Trusts and the 21-Year Rule

Trusts, once considered a tool exclusively for the wealthy, have become enormously popular in the last ten years for middle income persons and for good reasons: trusts provide great flexibility in tax planning strategies and estate planning.  

Trusts are subject to specific tax rules that ought to be fully understood and complied with.  One of those is the “21-year deemed disposition” rule where, for tax purposes, a trust is deemed to dispose of certain types of property for fair market value proceeds.  Failing to acknowledge this rule may result in the trust realizing capital gains, ordinary income or recapture without receiving actual proceeds of disposition.

This newsletter will review the 21-year deemed disposition rules and some tax strategies to help avoid or defer the tax implications.

The 21-Year Deemed Disposition Rule

The 21-year deemed disposition rule exists in order to prevent property held by a trust from being passed from generation to generation on a tax-free basis. 

The 21-year deemed disposition rule does not apply to all trusts or all types of assets held in a trust. Indeed, the rule applies to trusts which hold depreciable property, non-depreciable capital property, Canadian and foreign resource properties, land inventory and NISA funds No. 2.  More specifically, the deemed disposition rule applies to:

§  Qualified small business corporation shares

§  Qualified farm property and qualified fishing property

§  Mutual funds and other shares

§  Real estate and depreciable property, bonds, debentures, promissory notes and other properties

§  Personal-use property

§  Listed personal property (as defined by the ITA)

§  Land held as inventory

Interestingly, for estate planning purposes, life insurance does not fall into any of the above classifications and therefore is not subject to the deemed disposition rule.

Strategies for Dealing with the 21-Year Rule

For obvious reasons, trustees and beneficiaries want to avoid the 21-year deemed disposition rule as no one wants to pay taxes if they can be avoided. Happily, there exists several strategies allowing for the deferral or avoidance of the 21-year rule.

The easiest way to avoid the 21-year deemed disposition rule is to simply have the trust property distributed to the Canadian resident beneficiary on a tax-free basis (the Income Tax Act allows such tax-free distribution). One of the drawbacks of this option is that the beneficiaries lose their opportunity for income splitting and other tax planning strategies and the trustees lose control of the assets.

Depending on the assets held by the trust, another option is to distribute only a portion of the trust’s assets to the capital beneficiaries.  Essentially, all assets with accrued gains would be distributed to capital beneficiaries on a tax free basis while the assets that do not have a component capital gains could be retained by the trust. 

If a trust holds shares of a private corporation the trustees must consider the 21-year deemed disposition rule because failure to do so could result in double taxation; indeed the trust would realize a capital gain on the deemed disposition of the shares and, if the shares were later redeemed, the trust would also realize a deemed dividend. 

To avoid any double taxation, one strategy is to incorporating a new company (Newco) which shares will be owned by a new trust (most likely with the same trustees and beneficiaries as the first trust).  The trustees of the first trust would then make Newco a beneficiary of the first trust (if there is a power to appoint new beneficiaries).  Then, the first trust would distribute the Oldco shares to Newco prior to the 21-year deemed disposition date. 

There are other very similar strategies, to the one above, when dealing with a trust holding shares of a private corporation and the 21-year deemed disposition rule and the trustee(s) should consult with his or her tax advisors as to which strategy might be best.  The trustees must also be aware of the uncertain nature of the GAAR (General Anti-Avoidance Rules under the Income Tax Act) when implementing a 21-year deemed disposition strategies.

Estate Planning, the use of Trusts and the 21-Year Deemed Disposition rule

In estate planning, it is common to establish a trust under the Last Will and Testament and fund such trust with assets flowing through the estate of the deceased.  Such trusts are referred to as a “testamentary trust:” a trust that arose as a consequence of the death of a testator.  Testamentary trusts provide a unique opportunity as they pay tax on a graduated basis allowing for a variety of tax savings and income splitting.

In estate planning, the 21-year deemed disposition rule is often misunderstood and too often we have advisors recommending that the testator or the estate trustee avoid the 21-year rule “at all costs.”  As a result, the Will may have a clause requiring the trustee of the testamentary trust (or the estate trustee) to distribute the capital of the trust to the beneficiary before the 21-year deemed disposition in order to avoid a capital gain. 

Although such advice is not technically wrong, it is often given without an adequate explanation or understanding of the 21-year deemed disposition rule and may not realize the maximum benefit from the trust.  For instance, what if the assets of the trust do not have a capital gain component, i.e., no capital gain is arising at 21 year limit?  What if the tax savings of a testamentary trust in the long run are far greater than the capital gain to be realized on the 21 year deemed disposition?  In these two examples, why would someone want to lose the tax savings and income splitting opportunity simply to avoid a small capital gain, if any?

As an aside for estate matters, it is important to know that the 21-year deemed disposition timeline commences at the death of the testator/settlor and not on the day the residual beneficiary receives his or her share in a testamentary trust.

Conclusion

We can see that a trust may be viewed as a vehicle that provides a 21-year window of tax opportunities.  The 21-year deemed disposition rule ought to be reviewed and fully understood by any trustee of a trust; whether a family trust, a testamentary trust, an alter ego trust, a spousal trust, etc., in order to take advantage of those opportunities and realize the maximum benefit from a trust.

If you have any questions concerning the 21-year deemed disposition rule or concerning trusts in general, please do not hesitate to contact me directly 613.288.3220 or by email at sdesmarais@tslawyers.ca

Sébastien Desmarais
Lawyer

 

This article is provided as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter referenced in this document before making decisions.

Estate Planning and the Use of the Henson Trust and RDSP

Many families include a disabled child or adult and the parents are usually the child’s primary safety net. The onus is on the parents (or parent as the case may be) to provide core support to their children whether financial, physical or emotional and the list of duties for the disabled child may well escalate to a point where many are overwhelmed.

The Ontario government can assist by offering a variety of valuable services that will assist the disabled child and his or her family.  In Ontario, one can turn to the Ontario Disability Support Program (ODSP) which was established to help people with disabilities in financial need pay for living expenses such as food and housing.

Given the circumstance a child’s disability will require lifelong treatment and support, a great concern for their parents is how to effectively plan for the care and protection for their child after the parents are no longer living.  In fact, special considerations are necessary for parents of a disabled child or adult to ensure the child’s ODSP’s benefits are not compromised by their estate planning. This is a situation where guidance from a professional advisor could provide great benefit.

The Smith Family

As an example of an estate planning strategy involving a disabled child, I introduce the Smith family.

The Smiths have two children, Corey and Ryan, who are both over the age of majority. Ryan is a disabled child who receives ODSP benefits. The Smiths’ combined Estate consists of their principal residence, RRSPs and other investments for a net value of $1,000,000. 

The Smiths are making their Wills and although they wish to have their Estate distributed in equal shares between their children their primary concern is to ensure that their estate planning does not disqualify Ryan from his ODSP benefits. They know the ODSP rules are complex.

What options are available to them?

Henson Trust

The popular and preferred option is the use of an Absolute Discretionary Trust (commonly referred as a “Henson Trust”) created under the parents’ Wills. The Henson Trust allows their Estate Trustee, Corey, complete discretion over the trust so that he may continue to pay the necessary expenses of the disabled child. As a result of the Henson Trust, the Smiths have the assurance that Ryan shall be provided for in the years to come while knowing that he cannot compel Corey to make payments.

Ryan’s ODSP benefits shall not be compromised since the funds held in the Henson Trust are not considered his assets for ODSP purposes; that is because Corey, as Estate Trustee, has absolute discretion in the management of the trust.  Furthermore, Ryan’s income from the Henson Trust for non-disability related expenses, such as food, clothing, housing and entertainment, can be substantially supplemented without suspending or affecting the ODSP benefits. 

Also, depending on the parents’ wishes and in appropriate circumstances, the Henson Trust may also allow for income sprinkling by empowering the Trustee to “sprinkle” income among several beneficiaries.  

ODSP guidelines recognizes the Henson Trust as an exempt asset of the disabled child and as a result, it remains the most valuable option available as it represents a safety net for Ryan after the death of his parents. 

Registered Disability Savings Plan

The Registered Disability Savings Plan (“RDSP”) was introduced in December 2008. The RDSP allows for a combination of individual, family and government financial assistance contributions to assist people with disabilities to grow, manage and control a financial asset. 

To open an RDSP, one must qualify for the Federal Disability Tax Credit (DTC).  If a child or grandchild qualifies for the DTC the parent, grandparents or other legal representative may establish and contribute to an RDSP up to a lifetime maximum of $200,000.  The DTC-eligible person shall be the sole beneficiary of the RDSP.

As a result of opening an RDSP, annual contributions will attract:

• Canada Disability Savings Grants (CDSGs) at a matching rate of 100, 200 or 300 percent depending on the family income and the amount contributed up to a maximum lifetime CDSG limit of $70,000; and

• Canada Disability Savings Bonds (CDSBs) of up to $1,000 per year for low and modest-income families[1] for a lifetime maximum of $20,000. 

The most obvious thorn in establishing an RDSP is the matter of capital contributions (which are not deductible) as not everyone is in a position to fund such a plan. One strategy is to insert a clause in the parents’ Wills instructing the Estate Trustee to fund the RDSP with the disabled child’s share. 

The RDSP, like the Henson Trust, is an exempt asset for ODSP purposes and therefore the benefits of the disabled child contained therein will not be compromised.

The 2011 Federal Budget addressed the difficulty of funding an RDSP by creating a new funding option permitting conditional rollovers of RRSPs into RDSPs. Indeed, as of July 1, 2011, for deaths occurring after March 3, 2010, one may now roll the deceased parent’s RRSP proceeds into the RDSP of the disabled child on a tax-free basis.  This new rule extends to amounts transferred to an RDSP from the proceeds of a Registered Retirement Income Fund (RRIF) and certain lump-sum amounts paid from Registered Pension Plans (RPP). 

Ideal Estate Planning for the Smiths

The Smiths now have two valuable options available to them where they can provide for Ryan with the assurance that his ODSP benefits will not be jeopardized.  Their Wills could provide that their RRSPs (or a portion of them) be rolled into an RDSP on a tax-free basis.  If there is still “room” in the RDSP (that is if the RRSPs have not reached $200,000.00), then their Wills may also provide for a portion of Ryan’s share in the Estate to be paid into the RDSP up to the threshold value.  The remainder of Ryan’s share in the Estate shall be transferred into a Henson Trust for his benefit.  Corey would be the Trustee of the Henson Trust and would administer the trust for Ryan’s benefit. 

If the Smiths each maintained a modest life insurance policy (of $50,000 for example), they could name both of their children as alternate beneficiaries (the surviving spouse would be the first named beneficiary). If that is the case, Ryan and Cory would both receive $50,000.  In such instance, a life insurance trust could be created in which he would deposit the life insurance proceeds. Such a life insurance trust has a threshold of $100,000.

The proceeding examples explain how the Smiths are able to provide for Ryan without compromising his ODSP benefits through careful estate planning. 

Cautions

There are drawbacks to both a Henson Trust and RDSP that ought to be considered.  We recommend you consult with a professional so that those drawbacks be clearly highlighted and discussed. Ultimately, the estate planning must be tailored to the circumstances and the parents must decide what is feasible given their intentions and their means and the size of their family.

Conclusion

From the foregoing one can appreciate the tremendous advantage of Ontario parents having effective Wills in place is underscored when their child is disabled. The impact on that child’s future may be profoundly affected for the better.

If you have any questions, please do not hesitate to contact me directly 613.288.3220 or by email at sdesmarais@tslawyers.ca

Sébastien Desmarais, Associate

 

This article is provided as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter referenced in this document before making decisions.

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[1] When the household net income is under $21,816.00.