Benefits of Family Trusts

Ensuring your loved ones are financially secure and that your hard-earned assets are distributed according to your wishes is something that worries a lot of family heads and parents.

This is because there’s a lot to think about in that situation, especially when you’re trying to safeguard them for future generations and ensure that your assets are preserved properly.

A lot of Canadian families use family trusts as a tool to navigate these types of concerns and goals, and that’s where this guide will come in useful. 

This article will help you explore various aspects of this type of trust, including the most popular family trust advantages and how it can benefit you and your beneficiaries.

Additionally, we'll discuss some potential drawbacks and provide a real-life example to illustrate these points in action. This will help you have a better understanding of the concept and make an informed decision. 

What is a Family Trust?

Before diving into the details and benefits of a family trust, you must first have a full understanding of what family trusts are and their main components.

A trust is a legal arrangement where the assets of a person are held for the benefit of another, which is done through an intermediary entity that is trusted to hold the assets of said trust.

One of the common forms of trust is a family trust, also known as a Dynasty Trust. As the name suggests, the main aspect that distinguishes these types of trust is that they’re typically set up between family members to hold, manage, and pass on family assets and properties.

In Canada, trusts typically fall within two broad categories, which are:

• Living (Inter-Vivos) Trusts: These trusts are set up while the person who created the trust is still alive and comes into action during their lifetime. These trusts can also be revocable or irrevocable, which explains whether these trusts are subject to adjustments after they’re in effect or not.

• Testamentary Trusts: These are trusts created as a part of a person’s will, so they’ll only come into effect when that person passes.

A family trust can be either a living trust or a testamentary trust, which will be determined according to how the trust is drafted and when it’s supposed to come into action.

Understanding the Parties Involved in Family Trust

While there are different types of trust, they typically share similar key parties involved. Here’s a brief breakdown of each one of these parties from a family trust perspective.

Settlor

In a trust, the settlor is the person who creates it. They’re also the person who owns the assets and properties that are meant to be transferred through the trust.

Besides the settlor, they might also be referred to as the donor, grantor, or trustor. In the case of a family trust, the settlor is usually the head of a family or a senior member, whether they’re the parent or a grandparent.

Besides establishing the trust and transferring the ownership of property or assets into the trust for the benefit of others, the settlor also outlines the terms of the trust to specify how they want their assets to be managed and distributed.

Trustee

A trustee in a trust acts as a manager and fiduciary for the trust's assets. They are entrusted with the responsibility of holding and administering the property or assets for the benefit of the beneficiaries named in the trust.

The trustee must strictly follow the terms set out in the trust document. This includes managing and distributing the assets as instructed and following any specific guidelines or instructions for beneficiaries to earn their share of the wealth.

The trustee can be any individual, such as a family member, friend, lawyer, or financial advisor, or it can be a professional institution like a bank or dedicated trust management company.

There can also be more than one trustee per trust, and settlors can even name themselves as trustees.

Trustees have certain roles and responsibilities to uphold while managing trust and can be found liable for negligence if these duties weren’t fulfilled, including:

• They have a legal obligation to act in the best interests of the beneficiaries and set aside their personal interests, which is known as “fiduciary duty”.

• They must ensure fairness and never offer any preferential treatment to a specific beneficiary over others.

• They are responsible for keeping track of all trust recordkeeping and transactions, including income, expenses, and distributions to beneficiaries.

The choice of trustee depends on the complexity of the trust, the settlor's wishes, and the desired level of expertise in managing the assets.

Beneficiary

In a trust, the beneficiary is the person or entity who ultimately benefits from the trust by receiving the trust’s assets or income associated with it, as defined by the trust's terms.

One thing to know here is that a beneficiary can include multiple beneficiaries, including the settlors and trustees themselves.

In the case of a family trust, the beneficiaries are usually other family members, such as spouses, children, and grandchildren. However, even a corporation or a charity organization can be recognized as a beneficiary under Canadian laws.

Beneficiaries in a trust can be vested or contingent. Vested beneficiaries have a guaranteed right to receive trust benefits at some point, whether immediately or according to the trust's timeline.

On the other hand, a contingent beneficiary's right to benefit from the trust’s assets depends on a future event happening (or not happening), which is also detailed in the trust document.

The Advantages of Family Trusts

Family trusts offer a variety of advantages for beneficiaries and even the settlors, ranging from the protection of assets to giving you control during wealth transfer. Here's a closer look at some of the key family trust benefits to keep in mind.

1. Full Control Over How You Want to Manage Your Estate

One of the main advantages of setting up a family trust is that it empowers you to be the architect of your own legacy.

Under Canadian law, the settlor is technically no longer the owner of the assets once they’re fully transferred to the trust. But in reality, you still gain remarkably significant control over your wealth because you get to decide the details of your trust.

For instance, you can control how your wealth is managed and distributed, ensuring your legacy aligns with your values and goals for future generations.

Additionally, as a settlor, you get to name the entities and individuals you want to benefit from your assets once they’re included in the trust, whether they’re money, investments, properties, or belongings.

You can even designate vested and contingent beneficiaries (basically primary and secondary) to ensure your wealth goes according to your wishes. 

2. Tax Advantage

Under Canadian law, a family trust is technically considered a separate taxpayer that needs to file its T3 tax return and gets taxed at the highest bracket. 

However, when set up strategically, family trusts can offer several significant tax benefits. Family trust tax benefits include (but are not limited to):

Capital Gains Tax and Estate Freeze

Normally, when someone passes away, they're considered to have sold all their assets at market value for income tax purposes. This can create a big tax burden for the estate according to any capital gains recorded during that phase.

But with a family trust, things are different. Capital gains on any assets held within the trust are simply tax-deferred using the Estate Freeze strategy.

The intent of this strategy is to lock in the current value of a certain asset and its associated tax liability while attributing the future growth in value to the beneficiaries.

This essentially reduces the amount of taxes needed to be paid upfront on the estate of the deceased. In other words, the tax on those capital gains gets "skipped” to the next generation, who will pay it when the assets are eventually sold from the trust.

Lifetime Capital Gains Exemption

Another way trusts are used to reduce the tax burden on their beneficiaries is by utilizing Lifetime Capital Gains Exemption (LGCE).

This is simply a tax exemption you can use to sell shares of a small business (Qualified Small Business Corporation or QSBC) or farm property (Qualified Farm or Fishing Property or QFFP) without paying capital gains income tax, up to a certain amount.

As of 2023, this deduction exemption limit was changed to $971,190 for small businesses and $1,000,000 for farms.

Although trusts aren’t allowed to claim this exemption, beneficiaries themselves may claim it under certain conditions, potentially saving a significant amount on taxes. 

The trust can even distribute the profits from selling these shares to multiple beneficiaries, maximizing the tax advantage by splitting the exemption between them for maximum savings on taxes.

Keep in mind that these conditions can be quite complex, so you should always seek the help of a qualified professional if you want to benefit from these aspects.

Income Splitting

As previously established, trust income in Canada gets taxed at the highest rate. For that reason, it's usually in everyone’s interest to distribute the trust's taxable income to the beneficiaries each year instead of letting it get taxed at the highest rate within the trust itself.

This can result in remarkable tax savings, especially if the beneficiaries are within the lowest tax brackets.

While income splitting remains a popular reason to consider trusts, changes to the Income Tax Act by the Canadian government, known as the "attribution rules", have made it a lot harder to benefit from income splitting.

It’s always best to consult a professional on tax splitting, as they can advise you on whether it's a suitable and legal option for your situation, and help you structure your trust to comply with the rules.

3. Protection from Creditors

Family trusts can act as a shield against creditors. By transferring properties and assets to a trust, you essentially remove them from your personal ownership.

This means that if the settlor or one of the beneficiaries is sued or goes through bankruptcy, creditors won’t be able to access and seize these assets to settle debts, liabilities, or judgments.

However, there's an important catch to keep in mind here: family trusts need to be established during prosperous financial times.

Canadian law gives the court the authority to allow the assets of a family trust to be accessed if they suspect the trust was specifically set up to avoid existing creditors.

4. Preserves Your Assets to Benefit Multiple Generations

Family trusts are also an excellent way to preserve assets to make sure that they benefit your entire family, even long after you’re gone.

For instance, if you have a blended family, there might be a larger risk of conflicts and confusion among family members over inheritance and succession. However, with a family trust in place, you decide exactly who receives your assets in addition to when and how.

You can achieve this by structuring the trust to distribute assets gradually or aligning with specific milestones in their lives to make sure beneficiaries don’t spend your wealth unwisely.

Besides planned distribution, family trusts can also be a form of conditional gifting, as it allows you to give assets away under specific conditions. 

5. Avoiding Probate

While Canadian laws don't incur taxes on inheritance, beneficiaries still need to go through probate, the process of validating the will and distributing the assets.

The problem with this process is that it’s lengthy and can also incur heavy fees that eat away from the beneficiary’s inheritance.

The good news is that family inter vivos trusts are not subject to probate and can directly bypass it upon the death of the settlor.

6. Maintenance of Privacy and Confidentiality 

Unlike wills, which become part of the public record during probate, trust documents are generally private and confidential. 

This means the details of the trust, including the value of assets and even beneficiary identities,  can be made private and not readily accessible to everyone.

Disadvantages of Family Trusts

Besides all its merits, family trusts have their downsides that you need to keep in mind before making up your mind about them.

The 21-Year Rule

Despite the various tax advantages of family trusts, there are various laws in place to prevent indefinite delaying of asset distribution and deferring capital gains.

One of these issues is commonly known as the 21-year rule, which is a rule under the Income Tax Act that enforces the disposition of properties every 21 years.

In other words, the trust is considered to have sold all its assets at that time at fair market value, and any unrealized gains on the trust property must be taxed at that point, even if no sale took place.

Of course, 21 years is more than enough time for families to find flexible ways to handle tax burdens and save as much as possible, especially if they’re backed by a qualified specialist.

Additional Administrative and Record-Keeping

Family trusts introduce a layer of administration and record-keeping that wouldn't exist if assets were held directly by beneficiaries through inheritance.

Trustees are responsible for managing the trust's assets according to its terms, which involves keeping detailed records of income, expenses, and distributions. This can be time-consuming and requires continuous work in addition to meticulous organization.

Cost

Setting up and maintaining a family trust involves plenty of upfront costs. This includes the legal fees associated with drafting the trust documents as well as processing fees to ensure they comply with regulations and provincial laws.

There may also be ongoing costs for administrative tasks like record-keeping, accounting, and tax filing for the trust itself, especially since the trust is taxed at the highest marginal rate.

Additionally, navigating the technical and legal aspects of a family trust can be quite overwhelming and requires a trustworthy advisor in addition to a knowledgeable and responsible trustee, which typically incurs additional fees.

Example of Having a Family Trust

While this guide offers plenty of examples of how a family trust may help in various ways, here’s a simple scenario where you can see the benefits:

The Johnson family had always prioritized planning for the future. They knew they wanted their assets, a combination of a successful bakery business and a vacation cabin, to benefit their children and grandchildren for generations to come.

The trust was structured to minimize estate taxes by strategically transferring ownership of the bakery business to the trust, which reduced the overall taxable estate value of their wealth.

Additionally, when one of their children, Michael, went through a difficult financial period, the assets were shielded from Michael's creditors because they were held in the trust.

This ensured that the bakery and cabin remained secure for the family's future. Additionally, the trust appointed existing and future grandchildren as beneficiaries while setting age and educational milestones for them to start benefiting from the trust.

TL;DR

Establishing a family trust offers a huge variety of advantages that allow you to manage and distribute your assets to your beneficiaries according to your wishes.

This includes probate avoidance, tax benefits, securing continuity and succession, and asset shielding from creditors.

However, family trusts are not for everyone as you’ll need to be aware of the downsides associated with these legal agreements.

That’s why you need to consult the legal experts at Parr Business to help you make the right decision, so don’t hesitate to contact us if you’re interested in finding out more.