In the March 31, 2010 issue of Legal Alert I wrote an article entitled “Will Your Trust be Subject to a Canada Revenue Agency Audit? Are You Prepared?”. That article included the suggestion that trusts should be reviewed to ensure that the effect of the 21-year deemed disposition rule has been considered.
The Income Tax Act (Canada) (the “Tax Act”) provides that most personal trusts are deemed to dispose of and reacquire certain types of property of the trust 21-years after the trust is created (and on each subsequent 21 year anniversary). The disposition is deemed to occur at fair market value and will result in the trust being required to pay tax on any income or capital gains accrued throughout the 21 years (the “21 year rule”).
The resultant tax bill can be significant. The 21 year rule prevents the allocation of income or gain arising from the deemed disposition to beneficiaries, meaning that for inter vivos trusts ( trusts made during a person’s lifetime, not in a will), the entire amount of the income or gain is taxed at the top marginal tax rate.
Also, when the 21 year rule applies, the assets of the trust have not actually been disposed of and there may be a shortage of liquid assets in the trust with which to pay a significant tax bill.
Accordingly, the 21 year rule demands some planning.
You should determine with your tax and estate planning advisors;
(a) whether the 21 year rule will apply to your trust;
(b) when the 21 year rule will apply; and
(c) which property of the trust will be affected by the 21 year rule?
If your trust is subject to the 21 year rule and does own property that will be affected by the 21 year rule, here are some options for you to consider before the 21 year rule applies. These options are very briefly described and should be further explored with your tax and estate planning advisors.
Consideration should be given to whether the terms of the trust allow the trustee to take advantage of any of these options, and if not, whether a variation of the terms of the trust is possible or worthwhile.
1. Let the Deemed Disposition Occur
If the property that will be subject to the 21 year rule has not significantly appreciated, it may be advisable to let the deemed disposition occur and pay any taxes that arise.
2. Dispose of Trust Property
Actually disposing of the trust property to an arm’s length third party prior to the application of the 21 year rule allows the trust to realize the gain, and provides liquidity to pay any resulting tax bill. Any tax on accrued gain will be paid at this time and the trust will not be subject to any tax on that gain when the 21 year rule applies.
This can result in significant tax savings because, unlike the deemed disposition from the 21 year rule, the income or gain on these dispositions can be allocated among beneficiaries and as a result may be taxed at a lower marginal tax rate.
A disposition in this manner also may allow the beneficiaries to take advantage of the $750,000 lifetime capital gains exemption, if the trust allocates to a beneficiary gain from the disposition of property that is shares of a qualified small business corporation or qualified farm property.
3. Distribute Property with Accrued Gains to Beneficiaries on a Tax Deferred Basis
The Tax Act provides a mechanism to transfer property from a trust to capital beneficiaries of the trust and defer any tax. Property that has increased in value while owned by the trust can be transferred to beneficiaries in this way prior to the application of the 21 year rule such that when the 21 year rule does apply, the gain on that property is not taxed in the trust.
The trustee must have the power, pursuant to the terms of the trust, to distribute the capital of the trust to beneficiaries, in order to take advantage of this mechanism. In many cases it may not be appropriate to make a capital distribution to the beneficiaries because of age or other factors.
If a trust has beneficiaries who are non-residents of Canada careful planning regarding the distribution to non-resident beneficiaries is required.
4. Reorganize the Property of the Trust and Then Distribute Property with Accrued Gains to Beneficiaries on a Tax Deferred Basis
Prior to the distribution of shares of a corporation to beneficiaries of a trust a reorganization of the capital of the corporation may be advisable.
Consider the situation where a trust owns common shares of a family owned corporation, where the cost of those shares was $100,000 and the fair market value of those shares is now $200,000.
The trust could exchange those common shares for preferred shares worth $100,000 and common shares worth $100,000. The trust could retain the preferred shares and distribute the common shares to beneficiaries on a tax deferred basis. When the 21 year rule applies, there will be no tax payable on the preferred shares because they are worth $100,000 and their cost was $100,000. There will also be no tax payable on the common shares because they will have been distributed to the beneficiaries.
Other considerations, prior to the distribution of shares of a family owned corporation from a trust to the beneficiaries, are:
(a) future voting control of the corporation; and
(b) future growth of the value of the company.
The trustee may consider reorganizing the capital of the corporation such that the trust retains voting control of the corporation after the distribution of shares from the trust to the beneficiaries and retains shares entitling the trust to the future growth in value of the corporation.
Again, the trustee must have the power, pursuant to the terms of the trust, to distribute the capital of the trust to beneficiaries, in order to take advantage of this mechanism.
5. Terminate the Trust
You may want to explore with your estate and tax planning advisors whether the trust is necessary on an ongoing basis. You may be able to, pursuant to the terms of the trust or otherwise, terminate the trust and distribute all the property of the trust to the beneficiaries of the trust. Whether this is possible and whether it is advisable should be discussed with your tax and estate planning advisors.