FUNDAMENTALS OF TRUSTS

We use the word “trust” regularly. However, when it comes to its legal use in estate planning, the term “trust” is probably a mystery to most people.

For centuries, trusts have been used to control, preserve, and transfer property. Although they were more often used by wealthy individuals in the past, the topic of trusts should be part of every estate planning conversation today.

What is a trust?

A trust is a separate patrimony created for a specific purpose and the benefit of third parties (the beneficiaries). It consists of separating the ownership of a property from its management (carried out by the trustee). There is therefore a legal relationship between three distinct parties in a trust: the settlor, the trustee, and the beneficiary.

The structure of a trust can be very simple. In Quebec, to create a trust, the settlor must first dispose of property and transfer it to a patrimony separate from their own, called the trust patrimony. The original owner of the property, the settlor, then appoints a trustee to manage the property (like a house, shares, or bonds), who holds the property and manages it with the obligation to do so with prudence and diligence for a particular purpose. This is called “establishing” a trust.

There is usually only one settlor, but it is not uncommon to have two or three trustees, and as many beneficiaries as circumstances require. In some situations, the settlor may also be a trustee, a beneficiary, or all three. In any case, anyone interested in setting up a trust should be aware the Civil Code of Québec requires that at least one trustee who is neither the settlor nor a beneficiary be appointed to administer the trust. The Courts went further by requiring that such a trustee be “independent”, totally selfless and impartial. Hence the importance of choosing this trustee and ensuring that he/she participates in the decisions and transactions made by the trust.

In the rest of Canada, a trust is officially created when the settlor transfers their property to the trustee. Common law views trusts as a relationship — not as a separate patrimony — because of the trustee’s duty to hold the property for the benefit of the beneficiaries.

Either in Quebec or in the rest of Canada, it should be noted that a trust is not a legal entity but is treated as an individual for income tax purposes, and it is the trustee (as the legal owner of the property) who is required to complete the tax returns on behalf of the trust.

 How is a trust created?

 A trust can be created by an individual during his or her life (an “inter vivos trust”) or as a consequence of his or her death (a “testamentary trust”).

 The terms of an inter vivos trust are usually set out in a document (a “trust deed”) signed by the settlor. It will appoint a trustee or trustees and direct how assets are to be held, managed, and distributed to or for the benefit of the beneficiaries. An inter vivos trust is created once the beneficiaries and the terms of the trust have been settled by the settlor, and property has been transferred to a distinct patrimony that the trustee will hold and administer under the terms of the trust deed.

A testamentary trust, on the other hand, is created as a consequence of an individual’s death, usually pursuant to the Will of the individual or a beneficiary designation made in respect of an insurance policy, a registered retirement savings plan or a registered retirement income fund. A testamentary trust only comes into existence on the death of the individual who made the Will or beneficiary designation. A common example of a testamentary trust is one that names your minor children as beneficiaries of your estate but stipulates that assets from your estate be held in trust for them until they reach a certain age.

Why does one create a trust?

 A trust can be used when a person cannot or should not own an asset outright. With a trustee in charge of holding and managing the property, it will still be available to the beneficiary, but it will be subject to any instructions the settlor gives to the trustee(s). Common uses of trusts include:

• Oversee the inheritance of a minor child who cannot legally own property
• Protection against creditors who might otherwise seize property owned directly by the person
• Preserve family assets from claims arising from marital breakdown
• Optimize public assistance for a disabled person who may be subject to asset or income limits
• Manage and monitor charitable donations
• Establish the distribution of inheritances between generations or blended families
• Tax planning between spouses, as well as for business succession

 Choice of a trustee

Basically, the role of a trustee is to hold and manage property. For a professional fiduciary, this is the commercial proposition it offers.

If you are instead considering appointing a family member or friend as trustee, their qualifications should be carefully considered. This includes organizational skills, financial experience, and diplomatic skills, as well as the age of the person in relation to the expected life of the trust.

Finally, as stated previously, the trustee is required to always act with prudence, loyalty, and diligence and manage the property in strict compliance with the terms of the trust deed. This requires both integrity and conscience to avoid conflicts of interest. In other words, it is essential that the trustee be trustworthy, in the common sense of the term.

Rights of beneficiaries

Sometimes a trust has a single beneficiary who has all beneficiary rights to the trust property. Just as there are many situations in which a trust can be used, there are many ways to allocate beneficiary rights.

For example, under a Will, you may be the primary beneficiary or your right may be contingent upon the death of another person, such as a parent. You may be entitled to a specific item, a fixed amount or the remainder. Your rights may vest immediately or be deferred until a certain date or until an event occurs. If they are investments or real estate, you can get the income or the capital on the sale, or both. Additionally, this income can continue for a specific period of time, up to a specified amount or for life.

The 21-year rule

In Canada, trusts can be an effective vehicle to not only facilitate income splitting with family members but also to help taxpayers meet their estate planning objectives. However, it is important to review your corporate structure regularly to ensure the trust is still serving a purpose, and to plan well in advance for the deemed realization rule.

Commonly referred to as the “21-year rule”, it deems most trusts to dispose of their capital property and recognize the accrued gains every 21 years. Without this rule, trusts could be used to defer the realization of a capital gain for more than 21 years. Depending on the tax qualities of the trust property, the inclusion of the taxable portion of the capital gain in the trust’s income tax obligations for the year could be expensive, and difficult where the trust does not have liquid assets to pay.

The 21-year deemed disposition rule applies to most trusts (i.e. family trusts and testamentary trusts created for beneficiaries other than spouses or common law partners). However, for other types of trusts, the first deemed disposition does not occur 21 years after the creation of the trust. For example:

• An alter ego or self-benefit trust will be first deemed to dispose of its capital property on the death of the taxpayer.
• A spousal trust or a joint partner trust will be first deemed to have disposed of its capital property on the death of the second spouse.

Planning for the 21-year rule is technical and can become complicated because various issues of tax law, corporate law, and family law will need to be considered. Inadequate planning for the 21-year rule can result in an unexpected tax liability without the necessary liquidity.

Conclusion

Different types of trusts offer different planning opportunities, and different factors must be considered before setting them up. Each client’s unique circumstances must be considered before a trust is proposed. Life insurance can play an important role when a trust is established. It can be a cost-effective way of providing for tax debts that may arise under the trust.

If you would like to consider the possibility of a trust as part of your estate plan or business structure, contact us. Our team would be pleased to talk with you about the opportunities relevant to your circumstances.