It could be your best approach to long-term wealth-management planning.
Too many, a trust is still very much an enigma. While most people have an idea of what is trust is, they have trouble explaining its benefits beyond asset protection and tax minimization. Trusts deserve further illumination because they can be a valuable wealth management mechanism for high net worth families and particularly useful for tax and estate planning. The key to their effectiveness is understanding how they work. Unlike most other financial planning tools, trusts provide the benefit of long-term flexibility and control.
What is a Trust?
A trust is a relationship that arises whenever a person, called the settler, transfers ownership of assets to another person, the trustee, who controls and manages those assets on behalf of, and for the benefit of, specified beneficiaries. A trust effectively separates legal ownership and beneficial ownership. The trust indenture details this relationship and lays out the trust’s mandate and the trustee’s responsibilities and obligations.
Inter-vivos versus testamentary trust
Trusts are classified as either inter-vivos or testamentary.
An inter-vivo trust is created during the life of the settler, while a testamentary trust arises as a consequence of the settlor’s death, as per the terms of his or her will. Either trust can be created as discretionary or non-discretionary. The difference between the two is whether the settler has granted the trustee “discretion” when allocating income and/or capital gains to the beneficiaries or requires the trustee to follow a preordained determination. Discretionary trusts can go as far as providing trustees the authority to decide which beneficiaries will receive benefits, and when, and how much the beneficiaries will receive.
The key point to understand between these two types of trusts is how differently they are treated for tax purposes:
- Under an inter-vivos trust, all income and capital gains retained in the trust are taxed at the top marginal tax rate, which was almost 48 percent in 2012.
- Testamentary trusts are taxed at progressive marginal tax rates, the same as individuals.
Consequently, participants of an inter-vivos trust are motivated to distribute all income and capital gains to the beneficiaries to avoid paying the highest marginal tax rate
Tax Planning
To demonstrate how dynamic and flexible trusts can be in tax and estate planning, I have highlighted their more strategic uses. For this purpose we will be looking at discretionary family trusts.
Income splitting is one of the more popular uses of family trusts. This is mainly due to Canada’s graduated tax system. Income-producing assets are transferred to the family trust, whereby income and capital gain are distributed to lower-income beneficiaries. By shifting income to lower-income family members, the family’s overall tax burden is reduced.
When you consider a situation in which a beneficiary has no income, the tax savings can be significant. This is in part due to the personal tax exemption, which allows each person in Canada to earn almost $10,000 a year tax-free. This means that a person can earn – tax free – up to $19,000 of capital gains or as much as $48,000 in dividends, depending on the nature of the dividends.
A family trust also affords business owners the opportunity to multiply the small business capital gains exemption upon sale of shares held within it. This exemption is available to shares that are considered qualified small business corporation shares, which applies to most operating and privately held incorporated companies. Each Canadian resident has a lifetime capital gains exemption of $750,000. Consequently, the trust has available to it as many capital gain exemptions as there are beneficiaries. However, you may want to ask the beneficiaries’ permission first, because once a person’s capital gains exemption is fully used, it is gone.
When income splitting, be aware of Canada Revenue Agency’s attribution rules, which are designed to prevent income splitting in situations where assets are gifted to non-arm’s length individuals such as a spouse or minor children or, in this case, a family trust, resulting in less overall tax being paid. The result is that the income or capital gains in question gets “attributed” back and taxed in the hands of the original transferor. This can be remedied, however, by constructing the asset transfer as a bona fide sale or loan at prescribed rates. Incidentally , at current prescribed loan rates of one percent, it is almost like gifting it anyway.
Estate Planning
- Preserving assets for children.
When minors, or children who are not mature enough to handle the responsibility, inherit large sums of money, the results can be dreadful. A testamentary family trust can remedy the situation by placing the responsibility of managing those assets in the hands of trustees. The trust indenture can then be designed to distribute the capital to the beneficiaries at a certain age or particular life event. Equally, the trust can help prevent a child’s future spouse from benefiting from the family’s wealth in case of divorce. A family trust can also serve to protect your estate from being included in the “new matrimonial property” should you or your surviving spouse decide to remarry.
- Creditor proofing. In most circumstances, a family trust can protect your assets from creditors or claims arising from lawsuits, taxes, accidents and other similar financial risks. Because trusts separate legal and beneficial ownership, and because trustees control distributions of capital and income from the trust, beneficiaries are protected against possible creditor appropriations.
- Charitable giving. Trusts can make charitable giving a less definite and a more tax-efficient experience. With a charitable remainder trust you would continue to enjoy any and all income distributions from the trust while you are alive; upon your death the capital in the trust would then be transferred to the designated charity. Upon setting up and transferring assets to the trust, you will be issued a tax receipt based on actuarial estimates of the charity’s residual interest, which is effectively the discounted present value of the charitable donation’s fair market value. This can still result in a significant ax receipt. Take for example an individual donating his or her investment portfolio worth $500,000 at age 65 and that actuarial tables determine life expectancy to be 15 years and the discount rate to be five percent. The tax receipt would be more than $240,000 {$500,000/(1.05)^15] and at top marginal tax rates that would translate into more than $115,000 ($240,508 x 47.97%) of tax saving today. The only stipulation is that the original capital cannot be encroached upon before it is received by the charity. The advantage of a charitable remainder trust is being able realize the tax relief from charitable giving at a time you deem to be most beneficial, instead of your estate at the end of your life.
- Probate and confidentiality. Unlike a will, assets in a trust do not pass through probate upon death. The assets within the trust are either distributed or continue to be maintained within the family trust as per the trust indenture. In this way your estate avoids the additional costs and delay of probate. In addition, a will is a public document open to scrutiny, while a trust is a private “relationship” and privy only to its participants. Since the trust exists separately from your estate, the assets within the trust are immune to any challenges to the will.
The benefits of using family trusts in tax and estate planning cannot be denied. When looking to transfer family assets to the next generation, trusts can provide not only a tax-effective means, but flexibility in managing and distributing those assets. Done properly, a family trust is possibly the best vehicle to effect long-term wealth management planning for high net worth families.
Photo Credit: Tax Credits http://www.flickr.com/photos/76657755@N04/
