Family trusts are an essential part of wealth management for high-net-worth individuals (HNWI), especially when it comes to protecting your family’s wealth and ensuring its intact transfer from one generation to the next. In this blog, we will break down what a trust is, how it works in estate planning, its tax advantages, and how to set up and manage one.
Understanding the Basics: What is a Trust?
A trust is essentially a legal relationship that allows a person or organization to pass assets into the management of a third party on behalf of designated beneficiaries. When it comes to estate planning, most individuals use family trusts as a way of protecting and passing on their assets. The owner of the assets – known as the settlor – places them in the trust so that their beneficiaries, such as their children and grandchildren, can enjoy the income they generate in line with the settlor’s plans and wishes. One or more trustees are appointed to manage the assets and given powers to dispose of them in accordance with the settlor’s wishes. The trustees could be parents, grandparents, or even someone outside of the family, such as an attorney or financial advisor.
Types of Trusts and Their Uses in Estate Planning
There are two basic types of trust in Canada, which can both be used in estate planning, although they function in different ways.
A testamentary trust is set up through the settlor’s will and only takes effect once the settlor has died. The assets held in a testamentary trust will then form part of the settlor’s estate, and so they are subject to any applicable estate fees or taxes.
The second type of trust is a living trust, or inter vivos trust. When you set up a trust of this kind, you, as the settlor, immediately transfer your assets to your beneficiaries via the trust, with the stewardship of your chosen trustees. Once the transfer is complete, you are no longer the owner of those assets. You can add more assets to the trust whenever you choose. When you pass away, the assets you have transferred into the trust will not form part of your estate – since they are no longer your legal property – and will not be subject to probate or estate taxes.
Tax Advantages of Trusts in Wealth Transfers
Since trusts are taxable entities that pay at the highest tax rates without the prospect of any tax breaks, the best way to manage a trust’s taxes is to distribute its taxable income strategically among the beneficiaries. Family trusts offer three primary tax benefits for you as the settlor, as well as for your beneficiaries:
- The family will reduce its tax burden when a beneficiary dies: Beneficiaries can use an estate freeze strategy, meaning that if a beneficiary died, the capital gain on their portion of the trust’s income would not be taxed as it normally would.
- Income splitting: When the trust earns income, the gains can be distributed to the beneficiaries who are in the lowest tax brackets, ensuring the collective tax burden is minimized.
- Tax deferral through a corporate beneficiary: The profits of an operating company can be paid into the trust and then distributed to a corporate beneficiary.
Setting Up and Managing a Family Trust
It is relatively easy to form a family trust in Canada, provided you work with a lawyer and a financial planner. Before you start drawing up the paperwork, first know exactly which assets you plan to transfer. You will also need to have a list of beneficiaries and select your trustees very carefully. The expert advice of your lawyer and your financial planner will help you make the best decisions in this regard.
Once these are in place, decide how much money you want to settle into the family trust. Before your trust is established, you can decide how you want the assets to be managed and how much discretionary power you would like to give to your trustees. You must then choose either a living trust or a testamentary trust. This will depend on your financial goals. If you want to manage your assets during your lifetime and then reduce estate taxes and ease the transfer of assets after your death, you will probably want a living trust.
Your lawyer will then draft the trust document, including rules regarding the use of funds and access to them, asset protection and other factors. Setting up a family trust can take anywhere from two weeks to six months – depending on how long it takes you to finalize your decisions about the constitution and management of the trust.
When deciding on the key variables of your trust, it is best to seek the advice of a wealth management expert. Momentum Financial is a boutique financial and estate planning firm based in Georgetown, ON. Contact us for expert advice on trusts for estate planning and all other aspects of your financial planning.
