Trusts and the 21-year rule

Wealthy families commonly use trusts to manage wealth succession. It’s important to anticipate income-tax liability arising out of a potential deemed disposition of trust assets. Failing to do so could diminish the family’s long-term prosperity.

Regular family trusts are subject to a deemed disposition of capital assets every 21 years due to a rule designed to discourage the indefinite deferral of taxes on accrued capital gains.

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

Let’s look at an example. Donna Smith settled the Smith Family Trust on July 1, 1994, in favour of her adult children, using a silver wafer as the original gift. The trustees of this discretionary trust are Donna’s husband, Sam, as well as her two siblings. The three beneficiaries—Terry, Tammy and Tanya—are named income and capital beneficiaries.

Shortly after it was settled, the trust borrowed $100 to subscribe to newly issued common shares of Smith Limited as part of a corporate reorganization that included a freeze of Donna’s equity position in the firm. Dividends received by the trust from Smith Limited were used to repay the loan. These common shares and the silver wafer are the only assets held by the trust.

It’s now January 2015 and the common shares of the operating company have grown in value to about $10 million. Terry, Tammy and Tanya currently reside in Canada. The Smith Family Trust will realize a deemed disposition of its capital assets (the silver wafer and the Smith Limited common shares) on July 1, 2015, creating a capital gain to be reported on the 2015 trust tax return. The most significant income tax liability arises in respect to 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 the capital gain to the beneficiaries, and the shares meet the qualified small business corporation criteria, the beneficiaries could claim available capital gains exemptions and reduce the $2.4-million tax liability. The Smith Family Trust has limited options if it has no other assets to pay the tax. It could borrow against its Smith Limited shares, but the interest wouldn’t be tax-deductible. A loan of $2.4 million repaid over 60 months with interest of 5% would require payments of about $45,300 per month for a total interest expense of $317,000 over the loan’s term.

Alternatively, the trust could ask Smith Limited to pay dividends on the common shares held by the trust. But this would require about $3.9 million in dividends to have sufficient cash to fund the tax on the dividend (assuming a 38% effective marginal tax rate) and net the $2.4 million needed for the tax on the deemed disposition. 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. The Income Tax Act has a special provision allowing a tax-free rollover of the trust assets to the capital beneficiaries, with the beneficiaries assuming the trust’s adjusted cost base. The rollover could be denied if the trust document has provisions allowing trust property to revert to Donna as the settlor, or allow trust property to pass to persons chosen by Donna after the trust has been settled. The drawback to rolling the shares out to beneficiaries 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 be worth more than their parents’ preferred shares.

So, prior to using the tax-free rollout is the implementation of a unanimous shareholders’ agreement that would apply after the children became direct shareholders. By creating the shareholders’ agreement in advance, the terms and conditions can be established by Donna and the trustees without requiring consensus among the entire family.

Strategy #2

Consider having the trust freeze its position in Smith Limited by exchanging its common shares for retractable, redeemable, fixed-value preferred shares. And, get Smith Limited to issue new common shares to a new family trust. The old family trust could distribute its fixed-value preferred shares to Terry, Tammy and Tanya, as the capital beneficiaries of the old family trust.

The advantage is the children will own specially designed fixed-value preferred shares, while new common growth shares would be held in a new family trust. The new preferred shares issued to the children could carry votes, but may be 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.

Exceptions to the 21-year rule

The primary exceptions to the 21-year deemed disposition:

• spousal trusts (inter vivos and testamentary), which have a deemed disposition upon the death of spouse beneficiary; alter ego trusts (which are inter vivos trusts) have a deemed disposition upon the death of the settlor; and
• joint partner trusts (which are inter vivos trusts), which have a deemed disposition upon the death of the second partner.

Any of these trusts continuing after the deemed disposition triggered by death will have a deemed disposition 21 years later and every 21 years thereafter.

by James W. Kraft, CPA, CA, MTax, CFP, TEP and Deborah Kraft, MTax, TEP, CFP. James is vice-president, head of Business Advisory & Succession, BMO Nesbitt Burns, and Deborah is director, Master of Taxation Program, School of Accounting & Finance, University of Waterloo.