Will your trust be celebrating its 21st anniversary soon?
While trusts are a great tool for succession and wealth planning, you should be aware of the 21-year rule. This rule applies to most trusts, including family and testamentary trusts (other than spousal trusts).
Under Canadian tax law, a trust is deemed to dispose of the trust property (other than exempt property) at its fair market value on the 21st anniversary after its creation, and every 21 years thereafter. This rule was introduced to prevent trusts from deferring the realization of capital gains indefinitely and in some cases, trigger a significant tax bill.
To prevent unwelcome surprises, you should consult with your professional tax and legal advisors well before your trust turns 21 to consider the most effective tax planning method to mitigate negative tax consequences. Here are some of the most common strategies.
Let the deemed disposition occur
In some cases, you may want to let the deemed disposition occur if it triggers little or no tax. This would generally be an effective strategy in situations where the value of the property held by the trust has not significantly increased. For example, where the trust holds an investment portfolio that is frequently traded, the accrued gain may be nominal so triggering the gain will not give rise to significant tax.
You might also consider this strategy where any gains realized on the deemed disposition could be allocated to the beneficiaries and offset either by losses of the beneficiaries or through the use of the beneficiaries’ capital gains exemption.
Distribute the property to the beneficiaries on a tax-deferred basis
Generally, a trust can transfer the trust property to capital beneficiaries on a tax-deferred basis. Even if the property has increased in value during the period it was owned by the trust, it can be transferred to beneficiaries on a rollover basis if certain conditions are met. The properties with accrued gains will then be held by the beneficiaries directly and the gains will be taxable when the properties are sold by the beneficiaries during their lifetime or deemed to be sold on death. The trustees may decide to wind up the trust.
Note, however, that the tax deferral can be denied if the trust is considered a reversionary trust – that is, where the property contributed to the trust may revert to the person from whom the property was received or may pass to persons determined by the contributor.
Planning for the 21st anniversary of a trust is complex and needs to be done in advance to find the best strategy based on the particular facts and circumstances, especially if there are complicating factors such as the presence of beneficiaries who are minors, residents outside of Canada, or U.S. citizens or green card holders (whether they are resident in Canada or not). In addition, the trust deed must be reviewed to ensure that the trustees have the power to put the chosen plan in place.
Prior to making any decision and implementing a strategy to deal with the 21st anniversary of your trust, you should consult your financial advisor and your professional tax and legal advisors.