Like any financial tool, there are pros and cons and, more importantly, the right time and the right way to use family trusts. And, it goes without saying, there is also the wrong time and the wrong way to use family trusts.
A trust is simply a way to transfer assets from one person to another, through an indirect method. For instance, if I wanted to transfer a huge sum of money to you, I could just write you a cheque. Or, I could put it in a trust, and the trust would pay you. The trust would be managed by someone or by a group of people.
“A trust sounds somewhat convoluted. Why not just give me a cheque?”
A good question. And there are several answers. One of them is income splitting. Often parents earn the bulk of the income in a family, whereas children earn nothing at first, and much less than the parents even as they get older.
Using a family trust to split the income ensures that much of the income comes tax-free. Let’s say you have two young children with no income of their own, and the trust pays each of them $10,000 a year. Nobody pays income tax on their first $10,000. So that means there is an extra $20,000 on which you pay no tax. If you were paying tax at the high rate of 46 percent, you have just reduced your taxes by $9200 per year. Sweet.
If you earn sizeable capital gains, the income-splitting deal is even sweeter, as with dividends.
A family trust can be used also to pass money down to adult children or even to grandchildren. Typically this is a way to help support family members in a much lower tax bracket, without having to pay the higher tax. In other words, tax-free charity within the family. Yes, you could just send a check for $10,000, but you would be taxed on that money when you earn it if you don’t do it through a trust.
The other big reason to use a family trust is to side-step the whole will process at the end of your life. Funds put into a trust do not have to be disclosed to anybody other than those people involved with the trust. So you can keep your wealth and how you distribute it under wraps. The money in the trust is also protected from anyone challenging the will.
Often people leave trusts to minor children so as to support them over time rather than leaving a lump sum that might quickly be squandered. In cases where a person remarries, they are often left to children so that the funds are not part of the new matrimonial deal. In other words, a family trust can make sure that inheritance is passed on to children in a useful and effective manner.
Of course, you can put a trust right into a will, if you simply want to pass along your inheritance to your children in stages rather than paying one big cheque.
“Wow. Family trusts sound great. I’m heading out to the corner store to pick up a dozen of them.”
Not so fast. You can’t pick up a family trust for $19.99. There are significant costs in setting one up and there are ongoing legal and accounting fees involved, too. And the trustees – those who administer the funds – will want to be paid something, too. You might be one of the trustees if it is not an end-of-life situation, but you will probably want an independent person, such as a lawyer, to be one of the trustees.
There is also always the risk that you will lose control. It is important not just to think carefully about who the trustees will be, but also what the terms will be. Once you set the terms, the trust is in charge. You can’t change your mind, because the assets are no longer your own. They now belong to the trust under the rules it was established.
There is also the risk that your trust will be declared a fraud. Of course, if you have set it up properly and for legitimate reasons, this risk is pretty small. But if you are trying to stretch the envelope, there are penalties for fraud.
The disadvantages are small for those people who can really make use of a family trust. But if your assets are small and you have no need to protect them somehow or redistribute your wealth, chances are that you will end up paying as much to set them up and administer them as you will benefit from them.