The value of family trusts in an estate freeze
By ATB Financial 20 April 2020 6 min read
Estate freeze planning is one of the most common tax planning strategies available to business-owners in Canada to transition their wealth to the next generation. An estate freeze can and should be customized to reflect your personal circumstances. One valuable addition to an ordinary estate freeze is to take advantage of the tax and estate planning benefits of a family trust.
What is an estate freeze?
An estate freeze is a tax strategy designed to reduce the capital gains tax a taxpayer will owe in the future. They are often used proactively by business-owners during life, to reduce the tax they would owe on the shares of their company at the time of death.
In an estate freeze transaction, the existing shareholder of a company “freezes” the value of their ownership in the business, with any future growth of the company accruing to a new shareholder or shareholders.
Adding a family trust to your plan
An effective estate freeze requires the business-owner to issue the new common shares of their company to somebody else. In some cases, you may not know exactly who should hold those common “growth” shares. For example, you may wish for your children to benefit from the growth of your business, but be uncomfortable with them holding shares directly in your company, for various reasons. Shareholders - even non-voting shareholders - generally have some limited rights against the company, and it can be difficult to remove a shareholder from your company without their consent.
One common solution to these dilemmas is to utilize a family trust as a part of your estate freeze planning.
What is a family trust?
A trust can be difficult to understand. Though a brief explanation is provided here, you should discuss this topic with your tax and legal advisors for a better understanding of how trusts operate, and the rights, responsibilities, obligations, and liabilities of each person involved.
A trust is similar to a corporation in some ways, but very different in others. Unlike a corporation, a trust is not a “person” at law. Instead, it is more of a relationship. There are three roles involved in that trust relationship: the settlor, the trustees, and the beneficiaries. The settlor initially creates and funds the trust by making a gift of property to the trustees. The trustees are the people who control the trust and its property, somewhat similar to directors of a corporation. Trustees technically own and control the trust property, but they do not have a beneficial interest in it unless they are also beneficiaries. There can be one or many trustees in any trust relationship. The trustees have a fiduciary duty to act in the best interests of the beneficiaries, so many trusts use a professional trustee, but some business-owners prefer to use unpaid family members (including themselves), instead. In the context of an estate freeze, these trustees will normally have control over the growth shares of your company and how to distribute any dividends paid on those shares.
Beneficiaries are the ones who benefit from the trust property, somewhat like shareholders in a corporation. Though the trustees control the trust and own the trust property, the beneficiaries are the ones who benefit from it. Typically, beneficiaries have little or no control in operating the trust. They usually are not involved in decisions about trust property, including the amount and timing of any distributions from the trust. Unlike shareholders, they also typically do not have the right to replace trustees, unless the trust deed grants them that right. In many estate freezes, the beneficiaries include the current business-owners and any other family members that they might wish to benefit in the future.
These roles are described only in very general terms. One reason that trusts are popular for planning is that they can be incredibly flexible. While these three roles are required, the details of a specific trust and how each role will work can be chosen quite broadly (or narrowly) by the settlor.
Using a trust with your estate freeze
Rather than issuing the new common shares to their children, many business-owners will instead issue these shares to a family trust. If implemented properly, the common shares held by a family trust would grow outside of your estate, accruing to the benefit of the trust for tax purposes. This can help business-owners to obtain the tax benefits of an estate freeze, without necessarily granting their children any direct control over shares.
When your family trust owns shares, the trustees will control those shares. Your children can benefit as beneficiaries, but typically would not have a say in how the trust is operated. The trustees will usually have the discretion to choose which beneficiaries will benefit from the shares each year, in what amounts (if any), and at what times. The trustees can usually change these decisions each year, depending on your family’s needs. Effectively, a family trust allows a business-owner to split the control of the shares from the value of those shares. The trustees would control your shares, but the beneficiaries would benefit from them, at the discretion of the trustees. Assuming that you are a trustee of your family trust, this can provide significant flexibility for you and your co-trustees to manage your taxes.
A family trust can also add some flexibility for your estate planning. If a business-owner were to issue shares of their company to a specific child at the time of implementing an estate freeze, it would be difficult to reverse that decision. As mentioned above, once a person owns shares, it is difficult to remove them as a shareholder without their consent. In contrast, when a family trust is utilized, the trustees can often choose which children - if any - will benefit from those shares each year. This can afford you some freedom to change your estate plan in the future, as your circumstances, goals and dreams change.
Trust planning does have downsides to consider, however. Trusts tend to be fairly expensive. While the general concept of trusts is not complicated, there are several tax and legal pitfalls that must be navigated carefully. Both a lawyer and accountant with expertise in this area are recommended if you intend to pursue trust planning. Because of this, the professional fees involved in setting up the trust can be quite high. Additionally, trusts have annual compliance costs, such as annual tax filings and some minor legal fees. These costs must be weighed against the potential benefit of trust planning.
One other downside of trusts is that they may require additional tax planning during your life. When an individual dies, they are taxed on all of their accrued capital gains immediately before death. A trust cannot die. Instead, a trust is treated as if it has sold all of its property every 21 years. Though there are several strategies to avoid that tax, it is important to consider this additional planning and expense.
Trusts have historically been popular planning tools in Canada. They can be flexible and adaptable to many situations and provide important tax and estate planning benefits. Though this article outlines one of the benefits of a family trust, there are many other tax and non-tax benefits not discussed here. If you wish to consider utilizing a family trust, we recommend that you discuss this in further detail with your tax advisor.
This document has been prepared by ATB Wealth. ATB Investment Management Inc., ATB Securities Inc. (Member Investment Industry Regulatory Organization of Canada and Canadian Investor Protection Fund) and ATB Insurance Advisors Inc. are wholly owned subsidiaries of ATB Financial and operate under the trade name ATB Wealth. The information provided in this article is a simplified general summary and is not intended to replace or serve as a substitute for professional advice. Professional tax advice should always be obtained when dealing with taxation issues as each individual’s situation is different. This information has been obtained from sources believed to be reliable but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. This information is subject to change and ATB Securities Inc. (Member Investment Industry Regulatory Organization of Canada and Canadian Investor Protection Fund), ATB Investment Management Inc. and ATB Insurance Advisors Inc. reserves the right to change the information without prior notice, and does not undertake to provide updated information should a change occur. ATB Financial, ATB Investment Management Inc., ATB Securities Inc. and ATB Insurance Advisors Inc. do not accept any liability whatsoever for any losses arising from the use of this document or its contents.