Unwinding the Trust

The recent Federal Budget proposes some measures, which will significantly alter the tax treatment of family trusts where income flows to minor beneficiaries. The intent appears to be to eliminate any tax advantage in income splitting with a minor through a trust. The proposal does not affect the tax treatment of spouses and other adult beneficiaries of a family trust.

Another important tax matter affecting many trusts is that 1999 is the first year that capital gains tax can result from a deemed disposition of the assets of the trust under the 21-year rule.

Background of Trusts

Trusts are a creation of English common law, which date back for hundreds of years. There are typically three parties to a trust as follows:

Settlor-Testator: This is the person who gives property to the trust during their life or at death.

Trustee: Holds legal title to trust property.

Beneficiary: Receives the benefits from the trust and holds equitable title to the trust property.

An inter-vivos trust is one where the settler makes a gift during his or her life. A testamentary trust is a trust that is created by will.

Strategic uses of Trusts

Trusts can be used in both simple and complex estate planning situations. Some of the purposes of trusts include the following:

• Asset management and protection
• Special needs beneficiaries i.e. a disabled child
• Matrimonial property and
• Family wealth planning
• Planned giving
• Testamentary control

Capital gains tax

When capital gains tax was introduced in 1971, rules were brought in so that trust property could not be accumulated without being subject to capital gains tax at some point in time. The legislation established a rule that the trust is deemed to have disposed of its capital assets every 21 years at fair market value. This deemed disposition would trigger a capital gains tax. Assets would then be considered to have been re-acquired at fair market value. Where a trust owned significant capital assets such as shares of private or public companies, or real estate, the potential tax from the deemed disposition could be substantial.

Some assets are not affected by the 21 year rule. These assets would include cash and other financial instruments that do not have accrued gains as well as the cash value of life insurance policies, which is not a capital asset.

In 1992 the Federal Government introduced deferral rules to postpone the 21-year rule. However this decision was reversed in 1995 so that the 21 year rule or deemed disposition will occur in the tax year where January 1, 1999 falls for trusts that were set up between 1971 and 1978. In other words trusts that were set up between 1971 and 1978 face this deemed disposition problem now.

Distributing property

Capital property can be transferred from a trust to the beneficiaries on a tax free basis. The trust has no taxable income from the transfer and the beneficiary is considered to have acquired the property at the same cost as the trust. Under this scenario capital gains tax is deferred until the beneficiary sells the property or until the beneficiary is considered to have sold the property at death.

The solution

Trusts can avoid the 21 year rule by distributing the capital property immediately before the 21st anniversary of the trust by:

• Distributing property to the beneficiaries in accordance with the terms of the trust document or;
• A court ordered variation of the trust.

Variation of the trust

Variation of a trust is a legal process, which might include the following:

• Application to alter the terms of the trust.
• Consent of all of the trust to the variation of the beneficiaries.
• Typically the court must decide that the variation will not overturn the original trust provisions and will not benefit one class of beneficiaries over all the others.

Use of financial vehicles

When a trust distributes property to the beneficiaries there can be a current and future capital gains tax exposure related to the property that has been transferred. One method of providing for that potential tax liability is to purchase life insurance on the beneficiary. This can be a very cost effective way of funding the tax exposure.

Life insurance contracts and annuities are also used in order to assist with variation of trusts. Annuities can be used to guarantee an income to an individual who would otherwise be a life tenant in a trust. The guaranteed income can replace the income that would otherwise be received from the trust and allow for trust assets to be distributed to other beneficiaries.

Life insurance can be used to facilitate a trust variation especially where there are contingent beneficiaries. For example, consider where an income beneficiary (mother) is also a capital beneficiary only if she survives the settler of the trust (grandmother). In that case the courts and other beneficiaries might not agree to a distribution of capital property to the mother without the provision of life insurance or some other financial asset to replace the capital in the event that mother predeceased grandmother.

There are many other situations where annuities or life insurance might be a viable financial vehicle to enable the beneficiaries and the court to approve a trust variation. For more information on these financial vehicles please call us.