Family trusts have become a common tool in estate planning, asset protection, and tax planning. They can help clients manage wealth across generations while preserving control and offering flexibility. However, family trusts are not suitable for everyone. They involve ongoing administration, legal obligations, and costs that need to be weighed against the benefits.
In this article, Lexpert will explore the pros and cons of family trusts. We’ll help new and existing legal professionals evaluate whether this is ideal for their clients’ needs and preferences.
What is a family trust?
A family trust is a legal arrangement where a trustee holds property on behalf of beneficiaries, according to the terms of a trust deed. The person who sets up the trust is called the settlor. Trustees are often senior family members or professionals. Beneficiaries can include:
- spouses
- children
- grandchildren
- companies
- other trusts
Family trusts are usually set up for several reasons:
- to maintain privacy
- to manage or preserve family wealth
- to provide income splitting opportunities
- to protect assets from creditors or lawsuits
- to control how assets are distributed after death
In most cases, family trusts are discretionary. This means that the trustee will decide which beneficiaries will receive distributions and in what amounts. However, it can also be determined by the trust agreement.
Learn more about family trusts in this video:
If your clients have assets in more than one country or have a family outside Canada, they should go for a cross-border trust instead. This can be converted into a simple family trust if a non-resident beneficiary eventually settled in the country.
What is the tax rate for a family trust in Canada?
Family trusts are taxed at the highest marginal tax rate on any income they generate. They are required to file a T3 return each year and issue tax slips to any beneficiaries who receive income.
How long does a family trust last in Canada?
Family trusts can last for many years, but they are not permanent. Under the Income Tax Act, there is a rule that affects how long a trust can operate without tax consequences. This is called the 21-year rule.
Lawyers need to make sure that their clients understand that a family trust must be reviewed regularly, especially as it nears this date. Proper planning can help reduce tax and make sure the trust still meets the family’s goals.
How much does it cost to set up a family trust in Canada?
Setting up a family trust can cost between $1,500 and $10,000. The total depends on how detailed the trust is and how much legal help is needed. Most of the cost comes from professional fees. Since each case is different, it’s better for clients to consult with a lawyer for an estimate.
Family trust: Pros and cons
Want to be as successful and credible as those on our list of the best personal tax planning and estate lawyers? Understanding the upsides and downsides of a family trust is a key step in offering top-tier advice to your clients:
Pros of using a family trust
A family trust can offer significant benefits when used appropriately. Lawyers should consider these potential advantages when evaluating whether a trust structure fits a client’s financial and personal circumstances:
- protection of assets
- estate planning and continuity
- probate avoidance and privacy
- income splitting
- planning flexibility
Let's take a closer look at these benefits below:
1. Protection of assets
Family trusts can be a way to protect assets from creditors, lawsuits, or marital disputes. If assets are transferred to a properly structured trust, they might no longer be considered personal property of the settlor or beneficiaries. This separation can shield assets from claims in bankruptcy or divorce, provided that the family trust is not created to avoid existing obligations.
Courts might scrutinize transfers to trusts made during litigation or insolvency. For this reason, clients should plan ahead and seek advice before setting up a trust for asset protection purposes.
2. Estate planning and continuity
A family trust can provide more control over how assets are distributed to beneficiaries. Unlike a will, which comes into effect only upon death, a trust can operate during the settlor’s lifetime and continue afterward. This makes it easier to manage the transfer of wealth across generations and avoid interruptions.
Family trusts can also help reduce disputes by clearly outlining how and when beneficiaries should receive distributions. The trustee has the authority to follow the trust terms and make decisions that reflect the settlor’s wishes. This can be especially useful when dealing with minors, spendthrifts, or beneficiaries with disabilities.
3. Probate avoidance and privacy
Assets held in a trust do not form part of the settlor’s estate. As a result, those assets are not subject to probate. This can reduce legal costs and delay. In some provinces, probate fees can be significant, especially on large estates.
Avoiding probate also helps preserve privacy. Unlike wills, which become public records after probate, trust documents are generally private. This can be valuable to clients who prefer to keep their financial affairs confidential.
4. Income splitting
A discretionary family trust can allow for income to be allocated among multiple beneficiaries. If some of these beneficiaries are in lower tax brackets, the overall family tax burden might be reduced.
This strategy must be used with care. Tax rules around income attribution and Tax on Split Income (TOSI) can apply and limit the effectiveness of income splitting in certain situations.
5. Planning flexibility
Trusts can be structured with wide discretionary powers. This gives the trustee the ability to adapt to changing family circumstances, such as births, deaths, or financial hardships. Distributions can be delayed or varied as needed.
Trust deeds can also include specific terms such as age restrictions, incentive provisions, or education-related conditions. These allow settlors to tailor the trust to their personal values and goals.
Cons of using a family trust
While family trusts offer useful benefits, they also have limitations and risks:
- setup and administration costs
- ongoing legal and tax obligations
- loss of personal control
- tax limitations on income splitting
- risk of legal challenges
Here's an in-depth discussion of each:
1. Setup and administration costs
Creating a family trust involves legal, accounting, and sometimes tax advisory fees. Drafting a trust deed, transferring property, and establishing records can be complex. If the trust is used for tax planning or business purposes, the need for professional support might be ongoing.
Once the trust is in place, trustees have a duty to maintain proper books, file annual tax returns, and ensure compliance with the trust deed. These tasks can be burdensome and costly over time, especially if the family trust holds multiple assets or involves many beneficiaries.
2. Ongoing legal and tax obligations
Trustees have fiduciary responsibilities. They must act in the best interest of the beneficiaries, follow the trust terms, and avoid conflicts of interest. Failure to do so can lead to legal liability.
Family trusts are also subject to complex tax rules. As mentioned above, the trust must file a separate T3 return each year. Certain trust income is taxed at the highest marginal rate unless it is distributed to beneficiaries. New reporting requirements for express trusts have also increased disclosure obligations.
Trustees must be diligent and well-informed to manage these obligations correctly. Some clients might find the administrative burden more than they are willing to take on.
3. Loss of personal control
Once assets are transferred to a family trust, they no longer legally belong to the settlor. The trustee becomes the legal owner and must manage the assets according to the trust terms.
Clients must be prepared to give up a degree of control over the transferred property. If the settlor continues to control the trust too closely, courts or tax authorities might treat the assets as still belonging to them.
4. Tax limitations on income splitting
While income splitting is one reason to use a family trust, there are tax rules that restrict this benefit. The TOSI rules apply to certain types of income earned through a private corporation. These rules can prevent income splitting with adult children or other family members unless specific exceptions apply.
5. Risk of legal challenges
Family trusts can be challenged in court. Disgruntled beneficiaries or excluded family members might question the validity of the trust or allege undue influence or lack of capacity.
If the family trust is not properly documented or administered, it might be found invalid, or the assets might be considered part of the estate. Courts have wide discretion in equity and might look past the trust structure if they believe it was used to avoid obligations unfairly.
Trusts used in family law disputes might also be treated as part of the net family property, depending on the circumstances. This could reduce or eliminate their asset protection benefit.
Here’s a table summarizing our list of pros and cons of family trusts:
Family trusts in practice: What lawyers should keep in mind
Family trusts can offer real benefits for those who want to protect assets, plan for succession, or reduce taxes. However, they are not a one-size-fits-all solution. Lawyers can help their clients understand both the advantages and limitations before they choose to set up one.
The decision to create a family trust should also be based on long-term planning, not just short-term tax savings. With the right advice and structure, a family trust can serve as a valuable part of clients’ estate and wealth plan. But when used improperly or without full awareness of the responsibilities involved, it can create more problems than it solves.
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