The clock is ticking on your trust fund
What you need to know about the “21-Year Rule”
By Blair Knippel
With limited exceptions, trusts are deemed to dispose of their property for income tax purposes every 21 years. Known as the “21-Year Rule”, the passage of time ultimately impacts trustees’ decisions and the long-term effectiveness of trusts. Twenty one years following a trust’s creation, most assets are deemed to be disposed, and subsequently reacquired, for fair market value. If a trust holds assets with accrued gains, this deemed disposition creates a tax liability for the trust, thus preventing an otherwise indefinite deferral.
The consequences of the 21-Year Rule may be addressed in several ways. The tax arising on the deemed disposition may be paid simply by utilizing trust assets. Alternatively, the trustees may take the opportunity to transfer or roll-out the trust property to the beneficiaries on a tax-deferred basis or may embrace the passage of time by proactively planning for the 21-Year Rule’s practical impact.
Trustees who roll trust property to beneficiaries often have concerns respecting the loss of control over such property. Consider this example. Twenty years ago Mr. Smith structured ownership of SmithCo such that all of the common shares were owned by a family trust. At that time, his three children were each under 15 years of age but now they are all over 30 years of age. Mr. Smith must consider whether they are ready to become shareholders of SmithCo taking into account the stability of their marriages and living arrangements, their residency (be it in Canada, U.S. or otherwise), their economic lifestyles, and ultimately their future involvement and potential contributions to SmithCo.
These are difficult considerations. Some owner-managers are confident that their children are ready to become voting shareholders but others struggle to relinquish votes. Mr. Smith must decide if the Smith children are ready to hold voting shares in SmithCo.
Mr. Smith may opt to proactively plan for the 21-Year Rule without relinquishing control of SmithCo by:
- Subscribing for low value, super voting shares of SmithCo such that he has voting control;
- Preparing a unanimous shareholders’ agreement to which the beneficiaries must consent to being bound prior to roll out;
- Exchanging the common voting shares for three separate classes of common shares of SmithCo to permit future dividend-sprinkling amongst the Smith children; and/or
- Exchanging the trust’s voting common shares of SmithCo for non-voting preferred shares frozen at their current value with perhaps a new family trust subscribing for new voting common (or growth) shares.
When 21-Year Rule planning is being considered, tax deferral often drives decisions. Often however, such deferrals do not address the issue of determining the appropriate time to allow the next generation to control a family business. Some families use the 21-Year Rule consequences as an opportunity to establish family councils and family boards, and to formalize family leadership training and coaching to train inexperienced family members in business matters.
Mr. Smith should meet with his advisors with the following:
- The original trust deed and background information on the trust’s settlement to ensure, among other things, that there are no impediments that could prevent the tax deferred rollout to certain beneficiaries
- A description of the trust property held, acquired, disposed of, and exchanged by the trust during its existence
- A list of the income and capital beneficiaries of the trust, their current and future residency plans, and their intentions/objectives
- The background information on the objectives of the trust and consideration for the ability of the beneficiaries to control the allocable assets
- The financial and marital state of the beneficiaries
In summary, Mr. Smith may still control the impact of the 21-Year Rule to the Smith Family. His main options include:
- Do nothing and plan to address the consequential tax, if any, arising from the deemed disposition of the trust assets. Migration of the trust to a province where the resulting tax is potentially more manageable could be considered.
- Roll out the trust property to his children if he believes that his children are capable of holding the assets held by the trust, thereby eliminating the tax consequences of the 21-Year Rule but creating potential non-tax consequences.
- Permit a roll out of the trust assets but change their underlying nature to defer a potential shift in voting control away from the beneficiaries until he is confident a smooth business transition can take place.
Regardless of the decision made by Mr. Smith, the passage of time will impact his estate plans whether he intends it to or not.
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