Red Flags & Trust Issues: Top 5 Pitfalls in Trusts

Trusts are powerful estate and tax planning tools but they must be carefully structured and properly maintained in order to be effective. Whether you’re setting up a trust to manage assets for children, planning for incapacity, or seeking to achieve tax efficiency, it’s important to understand the legal and practical implications. There are certain areas of concern to be aware of before settling a trust. Here are five common pitfalls to keep in mind.

1. Is it really a trust?

A trust is established when a person (the settlor) transfers property to another person (the trustee) for the benefit of others (the beneficiaries). They are a legitimate means for estate planning and tax planning, however, if not set up or managed properly, can lead to unexpected issues.

While trust terms may be written or only oral, the existence of a trust is usually supported by a trust document setting out the settlor’s instructions to the trustee for carrying out the terms of the trust. A trust only exists if legal and beneficial ownership of property are separated and the “three trust certainties” are satisfied:

• the certainty of intention (to create a trust);
• the certainty of subject matter (property); and
• the certainty of objects (beneficiaries).

A trust may be characterized as a sham if it appears to exist on paper, but in reality, does not actually operate as one in practice. This can happen when the person who set up the trust does not truly intend to dispose of the assets settled on the trust but rather, simply wishes to create the impression that the assets have been disposed of while maintaining control of them. The trust may then be treated as void and be exposed to legal or tax consequences.

2. Who do the assets in a trust belong to?

Once assets are transferred to a trust, they no longer legally belong to you – they belong to the trust and its beneficiaries. A common example is when someone transfers a significant portion of their assets into a trust for their minor children but continues to act as though they can freely use or control those assets. While the trustee is the legal owner of the assets, they must act in the best interests of the beneficiaries (not the person who created the trust), and follow what is set out in the trust deed.

On the other hand, failing to transfer any assets into the trust means it cannot function properly. For an inter vivos trust, assets must be transferred during the settlor’s lifetime, otherwise, the trust has nothing to administer or distribute.

Additionally, the failure to properly allocate income to beneficiaries by the end of the trust’s taxation year means it remains taxable in the trust often at the highest marginal tax rate.

3. How long does a trust last?

A trust can be a valuable tool for holding appreciating assets and deferring taxes on capital gains. However, this deferral has a limited lifespan due to the “21-year rule.” Under this rule, a trust is treated as if it has sold all its assets at fair market value every 21 years, even if no actual sale happened, called a “deemed disposition.” This can be a burden for long-term trusts as any unrealized capital gain resulting from the deemed disposition is typically taxed in the trust at the highest marginal tax rate. To manage this risk, it is important to plan ahead and consider distributing assets to beneficiaries before the 21-year anniversary.

4. What must be documented?

A trust must be supported by clear and complete documentation. Without it, the trust’s validity, purpose, and management can be called into question. Ongoing records must be maintained, including:

• Minutes of trustee meetings;
• Records of distributions;
• Asset transfers; and
• Decisions made by the trustee(s).

Poor record-keeping can lead to disputes or problems with tax filing. Beneficiaries have rights against the trustees to enforce the terms of the trust.

5. What must be reported?

All trusts, unless certain conditions are met, are required to file a T3 return annually. The T3 return must include beneficial ownership information of a trust, being specified information on all trustees, settlors, beneficiaries, and controlling persons of the trust (each a “reportable entity”).

The following specified information is required for each reportable entity of the trust:

• Name;
• Address;
• Date of birth (if an individual);
• Country of residence; and
• Tax identification number (i.e., social insurance number, business number, trust number, or, in the case of a non-resident trust, the identification number used in a foreign jurisdiction).

Qualified beneficiaries may also need to be informed every fiscal period for information on the trust, such as a statement of assets and liabilities and a statement of disbursements.

Conclusion

Trusts may seem like a simple concept, offering flexibility and protection, but can become complex without proper planning, drafting, and administration. By identifying and understanding these common pitfalls from the outset, we can assist you in turning these trust red flags into green flags and ensure you minimize any risks to your assets and beneficiaries.

McLennan Ross has an experienced and talented Wills & Estates Team and our skilled Tax Team to assist you with estate and business planning and its related tax implications.