Family trusts have become an important tool in Canadian estate and tax planning, particularly where a family owns a business or significant investment assets.
A properly structured family trust can serve several purposes. It may be used to establish an estate freeze, facilitate the transfer of wealth to the next generation, provide flexibility in distributing income or capital, and, depending on the circumstances, offer a degree of asset protection.
That flexibility, however, comes with an important tax consideration that cannot be ignored.
The 21-year rule.
For many family trusts, the 21st anniversary can create a significant tax liability if planning has not been undertaken well in advance.
What Is the 21-Year Rule?
The Canadian Income Tax Act generally provides that most inter vivos trusts are deemed to have disposed of their capital property at fair market value every 21 years.
In simple terms, the trust may be treated as though it sold its assets at their current fair market value, even though nothing was actually sold.
If an asset has increased substantially in value, the deemed disposition can trigger a significant capital gain and, consequently, a substantial tax liability.
Consider a family trust that acquired shares in a private corporation many years ago for a relatively modest amount. If those shares are now worth several million dollars, the 21st anniversary could result in a very significant deemed capital gain.
The same concern can arise where a trust owns:
- Shares of a private corporation;
- Investment portfolios;
- Real estate;
- Commercial property; or
- Other capital property that has appreciated substantially.
The important point is that the tax may arise without an actual sale and without the trust receiving cash to pay the tax.
There Is No One-Size-Fits-All Solution
When a family trust approaches its 21st anniversary, there is no automatic answer.
The appropriate strategy will depend on the assets held by the trust, the beneficiaries, their individual tax circumstances, the family’s succession objectives and whether there is a continuing reason to maintain the trust.
Several possibilities may need to be considered.
- Distributing Assets to Beneficiaries
One possibility is to distribute some or all of the trust’s assets to beneficiaries before the 21st anniversary.
In appropriate circumstances, property can potentially be distributed on a tax-deferred basis, allowing the accrued tax liability to be deferred until a later disposition by the beneficiary.
This can be particularly attractive where the next generation is ready to assume ownership of the assets.
But this is not simply a matter of transferring the assets and moving on.
The tax position of each beneficiary, the nature and value of the assets, the terms of the trust and the family’s overall estate plan should all be examined before a distribution is made.
- Keeping the Trust and Paying the Tax
Sometimes the best answer is to keep the trust.
A family may have legitimate reasons for continuing the structure, including governance, control, asset protection or succession considerations.
In those circumstances, the Trustees may decide to accept the deemed disposition and deal with the resulting tax liability.
This approach may make sense where the trust has sufficient liquidity, available tax attributes or other resources to deal with the tax cost.
The decision should not be based solely on the amount of tax payable. The question is whether the continuing benefits of the trust justify the tax cost.
- Vesting Beneficial Interests
Another possibility that may be considered in certain circumstances is the irrevocable vesting of beneficiaries’ interests in the trust’s income and capital.
Rather than immediately transferring all of the trust property, the beneficiaries’ interests may become irrevocably established.
Depending on the circumstances and the wording of the trust, this type of planning may provide an alternative to an immediate distribution while preserving the trust structure for a period of time.
This is a highly technical area, however. Whether such an approach is available depends upon the trust deed, the nature of the beneficiaries’ interests and the applicable tax rules.
It should therefore be undertaken only after detailed legal and tax advice.
- Reorganizing the Corporate Structure
Where a family trust owns shares of a private corporation, corporate reorganization may provide another avenue for planning.
For example, the family may be considering a further estate freeze or an intergenerational transfer of the business.
The 21st anniversary can therefore become an opportunity to reconsider the entire corporate and ownership structure rather than simply treating the anniversary as a tax deadline.
These reorganizations can be complicated and often require the coordinated involvement of the family’s lawyer, accountant, tax adviser and financial advisers.
The Biggest Mistake: Waiting Until the Last Minute
Perhaps the most important lesson concerning the 21-year rule is that planning should begin well before the 21st anniversary.
Waiting until the trust is approaching its anniversary may significantly restrict the available options.
A trust established 20 years ago may look very different today.
The business may have grown substantially. Real estate may have increased dramatically in value. Beneficiaries may have moved to another jurisdiction. Children may have become adults and established their own families. Family relationships and succession objectives may have changed.
The original reason for establishing the trust may no longer be the same reason for keeping it.
That is why the 21st anniversary should be treated as a planning opportunity rather than simply a tax deadline.
What Should Be Reviewed?
Several years before the anniversary, the trustees and their advisers should consider:
- What assets does the trust currently own?
- What are those assets worth today?
- What are the unrealized capital gains?
- Who are the current beneficiaries?
- Where do the beneficiaries reside?
- What are their individual tax circumstances?
- Does the family still need the trust?
- Is control of the business an important consideration?
- Is an intergenerational transfer being contemplated?
- Would distributing assets to beneficiaries make sense?
- Should the corporate structure be reorganized?
- What are the costs of maintaining the trust compared with the potential tax consequences?
These questions can reveal opportunities that may not be apparent when the focus is simply on the approaching 21st anniversary.
Brian Madigan LL.B., Broker