This is the second in a series of articles in our special report on taxation in Canada. To see all the articles, click here.
Trusts are popular among ultra-high-net-worth families—especially for tax reasons.
Typically, when a family business owner dies, taxation can be a big burden. But if the assets are held in a trust, neither the owner nor the spouse owns them. As a result, the tax liability of that person’s estate will be much lower. Placing assets in a trust means ownership passes to trustees who control and distribute them on behalf of beneficiaries.
“The main tax benefits are protecting the family from estate tax due to the early passing of the patriarch or matriarch,” says Peter Weissman, partner, Cadesky Tax in Toronto. “When a person dies, they’re deemed to sell everything they own, and there’s capital gains tax. But when a person dies, the trust doesn’t die—it continues,” he says.
The assets in the trust are not subject to tax, “so you defer the tax for quite some time,” he adds.
Among the most popular trusts are inter vivos or family trusts, spousal trusts and joint partner trusts.
A family trust, the most commonly used option, allows the trust’s income and capital to be distributed to its beneficiaries, dramatically reducing how much tax needs to be paid. If there are any capital gains, the trust can allocate the taxable portion to beneficiaries who are taxed at a much lower rate.
While trusts offer myriad tax-deferring benefits, they can be quite complicated to administer, requiring annual tax filings, warns Rachel Blumenfeld, partner, Aird & Berlis LLP in Toronto.
They’re also expensive, especially if the family has members in different countries. “It adds another layer of complication to people’s lives,” she says, partly the result of additional compliance requirements introduced in recent years.
“There is now a lot more reporting required—more requirements for trusts where you have to report who settled the trust, a lot more information about the settlor, the trustees and the beneficiaries, things like their social insurance numbers, their dates of birth and addresses,” says Blumenfeld.
In general, trusts introduce complexity into one’s financial circumstances, says Ethan Astaneh, wealth advisor and client relationship manager with Nicola Wealth in Vancouver.
For example, “a trust requires you to identify a trustee, and while the tendency is to gravitate toward trusted family members, loved ones or friends, some may find it challenging to find suitable individuals to fill this role,” he says.
The important thing when drawing up a trust is to ensure it’s airtight, says Blumenfeld. She has seen cases where the lines between the estate and the trust become blurred, and problems arise. “You have to just make sure that everything goes to the right place.”
The administrative burden also must be weighed against the tax benefits. “Is it going to make the planning during the person’s lifetime more complicated?” she asks.
Family trusts
Family trusts are commonly used for tax purposes. Set up while individuals are alive, they are used for income splitting and to defer the taxation of assets to the next generations through an estate freeze, says Astaneh.
In an estate freeze, the founder freezes the value of the company at the point in time when the trust is established, says Blumenfeld. “You’ve fixed the value for purposes of determining what that tax bill is going to be, and the future growth will be held in the trust, to be distributed in the future to the next generation.”
When an individual owns shares of a Canadian controlled private corporation, and certain conditions are met, he or she can also benefit from the lifetime capital gains exemption upon the sale of those shares, says Astaneh.
“If those shares are held in a trust and there are multiple beneficiaries in that trust, you can effectively multiply the lifetime capital gains exemption,” he says. “Prior to Budget 2024’s proposal, the lifetime capital gains exemption was $1,016,000, and so by using a trust that has five family members you can multiply this by five, and so there can be substantial savings upon the sale of eligible company shares.”
A family trust’s design allows for flexibility, says Weissman. Unlike a will, in which you allocate specific sums to specific people, “you can create a family trust but have the flexibility to decide who gets what, and without having to change any documents,” he says. “Family trusts are commonly discretionary, meaning that the beneficiaries do not have a defined entitlement to the income nor assets of the trust. Instead, that decision is left to a trustee, who decides how much income and capital to distribute and who should receive it.”
Canada’s Income Tax Act mandates that a family trust disposes of the property 21 years after the date it was created. At this time the assets in the trust are considered sold, and any capital gains are taxed.
Family office advisors need to prepare for the 21-year rule well in advance of the deadline, Blumenfeld says. “We do a lot of planning to figure out how to mitigate that,” she says. “A lot of times you just get the shares out and you do it all again.”
Spousal trusts
Spousal trusts are included in a will and allow assets to be held in trust for the spouse during his or her lifetime. The spouse receives income from the trust while overseeing the assets, which will potentially be distributed after the spouse’s death, to beneficiaries. The key is to ensure the trust is structured properly.
“Spousal trusts are often set up during someone’s lifetime so spouses can transfer assets between themselves with no tax,” says Weissman.
Spousal trusts are typically used to ensure the surviving spouse has financial resources during their lifetime while ensuring the capital remains available for the children from a previous marriage, says Astaneh.
“Assets of a deceased person will typically roll into a spousal trust tax-efficiently, and so this helps defer taxation of capital gains,” he adds.
Blumenfeld says: “The main purpose of using them is going to be for probate planning, so you’re only going to see them in the provinces that have higher probate tax, such as Ontario, B.C. and Nova Scotia.”
Joint trusts
An alter ego—or joint spousal or common-law-partner—trust can be a great tool for reducing probate taxes, says Weissman. This is a type of inter vivos or living trust that allows the family business owner to transfer assets to the trust on a tax-deferred basis for the benefit of the spouse, and to have those assets taxed at a considerably lower rate.
That’s because assets that are properly transferred into a joint partner trust are not considered part of the business owner’s estate and are therefore not subject to probate tax.
“Joint partner trusts are similar to spousal trusts,” says Weissman. They both result in a deferral of capital gains tax on the death of the contributor because he or she won’t own the assets. They also allow the trust assets to be governed by the trust document, not the person’s will. He says this can speed up the administration of the assets faster than if they were part of an estate.
Know the rules
Regardless of which kind of trust is chosen, advisors need to educate clients about what’s involved in operating a trust. Understanding the purpose of the trust and the roles within a trust are critical to engaging with it as a settlor, trustee or beneficiary, says Astaneh.
“The use of trusts and creative financial structures needs to be complemented with the right family governance,” he says, “which requires supporting the human capital of the family.”
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