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A guide to trustee-beneficiary relationships

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A trust is a legal arrangement where trustees hold legal ownership to property on behalf of beneficiaries, who have the actual beneficial interest in the property.

Trusts are used for a large number of purposes, and they can be extremely effective for asset protection, management for inexperienced or unreliable beneficiaries and tax planning.

This article is especially intended for professional advisers (investment, financial planning, even legal and accounting) and trustees or beneficiaries of trusts. If you are not in that category, then you might find it interesting, but not personally relevant.

Please keep in mind I am not a lawyer or accountant. They are the specialists you need to consult if any of this applies to you.

Focus today is on the 21-year rule, a tax rule that requires most trusts to pretend they have sold all their investments at fair market value on the 21st anniversary of the formation of the trust and pay any resulting tax on the imputed capital gains, without generating any actual cash to pay those taxes.

This deemed disposition at age 21 can be extremely expensive if proper planning is not undertaken.

First, the exceptions and then some suggested planning strategies.

The exceptions are spousal trusts, joint-partner trusts or alter-ego trusts. These trusts can defer the deemed disposition of the property until the later of the death of the settler of the trust or their spouse. Those are about the only exceptions.

Trusts that are created for the ownership of cottages or other vacation property (including those in the U.S.), family trusts created to share ownership of companies and trusts created by a last will and testament other than for a spouse are all caught by this rule.

If property is transferred from one trust to another, this does not reset the clock. The original 21 years still applies on that transferred property.

You can see how the illiquid legacy properties, such as vacation homes or family business shares, can be a real problem. They may have gained significant value over 21 years, and the family may want to retain ownership. The 21-year rule could cause tax on the taxable half of the capital gain at the top tax rate, and it could also be subject to income from things such as recaptured depreciation.

On the other hand, there could be capital losses to offset these, but that's relatively rare over 21 years.

A common strategy is to write up the original trust document to specify that these properties will be transferred out to the beneficiaries directly before the 21st anniversary, thus avoiding the deemed disposition. The tax rules generally allow trust capital property to be transferred to the beneficiaries at original cost, so that the capital gain is deferred until an ultimate sale, or death of the beneficiary or surviving spouse.

This is effective, but may run counter to some of the asset protection, management and sharing goals of the original trust. This may also expose the property to claims from creditors or a future ex-spouse. As well, the trustees lose their control over the assets, and this control may still be valuable, or the whole purpose of the trust in the first place.

Even worse, and somewhat common in the case of private company shares, is the application of subsection 75 (2) of the Income Tax Act, which deems the transfer of the shares to be at fair market value instead of cost, resulting in the tax on gains having to be paid anyway.

With more liquid assets, like an investment portfolio, our approach is to realize capital gains gradually over the five years leading up to the 21st anniversary, thus avoiding a large one-time hit. This makes sense where there is good reason to continue the trust beyond 21 years. However, this latest federal budget has taken away the ongoing tax advantage for testamentary trusts.

As always, with complicated situations such as this, I like to quote Ed Sullivan, and just say, "Kids, do not try this at home." In other words, get good professional advice well in advance of such deadline dates.

 

Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.

 

David Christianson, BA, CFP, R.F.P., TEP, CIM is a financial planner and adviser with Christianson Wealth Advisors, a vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.

Republished from the Winnipeg Free Press print edition April 4, 2014 B14

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