This article was originally published in Finance et Investissement.
A family trust is a tax and estate planning tool widely used by family businesses in Canada. Among other things, it can be used to establish an estate freeze, facilitate the gradual transfer of wealth to the next generation, maintain a degree of control over family assets and, in some cases, provide better assets protection. Historically, family trusts have also been used in a variety of income-splitting strategies. Their popularity is also due to their great flexibility. Depending on the powers set out in the trust deed, trustees often have considerable discretion in deciding how income or capital is distributed among the beneficiaries and the timing of such distributions.
As a trust is generally created to last for a long time, it is essential to keep a crucial milestone in mind: the rule on deemed disposition (sale) that applies on the trust’s 21st anniversary.1
What is the 21-year rule?
To prevent trusts from being used to defer capital gains indefinitely, under Canada’s Income Tax Act, most inter vivos or “living” trusts are deemed to dispose of their assets at fair market value every 21 years. In practical terms, this means that even if no assets are sold, the trust is deemed to have realized the gains accumulated since they were first acquired. This can result in a substantial tax bill, even if no cash has been received.
The rule can have serious consequences for trusts that hold shares in private corporations, real property or investment portfolios which have greatly appreciated in value over time.
It may come as a surprise that there is no single solution to solving this problem as a trust approaches its 21st anniversary. The best strategy will depend, in particular, on the assets held, the beneficiaries’ circumstances, the family’s estate planning objectives and the need to control or protect the assets.
Distribution of property to the beneficiaries before the 21st anniversary
One approach is to distribute some or all of the trust’s assets to its beneficiaries before the date of deemed disposition. In some situations, this distribution may be made at the cost of the assets, thereby avoiding any immediate realization of latent gains. The assets are then transferred out of the trust, and the tax deferral continues in the hands of the beneficiaries until a future sale or their death. This solution is often considered when the next generation is ready to take ownership of the assets. Before adopting this strategy, an analysis of each beneficiary’s circumstances is required.
Crystallizing the gain and paying taxes
In some cases, it is worthwhile to keep the trust in order to protect the assets, family governance or control. For these reasons, the trustees may choose to accept the deemed disposition and pay income tax. This option may be appropriate when the trust has sufficient liquidity or usable tax losses, the unrealized capital gains on the assets are limited, or the benefits of keeping the trust remain substantial, despite the tax cost.
Indefeasible vesting of the beneficiaries’ interests
In certain situations, the trustees may consider irrevocably vesting the beneficiaries’ interests in the trust’s income and capital, commonly known as “indefeasible vesting.”
Rather than distributing the assets immediately, the interests in the trust’s income and capital become irrevocably vested in the beneficiaries. This approach may help avoid a deemed disposition of the trust’s assets, while temporarily keeping the assets in the trust. This may be a good solution when the trustees want to avoid an immediate distribution of assets for reasons related to governance, asset protection or trust administration.
However, this strategy depends on the terms and conditions of the trust deed and requires a thorough tax and legal analysis.
Trust reorganization
When the trust holds shares in a private corporation, various corporate reorganizations may also be considered, particularly in the context of succession planning or a further freeze on an estate.
These measures can sometimes be used to review the ownership structure and prepare more effectively for an intergenerational transfer of assets. However, they require time and close coordination among legal, tax and financial advisers.
The real strategy: start planning several years before the deadline
The 21-year rule should not be seen as merely a tax event, but rather as a strategic planning exercise. In practice, the most complex cases are often those in which the trustees only consult their advisers a few months before the date of deemed disposition. At this stage, some corporate reorganizations may be difficult to achieve.
The circumstances around a trust established 20 years ago may have changed considerably, as beneficiaries may have become non-residents, the family’s dynamics may have changed, the business itself may have evolved, or the assets may have become much more valuable.
Ideally, you should begin planning a few years before the deadline. This is to determine:
- the market value of the assets;
- the accumulated latent gains;
- the beneficiaries’ tax profiles;
- the family’s succession objectives; and
- any needs around controlling and protecting the assets.
The 21-year rule should not be viewed as simply a tax event, but rather as an opportunity to review the structure of the trust and your family’s objectives. Every situation is unique, so the final solution often involves a combination of strategies tailored to the assets held, the beneficiaries’ profiles and the estate planning objectives.
The key, however, remains the same: start planning early. Starting your planning process several years before the deadline generally gives you the most options and helps avoid a considerable tax bill that could jeopardize the objectives set out when the trust was created.
How Miller Thomson can help
If the 21st anniversary of your family trust is approaching – even if that deadline still seems a long way off – it is important to take action. The earlier you start planning, the more options you will have, and the less likely it is that the tax cost will jeopardize the objectives set out when the trust was first established.
Miller Thomson’s Private Client Services team assists family-owned businesses, trustees and their advisers with planning relating to the 21-year rule, whether this involves assessing distribution strategies, analyzing reorganization options, preparing indefeasible vesting, or coordinating the whole process with your tax and financial advisers.
- However, certain trusts are subject to specific rules. Trusts for the exclusive benefit of a spouse, alter ego trusts and mixed trusts for the benefit of a spouse usually have their first deemed distribution deferred until the death of the relevant person rather than until the trust’s 21st anniversary. ↩︎
