A family trust is a powerful tool for estate planning. You can use it to reduce your tax liability, as well as to transfer your wealth and protect your family’s assets. In this essential guide to family trusts, Nour Private Wealth tells you everything you need to know about the functions and benefits of family trusts, including the particular characteristics of family trusts in Canada. This is all the information you need to decide whether a family trust is right for you.
The basics – what is a family trust?
Let’s start with the essentials. You have probably heard the term many times, perhaps without knowing exactly what a family trust is. A family trust is a legal entity created to hold assets and enter into agreements and contracts with third parties. From a legal standpoint, once assets are transferred into a family trust, they are no longer the property of the person who transferred them. Instead, they belong to the trust, which is then administered for the benefit of the trustees or nominated beneficiaries, who are usually members of the relevant family.
What exactly does a family trust do?
Aside from being a legal entity in its own right, a family trust is a relationship between its trustees and its beneficiaries. The trustees are usually the parents or other heads of the family – perhaps a grandparent, aunt or uncle where extended families are involved. A trusted financial advisor might also be included as a trustee. The beneficiaries are any family members expressly included as such: grandparents, parents, children, grandchildren, etc. Companies wholly-owned by one or more of the beneficiaries can also be listed as beneficiaries in their own right. Another individual, known as the settlor, is the family member who sets up the trust, establishing it with a gift, which could be anything from a sum of money to a real estate portfolio or their total assets. After establishing the fund, the settlor has no further involvement. From the time the trust is set up, it holds the assets in question, and the trustees can administer them with the benefit of the trust and its beneficiaries in mind. The trust can buy or sell assets, make investments and transfer assets to other persons or organizations as the trustees see fit.
The advantages of having a family trust
Family trusts offer several attractive financial benefits that make them popular solutions for estate planning and the protection of assets. Here are some of the key benefits:
- Reduce taxes payable on death: An individual who holds many assets, from real estate to shares, can transfer these into a family trust to prevent their estate from having to pay exorbitant taxes after they pass away. The trust, rather than the individual, becomes the owner of the assets, meaning that any capital gains are earned by the trust as well. As a result, these gains are not taxable when the individual dies.
- Easier wealth transfer: A trust smooths and facilitates the transfer of assets within the family after the settlor’s death.
- Protection of assets: A family trust holds assets on behalf of its beneficiaries, shielding them from any claims that creditors might make against individual beneficiaries. If a beneficiary loses a lawsuit, for example, assets held in the trust cannot be seized for the benefit of a third party.
- Protection of children: There are numerous ways for a trust to be used for the benefit of children. The specific rules are laid down when the trust is established, setting out specific ways in which wealth may be transferred to children. It could come in the form of an annuity or a donation to be managed by the trustees rather than being transferred directly into the child’s hands. In this way, a trust can be used to provide for a child who is unable to work due to a disability or to create a long-term financial benefit for grandchildren.
How are Canadian family trusts different?
Family trusts have the same benefits in Canada as elsewhere. However, some of the legal frameworks applicable in Canada mean that trusts, which are commonly used by the wealthy in all countries, can be used to great advantage even by middle-class families.
The dividend tax credit and personal tax credit enable Canadian beneficiaries of family trusts, potentially to receive thousands of tax-free dollars in dividends or other revenues tax-free. This is the same for wealthy families in other countries. However, Canadian law allows for an estate freeze, making a trust very beneficial, even for a middle-income company. With an estate freeze, the owner of the estate can transfer assets to beneficiaries without any tax consequences. The current generation’s assets can be locked in at their current value, making it easier to prepare for the tax liability incurred when they die.
How to set up your family trust in Canada
Three conditions must be met for a family trust to be created in Canada. Firstly, the settlor must state their intention to create the trust. Secondly, the beneficiaries must be clearly identified, and thirdly, the assets that will be held by the trust must be expressly earmarked and itemized. These seem fairly simple, but the validity of the trust depends on several actions taken by the settlor and trustee once these conditions are met.
In practical terms, the creation of a trust entails four relatively easy steps:
- The trust agreement is drawn up with the aid of a notary or tax lawyer. The agreement clearly states the names of the trustees and beneficiaries and includes specific clauses outlining the assets to be transferred and how they are to be managed.
- The settlor makes an irrevocable donation. This does not have to consist of the entire sum of all assets that will be held by the trust in the long run. It may consist of a certain sum of money or a gold or silver bar. Once the donation is made, the trust formally exists.
- A bank account is opened in the trust’s name.
- A closing agenda is set in place and executed according to the guidelines provided by a tax practitioner. The guidelines list the steps to take to transfer assets from the settlor’s possession into the trust.
Although these steps seem straightforward, they are best carried out by – or with the advice of – a professional tax practitioner or wealth manager.
How long does it take to set up a family trust?
The exact time taken to set up a trust differs depending on the specifics of the agreement and the pace at which the settlor and their advisors move. Generally speaking, it takes an average of about two to four weeks.
How tax works with family trusts
A family trust is considered a taxpayer for federal income tax purposes and pays the top marginal tax rates. However, the trust’s tax liability can be reduced by allocating income or capital gains to one or more of its beneficiaries, who would then pay at their own marginal tax rates rather than that which would typically be levied against the trust. Trustees have the power to decide which of the beneficiaries will receive the income allocation each year. This practice is referred to as income splitting.
There are three main tax benefits involved with family trusts.
- Income splitting: As mentioned above, by dividing the trust’s income among its beneficiaries, the overall tax liability can be lowered. Instead of paying the high marginal rate, each beneficiary pays a much lower amount at their respective tax brackets.
- The ability to access other family members’ Capital Gains Exemptions: Every individual taxpayer gets one Capital Gains Exemption (CGE) in a lifetime. If a trust is a shareholder in a company, any capital gains that accrue to the trust can be allocated to the beneficiaries, each of whom can then use their CGE to shelter the gains and reduce the tax burden.
- Tax deference through corporate beneficiaries. If one of the beneficiaries of the trust is a company, there is the possibility of allowing dividends to flow to the company on a tax-deferred basis.
Types of trusts – which one is best for you?
There are two types of trusts in Canada: testamentary trusts and inter-vivos trusts. A testamentary trust is created as part of a will and comes into effect only after the testator/ settlor passes away. An inter-vivos trust is established while its creator is still alive. Which one you choose depends on what you intend to do with it. If your primary concern is to ease the transfer of assets to your heirs while ameliorating your estate’s tax burden, then a testamentary trust is probably all you need. On the other hand, if you want to use the benefits of a trust for your business and your family during your lifetime, you will want to establish an inter-vivos trust.
About Nour Private Wealth
Nour Private Wealth (NPW) is a team of wealth advisors licensed in seven provinces across Canada. We are committed to helping high net-worth families and individuals manage their wealth, grow their assets and plan their estates for an efficient transfer while lowering costs. For more information on family trusts, as well as all the other tools at our disposal to help you protect and grow your wealth, contact us today.