Can clients trust their heirs?

How, and when, a business owner should divide assets among children is one of the toughest questions in estate planning. Should your children share the assets equally? Does one child deserve more (or less) than the others? Are they ready for the responsibility?

Instead of putting off these decisions—and risking the consequences—establish a discretionary family trust. This involves placing assets into a trust established for your beneficiaries. If the trust is designed as a discretionary trust, none of the beneficiaries have any fixed entitlement to the assets. Instead, the trustees have full discretion to manage the assets and make distributions.

Case Study: Asset protection for succession

When applied to a succession plan, use of a trust can also provide:

• The ability to accrue future growth in the family assets and be taxed in the hands of the beneficiaries; and
• Creditor proofing for the family assets (from both the beneficiaries themselves and their creditors).

Recently, we used a discretionary trust to help a family achieve its succession planning goals. Harold and Hannah Berkowitz* decided to address their succession issues 20 years ago, when they were in their 60s, and plan for the eventual distribution of their business and real estate assets (worth close to $50 million) to their six children.

The legalese:

A trust is not a legal entity like a corporation, but rather a relationship that exists between trustees and beneficiaries in respect of trust property. A trust is established when a person (the “settlor”) transfers property to another person (called the “trustee”) to hold for the benefit of one or more other people (the “beneficiary”). Once the settlor has given the property to the trustees, the settlor generally has no ongoing involvement with, or liability to, the trust. The trustees are responsible for the trust property and have an ongoing obligation to administer the trust for benefit of the beneficiaries in accordance with the terms of the trust as set out in the trust deed.

Although most of their kids were responsible, the Berkowitzes had serious concerns about giving money to a few of them (due to drug addiction, in once instance).

The couple ultimately established a discretionary family trust for the benefit of their children and grandchildren, and transferred the portfolio of assets to that trust. There was little appreciated value in the assets because of the 1990s recession, which meant no significant tax was triggered.

The trustees have discretion to manage the assets and make distributions

The couple and a family friend acted as the trustees and, over the years, made distributions to the beneficiaries. Further, they delegated much of the management of the assets to one of their sons (who had always been involved in managing the family’s real estate holdings).

About 20 years after the trust was established, the trustees faced a decision. Canadian tax rules generally deem a trust to dispose of all of its capital property every 21 years (even if the assets aren’t taken out of the trust.) Since the value of the assets had increased, the deemed disposition would have resulted in an immediate tax liability. In most cases, this can be deferred by having a trust distribute all of its assets to beneficiaries prior to the 21-year deadline.

In this case, however, the Berkowitzes did not want to transfer the assets directly to the beneficiaries.

Instead, they wanted a structure to ensure the trust’s assets could be held and managed on a consolidated and professional basis for the family’s long-term benefit. To meet this objective, the trustees implemented a limited partnership structure to hold the assets.

The trust transferred the family assets to the limited partnership in exchange for limited partnership units. The units represented 99.99% of the equity interest in the family assets, but did not carry any ability to control or manage the assets. One of the reasons this structure was chosen was to avoid land transfer taxes that would have been payable if the trust had transferred the real estate properties to a corporation.

The legalese:

A partnership is a relationship between two or more persons carrying on business with a common view to profit. A limited partnership is a special partnership governed by various provincial limited partnership acts. A limited partnership has two types of partners: the general partners typically have management control of the partnership; the limited partners do not have any active interest in the management of the partnership (they simply receive a return on their investment) and their liability for the debts of the partnership is limited to the amount of their investment.

The limited partnership was organized so that a new corporation would act as the general partner of the partnership and manage the family assets. The Berkowitzes’ son (who also had managed the couple’s real estate holdings) was an employee of the corporation and continued to manage the assets.

Prior to the 21-year deadline, the trust distributed the units to the beneficiaries on a tax-deferred basis. Since it was established as a discretionary trust, the trustees had the flexibility to distribute the units in the proportions they considered appropriate (so not all children shared equally).

Further, the agreement stipulated that beneficiaries could only transfer their units to family members. And, even then, all other beneficiaries would be able to buy their proportionate share from any selling beneficiary.

Finally, since the general partner was given management control, the assets could be maintained without a disgruntled family member attempting to break up the business or force a liquidation of any assets.

(*Names have been changed)

Paul Gibney and Brent Pidborochynski are tax lawyers at Thorsteinssons LLP.

This article originally appeared in Canadian Capital.