Trusts have a long history going back to medieval times when landowners placed their property in trust while away fighting wars. But the modern trust has developed into an indispensable tool for tax and estate planning.
A trust is a relationship amongst the settlor (creator), trustee and beneficiary. The trustee holds the trust property for the beneficiary. It's best to put the terms of the trust in writing because it's difficult to validate verbal or informal trusts.
There are many reasons for having a trust. For example, a Henson trust can hold assets for a disabled relative so they are taken care of after the person's caregiver dies. A trust can also be used for asset protection. The trust's assets are intended to be kept from the hands of a beneficiary's creditors – tax authorities, lawsuits, or marital claims. The assets are not owned by the debtor and escape seizure by the creditor.
However, laws prevent a debtor from giving away assets in order to defeat creditors; a debtor's bankruptcy can result in previous asset transfers being overturned by a court. Asset protection is valid if done well before any creditors appear, and if it's for something like estate planning.
Similarly, trusts can be used to avoid Ontario probate taxes. These are about 1.5 per cent or $15,000 for every $1-million of value of the estate of the deceased, which includes investments, bank accounts, vehicles, jewellery, paintings, and Ontario real estate. The tax is paid by the estate, and the executors file a form to certify a detailed list of assets and their value.
The same assets can be taxed again when the survivor passes away. However, during the owner's lifetime, an alter ego or joint partner trust can be used to own the assets and escape this probate tax because they are no longer part of the person's estate on death. The trust deed would implement wishes of the deceased regarding who inherits the assets. Like a will.
Also, a Canadian trust that owns U.S. situs assets (i.e., U.S. real estate or shares in U.S. companies) may help you avoid U.S. estate tax on the death of a beneficiary.
Trusts are commonly used for succession planning for private companies when the owner wants the next generation to take over. Estate freezes allow owners to lock in the current value of the company with preferred shares, while a separate class of shares owned by a family trust will have the future value.
This allows the owners to plan for future tax liability, upon death, because the tax is quantifiable and can be funded with life insurance. Also, dividends paid to the trust can be distributed to beneficiaries and taxed in their hands, which achieves a measure of income-splitting. But this is possible only if properly set up and implemented, and the company is a Canadian-controlled private company that carries on an active business in Canada.
The Canada Revenue Agency has a number of audit projects to review trusts and related planning. The CRA looks to see if the trust is properly set up and administered, and that trust income goes to and is taxed in the hands of the beneficiaries. Diverting that income back to the parents, or to non-taxable entities, is usually a problem.
In any tax or estate plan, the benefit must outweigh legal fees for set-up and ongoing maintenance like annual tax returns. Proper planning should require input from professional advisors. A lawyer, accountant, investment advisor, and insurance agent will ensure that the plan is right for the client and effective, and will survive a tax audit.
Robert G. Kepes is a partner with Toronto-based Morris Kepes Winters LLP, a Canadian and U.S. tax law firm.