A discretionary family trust is a popular estate planning tool that can offer a range of tax benefits to families who want to protect and manage their assets over the long term. While formerly used only by the wealthiest Canadians creating so-called “trust fund babies”, these types of inter vivos trusts (a trust created during the settlor’s lifetime) are now a common estate and tax planning tool for every family.
Let’s begin by explaining how a discretionary family trust works, and describe some of the advantages and disadvantages associated with this type of trust.
How a Discretionary Family Trust Works
A discretionary family trust is a type of trust that is established by an individual (the settlor) for the benefit of their family members (the beneficiaries). The settlor can never be a beneficiary of the trust. Once the settlor has settled the trust, they should have no further involvement. Usually, trusted advisors, such as accountants or lawyers often serve in the role of settlor. The settlor settles the trust by gifting a gold coin or a $10 bill. This gift amount must always remain segregated from all other trust assets.
The trust is managed by a trustee, who is responsible for making decisions about how the trust assets are invested and distributed. The choice of trustees is usually a personal decision. Generally, one or three trustees act jointly to make decisions, based on the majority vote of the trustees where there are multiple trustees, which is why it is advisable to avoid having two trustees.
One of the key features of a discretionary family trust is that typically the trustee has “absolute discretion” to decide when and how to distribute the trust assets to the beneficiaries. This means that the beneficiaries do not have a fixed entitlement to the trust assets, and that the trustees are not required to treat the beneficiaries equally, but they can take into account a range of factors, such as the beneficiaries' financial needs or tax considerations, when making distribution decisions. The discretion also includes the ability to decide when a beneficiary receives income or capital from the trust.
The settlor of the trust can also specify certain conditions or restrictions on the trust assets, such as prohibiting the sale of certain assets, or requiring that certain beneficiaries meet certain criteria before receiving a distribution from the trust.
To prevent indefinite postponement of tax on capital gains accrued on property in a trust, these trust have a lifespan of a maximum of 21 years. A disposition of trust assets is deemed to occur every 21 years (referred to as the “21 year rule”), which results in taxes on the accrued capital gain.
Potential Benefits of a Discretionary Family Trust
Benefits associated with establishing a discretionary family trust, include:
Tax Planning: A discretionary family trust can be used as a tax planning tool to help minimize the tax liabilities of the settlor and the beneficiaries. For example, the trust can be structured to allow the trustee to allocate income and capital gains to different beneficiaries in a tax-efficient manner.
Asset Protection: By placing assets in a discretionary family trust, the settlor can help protect those assets from potential creditors or legal claims.
Control Without Ownership: A discretionary family trust can provide the settlor with a degree of control over how their assets are managed and distributed, even after they pass away.
Protection from Creditors: A discretionary family trust can provide some protection to the beneficiaries from litigation from creditors as the beneficiaries can be considered to have no direct benefit of ownership of the trust’s assets.
Flexibility: One of the key benefits available through the use of a discretionary family trust is flexibility. A trust can be tailored to the needs of a particular family and, if properly structured, should adapt itself to changing circumstances. flexibility in the succession of trustees.
When drafting a trust agreement, it is important for the lawyer to consider flexibility in the appointment of trustees to take into account changing personal and family circumstances during the life of the trust. Marriages and parent/child relationships can falter.
Potential Issues with a Discretionary Family Trust
Some disadvantages to establishing a discretionary family trust, include:
Tax on Split Income (TOSI): A trust pays tax at the highest personal marginal tax rate on all of its taxable income without the benefit of any personal tax credits.
Cost: Establishing and maintaining a discretionary family trust can be costly, as there are often legal and administrative fees associated with setting up and managing the trust. Also,
Complexity: Discretionary family trusts can be complex, and require careful planning and ongoing management to ensure that the trust is structured in a way that meets the needs of the settlor and the beneficiaries.
In conclusion, a discretionary family trust can be a powerful tool for families looking to protect and manage their wealth over the long term. A family trust can help with tax planning by allowing income splitting with minors. Another advantage of a trust is that it allows you to hold property for your family members while you decide on how it will eventually be distributed. By putting the property in a family trust, you can maintain control over how it's managed for at least 21 years before you have to make a final decision about distributing the assets among your family members.
By providing a degree of tax planning, asset protection, and control, these trusts can help ensure that the settlor's assets are used and distributed in a way that aligns with their wishes and goals. However, it is important to carefully consider the potential costs and complexity associated with these trusts before deciding whether to establish one. As with any type of estate planning strategy, it's usually a good idea to consult with a qualified legal or financial professional before making any decisions.