Trusts have been around a long time. However, I believe that the use of trusts in family estate and tax planning has been on the increase. There are lots of reasons for this not the least of which is the number of families that operate their own business and/or have significant assets (investments, rental properties, cottages, etc) with significant unrealized gains and therefore future tax liabilities attached to them.
When you are considering the implementation of a trust, in these cases often referred to as a ‘Family Trust’, you will generally be advised by your professionals about the benefits of the trust, but you may not consider all of the potential pitfalls.
I think it is a safe assumption that no one gets married with the intention of splitting up down the road. Likewise, families that have accumulated assets sufficient in size to consider the use of a trust are also unlikely to be thinking about splitting up at some point. Some do put planning in place for that possibility in the form of a pre-nuptial agreement but these can be fraught with difficulties to implement and enforce.
The purpose of this article is to simply make you aware of some of the pitfalls of trusts, in the unhappy event that you and your spouse were to end up splitting.
I paraphrase section 4 of the Family Law Act (“FLA”) as follows:
4(1) defines property as:
- any interest in real or personal property,
- owned now or acquired in the future,
- including vested or contingent ownership.
4(2) provides for the following exclusions from a spouse’s Net Family Property (“NFP”):
- property, other than a matrimonial home, acquired by gift or inheritance, and
- income from property acquired by gift or inheritance if expressly stated by the donor or testator that it be excluded from NFP.
The simplified version of how assets are divided under the FLA is that each spouse keeps the value of what they owned at the date of marriage, but has to equally divide the increase in value accumulated during the marriage. This concept sounds simple enough, but many issues complicate it including the following:
- What assets were owned at date of marriage and what was their value?
- How do we value ‘complicated’ assets at date of separation? For example…businesses, pension entitlements, etc.
- How do we account for future tax liabilities?
- Who keeps which assets and assumes which liabilities?
- How do we fund an equalization payment if we are ‘asset rich and cash poor’?
However, one of the issues that can be the most contentious is the value of an individual’s interest in a ‘discretionary trust’.
In a discretionary trust the beneficiaries and/or their entitlements to the trust funds are not fixed. In other words, the trust is discretionary in one or both of two respects:
- The trustee may have the power to determine which beneficiaries will receive payments from the trust and which beneficiaries will not.
- The trustee can select the amount of trust property that each beneficiary may receive.
Therefore, a beneficiary of a discretionary trust generally has no guarantee of receiving anything, or they may receive as much as everything! When families are acting in concert, fairness generally prevails and each beneficiary is treated equitably (which is not meant to always be ‘equal’). However, when families are in turmoil, how do you put a value on such a contingent interest?
Whether a beneficial interest in a trust should be included in, or excluded from, NFP hinges on two key factors:
- The degree of control the beneficiary spouse has over the trust and its assets.
- Whether the property to flow to the beneficiary spouse was intended to be excluded from NFP.
Think of a situation where a spouse owns a business and sets up a trust with themselves as sole trustee, co-trustee, or a non-trustee. Generally they are a discretionary beneficiary along with their spouse and their children, both those born prior to the start of the trust, and those born afterward. Add in grandchildren and the complications only escalate!
Factors considered by the courts in determining entitlement under the FLA have included the following:
- Evidence related to the founding intent of the trust. Was it designed to effectively allow control by the beneficiary?
- Composition of the trustees, including whether the beneficiary is a trustee.
- Any requirement that the beneficiary be part of any trustee decisions.
- History of past trustee actions demonstrating direct or indirect control by the beneficiary.
- Powers of the beneficiary to remove, appoint replacement, or add new trustees.
- Relationship of the beneficiary to the trustees.
These factors are not exhaustive, or determinative in their own right and weight will be assigned on a case by case basis. If and when an entitlement is found to exist, the question of attributing a value to that interest remains.
The simplest option, and one used in many cases, is to determine the value of an interest in a discretionary trust by treating the trust assets as if there was a deemed realization among all capital beneficiaries and allocate that value equally as at that date.
Another option, which requires consent of the parties, is to wait for actual distribution(s) and equalize at that date. You can likely foresee the problems this may cause.
Either way, the process to attribute a value to a beneficial interest requires an accounting of the trusts assets including the following:
- The fair market value, intrinsic value, or value to owner, of the trust assets.
- The future liabilities of the trust including income taxes, transaction costs, etc.
- Income or amounts capable of being excluded from NFP under section 4(2) of the FLA.
So I think it is fair to say that the introduction of a discretionary trust can be a severely complicating factor in the equalization of assets, as well as the determination of income for support, under the FLA. Just one more thing to think about before you decide if a Family Trust is right for you!
Article written by: Dwayne Pyper, CPA, CA, CBV, Q.Med