Family trusts are commonly used as a convenient way to own shares in a company and as a succession tool for commercial businesses, but they can also be incorporated into a family farm structure…depending on the circumstances.
“A farm corporation may have at its disposal favourable tax rules that may allow it to achieve the same objectives without the need for a family trust,” says Edith Frison, a tax specialist with MNP LLP. “Family trusts are not for everybody. They require specific actions and documentation to set up, and there is annual administration required to remain compliant with Canada Revenue Agency (CRA) if you have a family trust.
“However,” says Frison, “if they work for you, they typically work very well.”
There are many reasons for establishing a family trust. One is where parents want to fund their children’s university education or they wish to provide money for other reasons, such as a house purchase. A family trust allows them to allocate income to their children in a tax-efficient manner to fund their expenditures.
How will the kids turn out?
Another reason for a family trust is succession planning. “Succession planning is where we see family trusts used in farming most often,” says Frison. “The parents may not want to make the children shareholders in the farm business when they are 18 or 20 years old because they don’t know what their children will do in the future.
“Making them beneficiaries in a discretionary family trust means they don’t actually own any shares. When it comes time to distribute the assets or to pass the family farm on to the next generation, it can be passed to any of the beneficiaries who are beneficiaries of the family trust,” says Frison. “It buys parents time to see what path their children will follow; and whether they should receive the shares of the farm business. The trust also provides parents with the option to keep the shares of the business themselves if they decide their children are not the right fit for their succession plan.”
Every parent hopes their adult children will never encounter unfortunate events or hardships that could negatively impact their lives. In today’s society, however, things such as divorce or substance abuse problems are all too common.
If a child is an owner in a family business, these kinds of problems could put the value of any assets they own — including shares in the family business — at risk and subject to their creditors or even the creditors of their spouses.
A family trust is typically an alternative to direct, family member share ownership.
A beneficiary of a discretionary family trust cannot transfer trust property to someone else because he or she doesn’t own it.
“We’ve seen incidents where, at the time of death, a shareholder’s assets are distributed in accordance with a will that creates unforeseen circumstances,” says Frison.
Frison gives the following example: “A son is a shareholder in the farm and his will has his shares of the family farm left to his wife upon his death. His mother and father (the other shareholders of the corporation) unfortunately, don’t get along with his wife and they never anticipated that she would be a part of the family corporation. Now, after the son’s untimely death, his mother and father are in a business with his widow. She could potentially be part of the decision-making process for the family corporation and/or could be entitled to information regarding the business that the family is not interested in sharing. A discretionary family trust provides a way to have individuals involved in the corporation without jeopardizing family harmony.”
What is a family trust?
A trust is not a legal entity like a corporation, but rather a relationship between the trustees who control the property and the beneficiaries who enjoy all benefits derived from the trust property.
A family trust requires the following individuals:
- Settlor, whose only role is to create and set up the terms of the trust.
- Trustees, whose role is to administer the property in the trust.
- Beneficiaries, whose role is to receive trust property at the trustees’ discretion.
Family trusts can be cumbersome to set up and administer and have strict rules governing how they are established and operated. The settlor must provide an object of value that becomes the property of the trust and physically passes it to the trustees, expressing the intention that it be held for the benefit of the beneficiaries.
The most common relationship MNP sees when creating a family trust is that the settlor of the trust is a grandparent, the trustees are their children, who control the family trust, and the beneficiaries are their grandchildren, who receive income and capital from the trust.
A family trust acts as a conduit to flow income to its beneficiaries. For example, the family farm business pays dividends to the family trust and the trustees allocate those dividends to one or more of the beneficiaries at their discretion. Allocations to the beneficiaries are flexible and can change from year to year depending on their needs. The beneficiary must eventually receive the actual value of dividends or capital gains allocated to them.
The life of a family trust is 21 years, and upon the 21st anniversary a decision should be made to distribute the remaining capital of the trust (shares of the company) to the beneficiaries, or adverse tax consequences could occur. Because of this time frame, family trusts are typically set up when children are in their late teens and approaching the age when they will require funds for university or other needs.
A tax-planning aid
Because a family trust is a separate taxpayer under the Income Tax Act, it is required to file a tax return by March and it must maintain minutes, which usually involve an annual fee from the accountant and/or lawyer to prepare, file and maintain these legal documents.
Any taxable income remaining in a family trust is subject to income tax at the highest marginal income tax rate. If the trust allocates its income to the beneficiaries, it pays no tax. The beneficiaries would be responsible to report the income received.
Protecting assets with a family trust
Family trusts can also protect assets. Any business can be exposed to risks associated with its day-to-day activities, no matter how well it’s insured. As the farm business matures it may build up excess cash that’s not required at the time and consequently, this cash can be exposed to the risks of the business.
“A family trust can assist in protecting the excess cash by transferring it to a new holding company (corporate beneficiary) on a tax-deferred basis. This cash is then held away from the business operations and is protected from business risks,” says Frison. “If the operating company requires some of this cash in the future, it can be lent by the corporate beneficiary (or holding company) back to the operating company and secured with a General Security Agreement, as would any other loan.”
Flexible but not for everyone
Family trusts are flexible and can name multiple beneficiaries.
But once legally documented in a trust indenture, a trust cannot add or remove beneficiaries.
“Discretionary family trusts are very flexible tools, but they aren’t for everyone,” says Frison. “It’s essential to get the advice of your professional advisers to decide if a family trust is the best option for you.”