Family trusts and the 21-year rule: something to keep in mind
In today’s environment, family trusts are often used to transfer companies from one generation to the next. This is usually referred to as an “estate freeze using a family trust.” Generally, a family trust is created when the freezor is uncertain about the future and wants to take advantage of tax savings now, but without actually transferring the business. Using a family trust provides the option of splitting income, multiplying the use of capital gains exemptions and limiting income taxes at death, while maintaining some control over the management of the shares held by the trust.
While under the Civil Code of Quebec a family trust has a 100-year life, the Income Tax Act provides that property held in a trust is deemed to be disposed of at fair market value after 21 years. In addition, even though the plan is to retire before the trust’s 21st anniversary, the freezor is not always ready to pass the torch when the time comes. Many solutions exist for not only minimizing the tax consequences resulting from the 21-year rule, but also for maintaining control and appropriate protection of the assets. Practitioners should therefore carefully monitor the situation in relation to this rule, since a number of trusts created in the 1990s will soon reach their 21st anniversary.
The simplest way to prevent a deemed disposition at fair market value of all the property in a trust on its 21st anniversary is to distribute the property to the beneficiaries. As a general rule, distributing property to a beneficiary can be done without any tax consequences. However, the beneficiary receiving the property acquires full control and, if the beneficiary is experiencing severe financial difficulty, this property could be seized by creditors. Some may want to trigger the deemed disposition to avoid such a situation. When a trust holds property with a significant capital gain and property with a value that is almost equal to the tax cost, both of these options may be used simultaneously. For example, the property with an unrealized gain can be distributed to the beneficiaries and the other property can be subjected to the deemed disposition rule. However, a tax-free distribution to beneficiaries may not apply if the trust has already been contaminated by certain attribution rules since its creation. It is important to review these rules before liquidating.
In certain cases, besides the income taxes payable, many other factors should be taken into account, such as the risk of property seizure, the beneficiaries’ ability to administer the property, etc. Depending on the situation, planning that includes setting up other trusts, or using existing or newly incorporated companies can be considered.
Creating a new trust to hold growth shares after a new estate freeze has been made by the initial trust is a frequently used planning strategy. Accordingly, the initial trust could transfer the shares to a new company in exchange for common shares. The initial trust would issue the common shares to one of the beneficiaries who could be the founder’s child (to avoid issuing retractable preferred shares to the beneficiary).
Jean-François Thuot, CPA, CGA
Raymond Chabot Grant Thornton
Member of the Order’s Technical Working Group on Taxation and Commodity Taxes