The 21-Year Rule is Taxing on Family Trusts
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Angela M. Ross
Associate Partner, Tax Services Practice
“Any family trust, whether it is created during someone’s lifetime or on the death of a person, has to treat itself as having disposed of its property every 21 years.”
Family trusts are popular estate and succession planning vehicles for good reason: they can be versatile and effective tools to help manage family wealth and taxes. But many Canadian family trusts are now well into their second decade and need attention to avoid significant—even devastating—tax bills triggered by the Income Tax Act’s “21-year rule.”
“This rule,” says Angela Ross, associate partner, tax services, PwC, “states in general that any family trust, whether it is created during someone’s lifetime or on the death of a person, has to treat itself as having disposed of its property every 21 years.”
In Canada, when someone dies, they are seen as having disposed of their property (except property left to their spouse) at fair market value and their estate pays taxes on any gains realized on that property. Any property then acquired by their child will again be deemed disposed on the death of that child. Were it not for the “21-year rule,” a family trust could hold property for multiple generations without ever incurring tax on the death of a generation.
So every 21 years in a family trust’s “life,” the CRA looks at the property in a trust as if it were the property of someone who had just died. “When the 21 years are up, if the trust holds property on that date, it is deemed to have disposed of the property at its current market value and has to pay taxes on it. Say the trust owns property that had an original cost of $10 but its value on the 21-year anniversary is $100. That trust will be deemed to have realized a $90 capital gain.”
As we enter 2011, many Canadian family trusts are approaching the 21st anniversary of their creation and families need to be aware that in most cases, with proper, advanced planning, steps can be taken to defer the tax. “A trust can generally transfer its assets to Canadian resident beneficiaries on a tax-deferred basis prior to the 21-year anniversary, meaning it can transfer its assets to beneficiaries without triggering the tax on the gain,” says Ross. “So if the trust owns property with a cost of $10, and at 20 years, its fair market value is $100, the trust can transfer the entire asset to its Canadian resident beneficiaries at its $10 price. The trust disposition would reflect $10 of proceeds and not the $90 gain. The taxes on the $90 capital gain can be deferred until that beneficiary sells or dies.”
Ross advises family trusts to begin planning for the transfer at least a year in advance of the 21-year anniversary—although in more complex cases two or more years will be needed. Some important points to keep in mind include:
- With the exception of Canadian real estate held in a trust, the general rule is you can’t transfer the trust’s assets at cost to beneficiaries who are not Canadian residents. But even if you have non-Canadian resident beneficiaries, depending on the terms of the trust and situation, it may be possible to do some planning to get the assets out for the benefit of that non-resident. It can be very complicated, so start early.
- If timed properly and you have the right tax scenario, you can transfer the trust’s assets to grandchildren rather than your children and thus defer the taxes for another generation.
- In the case of a family trust owning a business that is transferring shares to children or grandchildren, it’s prudent to have a shareholders’ agreement in place before the children or grandchildren receive the shares.
- Even if your family trust is nowhere near 21 years old, having it reviewed carefully by an expert now can be a smart move. “There are a few provisions in the Tax Act that could prevent you from doing the rollout before 21 years,” says Ross. “Most important is 75(2)—the revocable trust provision. It applies if the trust received property from any person who is a capital beneficiary of the trust or is a person who decides when the trust property is disposed of or to whom it eventually goes. It’s a brutal provision that may prevent the rollout of any assets to beneficiaries before 21 years and it’s one people need to be aware of.” Although there’s nothing that can be done to change it, with enough time, it’s possible to develop strategies to fund the eventual tax liability. “The sooner you know you have this issue, the better,” says Ross. “Alternative planning may be possible. You could implement a reorganization at say 10 years to stop the growth in a bad trust and potentially start the growth in a good trust and minimize the tax hit that’s going to happen at 21 years.”
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