What’s the purpose of a trust?
A trust is used to transfer the administration of personal or real property (like a house, shares or bonds) to another person (the trustee). This means that the property no longer belongs to the person who transferred it.
There are two main categories of trusts (sometimes known as “personal trusts”):
- Inter vivos or “living” trusts, including family trusts (the subject of this article)
- Testamentary trusts (created following a death)
You should be aware that other types of trusts also exist, as well as other ways to categorize them. These include mutual fund trusts, trusts created to meet the needs of certain institutions and employee benefit trusts. In broad terms, trusts offer a certain degree of flexibility in terms of taxation and estate planning.
Three parties are involved when a trust is created, and each plays a key role:
The settlor is the person who creates the trust. Once the trust has been set up, the settlor no longer has an active role. The settlor is usually not a beneficiary (current or potential) of the trust.
In Quebec: To create a trust, the settlor must first dispose of property and transfer it to a patrimony separate from their own, called the trust patrimony.
In the rest of Canada: A trust is officially created when the settlor transfers their property to the trustee. Common law views trusts as a relationship—not as a separate patrimony—because of the trustee’s duty to hold the property for the benefit of the beneficiaries.
The person(s) entrusted with administering the property. The trustees manage the property held in the trust and decide how it will be distributed to the beneficiaries. They act in accordance with the terms of the trust document, which sets out the trustees’ responsibilities.
In all scenarios, the role of trustees in relation to beneficiaries implies that they will:
- Act with prudence, diligence, honesty and loyalty
- Avoid conflicts of interest
- Be accountable to the beneficiary
In Quebec: Trustees are only administrators. They cannot claim any ownership rights over the trust’s assets or the trust patrimony. However, under the Civil Code of Quebec, a settlor or beneficiary may also be a trustee, provided that there is another trustee who is neither the settlor nor a beneficiary (an independent trustee).
In the rest of Canada: The settlor may appoint themselves as a trustee and need not be assisted by another trustee in administering the trust. However, this is not recommended for family trusts, due to tax attribution rules.
The person(s) entitled to receive the trust’s income and capital. What the beneficiaries receive may be determined by the trust agreement or the discretion granted to the trustees.
In a family trust, the beneficiaries are often members of the family. It’s also possible for a company or another trust to be beneficiaries.
The potential benefits of a family trust
1. Reducing your tax burden
Once the assets have been transferred to the trust, they and the income they generate are no longer part of the settlor’s patrimony and can be allocated to the beneficiaries, who must include them in their own tax returns. This results in income splitting. Because Canada’s tax system is progressive, this can help reduce the overall tax burden.
For example, two people who each report $50,000 in income may owe less tax overall than one person who reports $100,000.
However, there are a number of tax laws that restrict income splitting. If you want to create a family trust solely for the tax advantages, it’s important to weigh whether it’s worth your while. Speak with a tax specialist for more information.
N.B.: If the income is not allocated to the beneficiaries, it will be taxable to the trust at the highest marginal tax rate. The tax bill may be higher.
2. Reducing taxes payable at death
The estate freeze strategy
Owners of incorporated businesses can use a family trust to reduce the tax payable upon their death.
Here’s how it works:
- The trust becomes the owner of participating shares in the corporation at the time of the freeze.
- Any increase in the value of the shares will occur within the trust, which means that it will not be taxable at the business owner’s death.
- Tax will need to be paid when there is an actual disposition of the new shares held by the trust (e.g., a sale) or a deemed disposition (i.e., a notional sale to assess how much tax is payable).
In the case of an estate freeze, a family trust also allows a great deal of flexibility in determining who will take over the business and how.
Probate in common law provinces
In the common law provinces, estates are required to pay probate fees, which are a form of estate administration tax. When property is transferred to a family trust (inter vivos), it is no longer subject to probate with the deceased’s estate. Depending on the deceased’s province of residence, the savings may be substantial.
3. Planning for the transfer of your wealth
Family trusts can be used to pass on wealth within the family. They allow you to specify who should receive the money and what it should be used for, whether during the settlor’s lifetime or after their death. One advantage of using a trust is that it can prevent children from frittering away their inheritances. It’s recommended for high-net-worth individuals to plan for the transfer of wealth as part of estate planning, which may involve a family trust.
4. Protecting your assets
A family trust holds property on behalf of the beneficiaries and protects it from creditors. The trust assets cannot be seized following a lawsuit or personal bankruptcy. It’s important to remember, however, that the trust must be created when everything is going well. If trouble was already brewing when it was set up, a judge may still allow the assets to be seized.
5. Protecting a child
A family trust makes it possible to give someone a gift without simply handing it over to them. For example, a trust could be used to secure the future of a child with a disability or to provide for grandchildren. The rules established when the trust is created can include provisions on how children should receive the money.
The disadvantages of a family trust
The 21-year rule
The main downside is the 21-year deemed disposition rule. Under the Income Tax Act, trusts are generally deemed to dispose of their property 21 years after their creation. The trust is considered to have sold all its assets at once, and all the unrealized gains on the trust property are taxed. So, while trusts can remain in effect for a long time, they can’t last forever. It’s up to the settlor to decide when the trust should be wound up. All trusts should include an ultimate distribution clause that sets out when and how the trust assets will be distributed.
Significant administrative requirements
The income tax rate for family trusts is the highest marginal rate. Trusts are taxed on the income they generate and must file a T3 return (link to external site) every year and issue tax slips. Furthermore, under new rules, most trusts are required to file a T3 return even if they have no tax to pay or income to report.
The law does not impose any specific record-keeping requirements on trustees. However, trustees have a duty to document their work so that they can account for their administration of the trust and the tasks performed. The way that they document it may vary depending on the type and value of the property they are responsible for. Trustees must also take minutes of their decisions and produce financial statements.
How to create a family trust
Are you thinking about setting up a family trust? Start by asking yourself these questions:
- What objectives do you hope to achieve by creating a family trust?
- Who will the settlor, the trustees and the beneficiaries be?
- What property will be transferred to the trust?
- Which trusted experts can assist you with the process?
Next, follow the key steps in creating a trust:
1. Draw up the trust agreement
The trust agreement (or trust deed) names the trust and determines its intention or objective. It also specifies the trustees and beneficiaries and can include various clauses. Ideally, this step should be handled by a notary or a tax lawyer.
2. Make an initial gift
To create a trust, the settlor usually makes an irrevocable gift. To avoid the attribution rules when setting up a family trust, the initial property transferred to the trustee could be something like a silver coin or bar.
3. Open accounts for the family trust
You may need to open one or more bank accounts for your trust. Ask for help with this step from a financial planning specialist at your financial institution.
4. Fund the trust
Your tax advisor can provide a list of steps for transferring assets to the trust. These assets may include:
- Real property
- Works of art
- Collectibles and heirlooms
- Bank accounts
- Company shares and other investments
5. Register the trust
In certain cases, trusts must be registered with your province. A notary, lawyer or tax specialist will be able to advise you on whether this is required in your case.
There are fees associated with the various steps in creating a family trust. How much does a family trust cost? The overall cost is highly variable. To avoid surprises, be sure to factor in the fees charged by the various professionals involved in the process.
A family trust is a sophisticated tool with a multitude of associated legal and tax rules. Don’t hesitate to ask our experts for help analyzing your situation and setting up your trust. They can also advise you on how to optimize it and make the most of the many benefits it offers.