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Family trusts are commonly used in estate planning for families and family businesses. In this article, we introduce the concept of family trusts and highlight some benefits of using this legal tool for your estate planning.

1. What is a trust?

A family trust is a type of trust. A trust, unlike a corporation, is not a legal entity but is a relationship between the settlor, trustee, and beneficiaries. A trust exists where property is held by a person for the benefit of one or more persons. The settlor is the individual who establishes the trust by transferring property to the trustee to hold such property for the benefit of the beneficiaries. The trustee receives the trust property from the settlor, and holds title to and manages such property for the benefit of the beneficiaries of the trust. The beneficiaries of the trust are entitled to the benefit of the trust property, but do not participate in the management of such property.

The trustees of family trusts are often senior members of the family. Such trustees may hold in trust the trust property which is the wealth gained by the parents, who are often family business owners. The beneficiaries of the family trusts are typically the children and their descendants, to whom the trustees may make distributions from the wealth held as trust property. 

By way of illustration, consider the hypothetical example of the Li family: Mr. Li and his wife, who carry on a very successful family business, wish to transfer to their children some of the family’s wealth and the future increases in the value of the family business. Mr. and Mrs. Li may decide to establish the Li Family Trust, with Mr. Li’s parents being the settlors of trust property, and designate their children and descendants as beneficiaries of the trust. Mr. Li may also designate himself to manage the wealth that may be transferred into the trust, i.e., to be the trustee of the Li Family Trust. As trustee of the Li Family Trust, Mr. Li would hold legal title to all of the trust property, and oversee the management and distribution of such trust property to the beneficiaries based on the specific needs of each individual.

2. Benefits of Family Trusts

Compared to other legal vehicles, family trusts may offer three benefits: (1) wealth preservation; (2) opportunities for income tax planning; and (3) ease of succession planning.

Wealth Preservation

Family trusts are helpful for wealth preservation for two main reasons. First, a family trust may be structured to provide the trustee with discretion to determine whether to pay any income or capital to the beneficiaries, and whether to pay one or more beneficiaries to the exclusion of others. The trustee’s discretion allows the trustee to keep the wealth within the family and make distributions based on the needs and circumstances of each individual beneficiary. For instance, in the case of the Li Family Trust, Mr. Li, as the trustee, may make different distributions to tailor to the unique needs of two of the beneficiaries: Mr. and Mrs. Li’s son, who is attending university, and Mr. and Mrs. Li’s daughter, who is planning to purchase a house. Mr. Li may also exercise his discretion in distributing only a portion of the trust property in the short term, such that the capital may yield more income in the future to be distributed to the beneficiaries.

Second, since the assets held by the trustee are no longer owned by the parents who own the family business, such trust assets are typically insulated against claims by creditors for debts owed by the parents.  For instance, consider a situation in which Mr. and Mrs. Li’s family company borrows funds from outside parties for its business, with Mr. and Mrs. Li guaranteeing the loan. If the family company is unable to repay the debt and the creditors call on the guarantee, although Mr. and Mrs. Li may suffer a financial loss, the creditors which made the loan to Mr. and Mrs. Li’s company cannot claim against the trust property of the Li Family Trust.

Tax Planning

Family trusts may also offer various tax advantages. Under Canadian tax law, a family trust is a taxpayer for income tax purposes and pays income tax at the top marginal tax rate. Subject to certain income tax rules, the income or capital allocated to the beneficiaries can be deducted from the taxable income of the trust.  With careful planning, the trustee can exercise its discretion to allocate the trust income or capital to certain beneficiaries with lower marginal tax rates to reduce taxes payable by the trust. In the case of the Li family, Mr. Li, with the advice of a tax advisor, may choose to allocate some of the income from the trust property to Mr. and Mrs. Li’s two children, two of the beneficiaries of the Li Family Trust who pay income taxes at a lower rate than Mr. and Mrs. Li. By shifting family assets to the trust, the income generated by such assets has been shifted to the trust, thereby effectively lowering the overall income taxes payable by members of the Li family.

Further, through the Li Family Trust, senior members of the Li family may minimize capital gains taxes payable by their estates upon their death. Under the Income Tax Act (Canada), a final income tax return must be filed by the deceased’s estate that includes the net capital gains on all capital property owned by the deceased. By transferring a substantial portion of their capital property to the Li Family Trust, the senior members of the Li family may ensure that their estates are not responsible for paying capital gains taxes for all of the capital property which they presently own.

Ease of Succession Planning

Family trusts can also be a great tool for succession planning. For example, Mr. and Mrs. Li expect that the value of their company will increase in the near future. Since Mr. and Mrs. Li already pay taxes at a high income tax rate, they may like to redirect any future increases in the value of the company to their children while retaining the control of the business in their hands. After a reorganization of the company, the Li Family Trust can hold a class of shares that accounts for any future increases in the value of the company. Mr. and Mrs. Li’s children, who are beneficiaries of the family trust, receive distributions from the increases in the value of the company shares, and are taxed at a lower income tax rate. Mr. and Mrs. Li can retain control over the company by holding the class of shares with all of the voting rights over the company.

A family trust can also help avoid hurt feelings and legal challenges when family assets are distributed through a will. The British Columbia Wills, Estates and Succession Act allows a judge to change a will to ensure it is “adequate, just and equitable” to the deceased’s spouse and children. This provision means that a person’s assets may not be distributed exactly as they wish. Since a family trust is set up before death, and assets in trust are not part of the deceased’s estate, distribution in the trust is not subject to challenge under the Wills, Estates and Succession Act. 

3. Settlor loses ownership of trust property

One disadvantage of family trusts is that the settlor that transfers property to the family trust loses control of the property upon transfer, since that property becomes the property of the family trust. In the case of the Li family, if Mrs. Li transfers title to her house to the Li Family Trust, should she decide to sell the house later on, she no longer has the authority to do so, as the house is the property of the Li Family Trust. However, as seen with the other examples involving the Li Family Trust above, with careful planning, family trusts can be a powerful and flexible legal tool for business and succession planning that is tailored to the unique needs and specific goals of the family.

4. Conclusion

As we have seen with the example of the Li Family Trust, a family trust is a specific type of trust that allows trustees, who are often senior members of the family, to hold in trust the wealth gained by the parents for the beneficiaries, who are typically the children and their descendants. The trustees manage the trust property and make distributions to the beneficiaries from the trust property. Family trusts can allow for wealth preservation, income tax advantages, and ease of succession planning and can be a useful tool to assist with the transition of the family legacy from one generation to the next.  

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References:

Income Tax Act (R.S.C., 1985, c. 1 (5th Supp.)).

Mark Gillen, Faculty of Law, University of Victoria, Canada, Law of Trusts, 3^rd Edition.

Trevor Todd, The Use of Discretionary Trusts in Estate Planning. The Scrivener, Volume 11 Number 3 October 2002, pp35-38.