Pros and cons of family trusts

While recent changes in federal tax policy may affect whether trusts represent the best planning strategy for some families, the vehicles still have benefits. Many Canadians settle trusts for their families for privacy purposes as well as to provide trustees the ability to gift to beneficiaries in accordance with the trust’s (and family’s) goals.

Potential downside

With the new reporting rules, trustees must disclose, in good faith, all possible known beneficiaries, trustees, settlors (including subsequent contributors) and persons who can “exert influence” on a trust. Compliance with these rules would include contacting all beneficiaries, even those who may never receive any benefit from the trust, and people who have become estranged, which can be a cumbersome and costly administrative burden.

Significant uncertainty remains about what may constitute the ability to “exert influence.” All of this adds new compliance costs and, along with increased taxes, may tip the cost/benefit analysis against trusts for some families.

Family trusts still can allocate income (and capital) to Canadian resident beneficiaries so they can access their graduated tax rates and capital gains inclusion rates. However, such a strategy may increase the vulnerability of the trust assets to a family creditor claim upon dissolution of marriage or common-law relationship.

As many families create trusts to offer asset protection for their family-member beneficiaries, they should discuss with trusted advisors the family situation and the impact of distributions.

Benefits of family trusts

While family trusts appear to enjoy fewer tax benefits than in years past, one significant benefit can be found when family trusts own private corporation shares. In some cases, a trust has the ability to “multiply” the lifetime capital gains exemption (LCGE) on qualified small-business corporation (QSBC) shares without having to pay regular income tax on the resulting capital gain up to the LCGE amount. As of June 25, 2024, this exemption amount is $1,250,000, a significant increase from the $1,016,836 amount pre-Budget 2024.

Qualified small-business corporation shares. A family trust itself cannot claim the LCGE. But, when there are multiple beneficiaries and the criteria can be met, the trust can allocate a portion of a capital gain realized by the trust on a disposition of QSBC shares to multiple beneficiaries in a way that maximizes the use of each beneficiary’s available LCGE. This can occur only if it is permitted in the trust deed and the required designations are made by the family trust under the Income Tax Act. Generally, the result is a significant overall reduction in taxes on the sale of the QSBC shares compared with an individual realizing the disposition alone (subject to, among other things, the updated alternative minimum tax). 

Even when a share sale is not imminent, the potential long-term savings for a family on the eventual disposition of QSBC shares that are expected to appreciate in value can be significant and can far exceed the increased costs and taxes paid in the interim.

Amending terms. With regard to trusts that encounter challenges in adjusting to the recent legislative changes due to poorly defined trust terms or vague descriptions of beneficiaries, it may be possible to amend or vary terms and definitions. In some cases, this may include clarifying who is, and who is not, a beneficiary, in line with the original intent of the trust.

Not all trusts can be varied easily, even with the assistance of the court, and this step should be undertaken only with the advice and guidance of an experienced trusts lawyer. Significant amendments to the terms of a trust can result in a deemed re-settlement of the trust, with significant tax ramifications.

Non-tax benefits. Further, there remain many non-tax reasons to set up a family trust, and for families to keep an existing family trust. These include protecting and safeguarding funds for minor, disabled and spendthrift beneficiaries, the ability to use the family trust as voting shareholder for related corporations, and general planning flexibility for family members. These benefits have value that, for many families, may exceed the costs of compliance and additional taxes arising from recent legislation.

Family trusts also remain effective asset protection tools when set up correctly. Even in the case of spousal or family creditors, the trust interests may potentially be excluded in many instances where properly executed prenuptial or cohabitation agreements are in place.

Be prepared for more changes

While the selected legislation changes appear to represent a continued erosion of positive tax treatment for trusts, family trusts do remain valuable and effective planning vehicles. These changes can be burdensome and costly in many instances, but they alone may not be the deciding factor in determining whether to settle or maintain an existing trust.

Changes in estate, trust and tax legislation will continue to occur frequently. Remaining prepared for change requires a balanced and moderate approach with the assistance of qualified professionals, not only at the planning and implementation phases but also in the ongoing administration phase.

This is the second article in a two-part series on family trusts.

Previous article: How tax changes affect family trusts