Defer tax before a family trust turns 21

Families often use trusts to pass on wealth, but it’s important to anticipate income-tax liability that can arise when CRA deems assets within those trusts to be disposed of.

Regular family trusts are subject to a deemed disposition of capital assets every 21 years, stemming from a rule designed to discourage indefinite tax deferral on accrued capital gains.

The 21-year rule triggers realization of capital gains and losses on all the capital assets held within the trust, regardless of when the assets were acquired. While it’s an imaginary disposition for tax purposes only, liability for many family trusts can be significant.

Here’s an example.

• Donna Smith settled the Smith Family Trust on July 1, 1994, for her adult children, using a silver wafer as the original gift. Trustees are Donna’s husband, Sam, and her two siblings. Three beneficiaries – Terry, Tammy and Tanya – are named income and capital beneficiaries.
• Later that year, the trust borrowed $100 to purchase newly issued common shares of Smith Limited as part of a corporate reorganization, which included a freeze of Donna’s equity position in the firm. The loan was repaid with dividends received by the trust from Smith Limited. Those common shares and the silver wafer are the only assets held by the trust.
• By January 2015, the common shares of Smith Limited have grown in value to about $10 million. All three beneficiaries currently reside in Canada.

A deemed disposition of the assets in The Smith Family Trust (the silver wafer and the Smith Limited common shares) will take place on July 1, 2015. The resulting capital gain will need to be reported on the 2015 trust tax return.

The biggest tax hit comes from the shares, amounting to about $2.4 million ($10 million capital gain, assuming a nominal adjusted cost base and a 48% top marginal tax bracket in the province in which the trust is resident).

Assuming the trust allocates a portion of capital gain to the beneficiaries, and its shares meet the qualified small business corporation criteria, the beneficiaries could claim certain capital gains exemptions to reduce tax liability.

There aren’t a lot of options if the trust doesn’t have other assets to pay the tax. It could borrow against its Smith Limited shares, but the interest wouldn’t be tax-deductible. On a $2.4 million loan repaid over 60 months at 5% interest, the beneficiaries would be paying about $45,300 per month. And interest costs would reach $317,000 over the loan’s term.

Or, the trust could ask Smith Limited to pay dividends on the common shares held by the trust. But to generate enough cash to cover the initial tax bill, plus tax on the dividends, this would require about $3.9 million in dividends (assuming a 38% effective marginal tax rate).

Proper planning can defer this tax.

Strategy #1

The easiest approach would be to transfer the trust assets to the capital beneficiaries, assuming the trust document permits it (some don’t). A provision of the Income Tax Act allows a tax-free rollover of trust assets to the capital beneficiaries; with the beneficiaries assuming the trust’s adjusted cost base.

The drawback is that direct ownership of the shares passes to Terry, Tammy and Tanya. Depending on the preferred share attributes, it is likely Donna can retain control of Smith Limited by having more votes than the common shareholders. However, the children’s common shares may end up being worth more than their parents’ preferred shares.

So, it’s important to consider implementation of a unanimous shareholders’ agreement that would apply after the children became direct shareholders. By creating this agreement in advance, terms and conditions can be established by Donna and the trustees without requiring consensus among the entire family.

Strategy #2

Or, you could have the trust freeze its position in Smith Limited by exchanging its common shares for retractable, redeemable, fixed-value preferred shares; and cause Smith Limited to issue new common shares to a new family trust. The old family trust could then distribute its fixed-value preferred shares to Terry, Tammy and Tanya, as the capital beneficiaries of the old family trust.

The new preferred shares could carry votes, but may be worth less than Donna’s preferred shares. Similar to the previous strategy, the implementation of a unanimous shareholders’ agreement in advance of the share distribution will aid in the long-term control of the company, minimizing future disputes.