong to the same family.
- Beneficiary
A beneficiary is a person who benefits from the trust according to the provisions. The benefit can be income or later inheritance of property.
- Settlor
The person who transfers his property to another person to create a trust is called the Settlor.
- Trustee
A trustee is a close family relative, an advisor, or any other person who assumes the responsibility to manage the trust and fulfill the duties given to him.
- Contributor
As evident from the term, a contributor contributes to the trust. It can be a third party who donates to the trust or extends a loan to it. In ordinary circumstances, it is the Settlor.
Why Create a Trust?
There are many reasons families create trust. These can include, but are not limited to, income division for better tax management, preservation of family estate as undivided, smooth inheritance, and avoidance of probate fees, all of which can lead to significant financial gains.
What Do You Do to Make a Trust Valid?
- Intention: A clear intention to create trust should be there.
- Property: The property should have certainty in its details.
- Beneficiary: Certainty of the identity of beneficiaries.
How Do You Create a Trust?
An agreement transpires containing
- The names of the trustees
- The names of the beneficiaries
- The details of the assets
- Pertinent clauses about the management of assets.
- An irrevocable donation by the Settlor (A trust can also be revocable, but it will be weak in its purposes)
- The process includes creating a bank account in the trust's name.
- Regular review and updates are needed to keep pace with evolving family circumstances.
Benefits of Creating a Family Trust?
There are many benefits of creating a family trust. Following is an explanation of why people make a trust
- Preservation of Assets and Bar against Will Disputes
The assets in a trust don’t belong to the Settlor or the beneficiaries. Hence, no lawsuit, creditor, or family law claim lies against the property. The property is protected because claimants or creditors cannot view those assets as a means to settle any legal claim, debt or judgment against any persons involved in a trust. After all, they don’t own the property.
Similarly, Will Variation claims are also a legal reality. However, misgivings die out with a Trust created within the Settlor’s lifetime because these trusts are not subject to Will variation claims.
- Control over Property against Whimsical Family Members
A parent who has owned an inherited estate for 50 years would not like it to be immediately dismembered and sold by an extravagant family member. While the parent still wants his child to own the property before or after his death, he doesn’t want the family estate to disintegrate. Trust acts as a barrier against temperamental selling.
- Financial Support for the Unwell Beneficiaries
Trusts are a reliable tool to protect mentally infirm or physically disabled family members financially. It is breathing room for household members who cannot manage their finances. Moreover, it can enable them to benefit from trust while preserving Governmental Disability Credits.
- Maintenance of Privacy
The inheritance process is usually a public proceeding. However, privacy is maintained in the case of a trust. A family trust created during the lifetime can ensure that the administration of assets takes place confidentially.
Financial Benefits of Creating a Trust
- Low Tax due to Income Splitting
When income reaches the members of a trust, the tax applies to individual hands rather than collectively. Because taxation is progressive (Less tax on less income), such split income falls within a lower tax bracket, leading to less taxation.
For example, a trust income of $50000 split between two people may incur less tax than when reported as one person’s income.
- Saving Probate Fees
Trusts are instrumental in saving Probate fees. Probate fees are governmental fees incurred in administering the estate to the beneficiaries. On the Settlor’s demise, transfer to beneficiaries through a trust is not subject to these fees. Therefore, trusts are more cost-saving than inheritance through will.
- No Death Taxes
Ordinarily, on a person’s death, all his assets are subject to Deemed Disposition (the presumption for tax purposes that the deceased disposed of all his assets immediately before his death). It means that the Canadian Revenue Agency will charge tax on everything the deceased owns in proportion to the increase in the value of the assets. The Revenue Act calls it Capital Gains Tax. Meanwhile, property belonging to an estate is not subject to a deemed disposition. It rolls over to the beneficiaries automatically, and tax deferral takes place.
- Lifetime Capital Gains Exemption (LCGE)
The LCGE is a tax exemption granted to an eligible small business. While a trust is not eligible for it, its members are entitled to it. They can sell their shares in a small business owned by the trust without paying income tax.
- Dividend Tax Credit and Personal Tax Credit for Low-income Members
Trust members with no other income or low income, such as students, can receive this benefit and be entitled to tax-free dividends from Canadian companies.
- Want to Give to Charity and Get a Tax Break Today? Create a Trust
A Charitable Remainder trust serves this purpose. If a person intends to donate a portion of his wealth to charity but also needs this money for the remainder of his life to support his current lifestyle, he can create a trust. On making such a trust, he may be entitled to a tax credit, enabling him to enjoy a tax-free life. His property will go to a trust on his death.
- Estate Freeze
Estate freeze means that the value of a property freezes at its current fair market value. In this way, no capital gain occurs; hence, no capital gains tax becomes liable for a considerable time. Without a doubt, it is better to have comfort for a decade or two instead of paying all the taxes immediately.
Unlike other countries, where trusts are a necessity for large estate families, Canadian law permits estate freezes and makes family trusts likewise a necessity for families with small estates.
Considerations, Limitations and Cons of Trusts
- Give Preference to Formal Trust!
A trust is a relationship rather than a legal entity. Hence, it can be created informally, without a document, and with the action or explicit declaration of the parties.
However, it is highly advisable to do proper documentation to make a trust immune to future confusion.
Mind the costs of creating and maintaining trusts and weigh them against potential benefits.
- Trust also Dies
Notably, the life of a trust in Canada is 21 years. This rule prevents indefinite tax deferral. Like deemed disposition for a person, CRA considers a trust to dispose of all its property at its 21st anniversary, and taxes become due.
- Mind the Exemption Slabs!
The lifetime limit for Qualified Small Business Cooperation Shares is $971,190. Manage your transactions in such a way that the boundaries are respected.
- If the Authorities Sense Tax Evasion, Attribution Rules Come into Action
Trusts are not tax evasion safe-havens. Suppose it appears that the presence of a trust is only to shift to a lower tax bracket: for example, the person to whom the dividend or income goes is a close relative, such as a child under 18 or a spouse. In that case, attribution laws come into action, and property goes back to the Settlor.
Similarly, suppose the transferor (Settlor) still has control over the property, and the purpose behind the trust is only to evade higher tax rates; in that case, the property goes back to the Settlor.
A person wanting to avoid such a scenario should opt for an irrevocable trust.
- Renewed Privacy concerns
The latest amendments to trust laws have sought to incorporate Financial Action Task Force recommendations to curb money laundering into regulations. Therefore, privacy is no longer a hallmark of trust.
- Tax on Split Income (TOSI)
While split income saves one type of tax, it causes some others. Tax on Split Income law was introduced in 2018. Before that, a trust owning a business could receive income and distribute it to the beneficiaries, avoiding tax. Now, there is a cost that applies to under 18 beneficiaries. However, tax planning can be taken into account to reduce such costs through Dividend Tax Credit and Personal Tax Credit.
Which Trust is for Me?
Following is a brief account of different kinds of trust. You can choose one that suits your circumstances:
- Discretionary Trust: In this trust, the trustee can decide when and how to distribute the property.
- Non-Discretionary Trust: A trust in which it is the document of trust that decides when and how to distribute the property.
- Bare-Trust: It is not a trust, but it is so, in a way. Suppose a mother makes her child the beneficiary of her property. Only she can sell the property as the actual owner. Now, if she dies, the property goes to the child. Also, the child receives income from the property. Hence, it is a trust in a particular fashion.
- Alter Ego Trust: In such a trust, a 65 or older person can receive all his income tax-free during his lifetime.
- Inter Vivos Trust: A trust created during the lifetime of a person is an inter vivos trust. It is beneficial for protecting the assets of a vulnerable person.
Bottomline
Trusts are common nowadays. Their benefits can outweigh their costs. With laws surrounding trusts becoming increasingly complex, it is pertinent to seek proper advice from a professional before establishing one.