What is the 21-year rule?
Family trusts created during someone’s lifetime are deemed to dispose of their property every 21 years. Although the trust is deemed to have disposed of property for tax purposes, an actual disposition typically does not occur. This 21-year deemed disposition occurs at fair market value (FMV) and results in the realization of any inherent capital gains on all capital assets held within the trust. The rule is designed to prevent the indefinite deferral of capital gains tax over multiple generations. This deemed disposition for tax purposes can create a significant tax liability for the unexpected. Liquidity is often an issue that arises with a deemed disposition and no actual disposition to fund the tax liability.
Dealing with the 21-year rule
Bob Miller, a resident of Ontario, settles the Miller Family Trust (in Ontario) on January 1, 1996, for the benefit of his three adult children, using a $100 bill as the original gift. Shortly after it was settled, the trust used the $100 to subscribe for newly issued common shares of the family construction company, Miller Limited, as part of a corporate reorganization that included a freeze of Bob’s equity position in the company. Although beyond the scope of this article, this type of reorganization is commonly referred to an estate freeze.
The date is now July 1, 2016 and the common shares of Miller Limited have grown in value to approximately $10 million. On January 1, 2017, the Miller Family trust will realize a deemed disposition of the Miller Limited shares, creating a capital gains tax liability of approximately $2,676,500 ($10,000,000 x 50% x 53.53% in Ontario). Since the only assets in the trust are the Miller Limited shares, the Miller family Trust has no liquidity available to fund for this tax liability.
Strategy 1 – Do Nothing
One possibility is to do nothing. The Miller Family Trust would allow the deemed disposition to occur and pay the associated tax liability. This may be an attractive option for trusts set up for the benefit of small children because it will enable the trust to continue in accordance with its terms, so that the objectives envisioned for the trust can continue to occur. However, the Miller family Trust will have significant capital gains at the deemed disposition date and this would not be a tax efficient alternative. This is especially the case since the trust was set up to benefit Bob’s adult children and not hinder them with a significant tax liability.
Strategy 2 – Rollout of Assets
Another possibility would be to transfer the shares to the beneficiaries, Bob’s three adult children. A special provision in the Income Tax Act would allow this transfer to occur on a tax-free rollover basis. By rolling the shares out to the beneficiaries, direct ownership of the shares passes to Bob’s three children. This can be problematic for a number of reasons, such as Bob losing ultimate control of his company at a time before he wishes to relinquish it, or the potential threat of family law litigation associated one of his children going through a divorce and having to distribute the shares with their spouse. That said, there are measures that can be taken to mitigate these risks, such as the implementation of a unanimous shareholder’s agreement in Miller Limited, which would apply after Bob’s children became direct shareholders. This type of agreement could enable Bob to retain control by dictating the terms and conditions of his children becoming direct shareholders in Miller Limited, without requiring the consensus of the entire family.
Strategy 3 – Refreeze Assets and Settle New Trust
In some circ*mstances, despite the possible arrangements to minimize the control of Bob’s children discussed above, the trustee(s) may determine that they do not want to distribute the appreciated property out of the trust to one or more of the beneficiaries. In such circ*mstances, an estate freeze should be considered. The trust would freeze its position in Miller Limited by exchanging its common shares for fixed-value preferred shares. Miller Limited would then issue new common shares to a new family trust and the old Miller Family Trust would distribute its fixed-value preferred shares to Bob’s three children. The advantage of this strategy is that Bob’s children will own fixed-value preferred shares, while the new growth of Miller Limited will be attributed to the common shares held in the new family trust with a reset of the 21-year clock. If control is an issue of concern, a unanimous shareholder agreement, as described above, can be implemented in order for Bob to maintain the long-term control of his company. Alternatively, Bob could be issued voting control during his lifetime.
Exceptions to the 21-year rule
The primary exceptions to the 21-year rule are:
- Alter ego trusts, which have a deemed disposition upon the death of the settlor;
- Spousal trusts, which have a deemed disposition upon the death of your spouse; and
- Joint partner trusts, which have a deemed disposition upon the death of the second partner.
However, take note that any of these trusts which continue after the deemed disposition triggered by death will be subject to the 21-year rule every 21 years going forward.
Planning for the 21-year rule is technical and can become complicated because various issues of tax law, corporate law, and family law will need to be considered. Inadequate planning for the 21-year rule can result in an unexpected tax liability without the necessary liquidity.
