A living trust can be very useful in estate planning if set up correctly and for the appropriate purposes, but before determining whether a trust is suitable for your purposes, it is important to weigh up the advantages and disadvantages of doing so.
ADVANTAGES OF A LIVING TRUST
- Estate-pegging
A significant advantage of a living trust is that it allows you to peg the value of the assets in your estate while allowing the growth in those assets to take place in the trust, thus reducing your estate duty and other tax liabilities. As such, moving growth assets such as a second property or a share portfolio into a living trust can be an effective mechanism for fixing the value of your estate for estate duty purposes. By using your annual donations tax exemption of R100 000, you can effectively reduce the value of the loan account each year, thereby reducing your estate duty liability.
- Asset protection
A living trust can be used to protect assets from creditors, although it is important to ensure that the trust is not set up specifically to prejudice your creditors. When selling assets to a trust, keep in mind that the loan account appears in your estate as an asset that can be attacked by your creditors. It is only once the value of your loan account decreases over time that the full benefits of asset protection will arise. In the event of high-risk business ventures, a living trust is an effective way of protecting your assets from potential creditors.
- Using the conduit principle
Trusts are taxed at 45%, but that rarely matters, because they should not earn taxable income, and, if they do, it should bypass the trust completely. If taxable income received by or accrued to a trust is distributed to a beneficiary, before the trust’s tax year end (28 February), then it may flow through a pipe, or conduit, directly to the beneficiary without touching the trust.
The nature of the income is unchanged. That is, a dividend remains a dividend, interest remains interest, rent remains rent, a capital gain remains a capital gain etc, and is taxed in the hands of the beneficiary as if the trust did not exist.
Whilst this can be advantageous if the beneficiary is on a low marginal tax rate, the downside is that it siphons wealth out of the trust whose very purpose was to grow wealth and protect it from creditors and taxes on death. It would have been far better if the trust never earned income in the first place and that is achieved by interposing a company between the trust and the investment, then the company pays the tax.
- Providing for those with disability
If you have a child or dependant who suffers from a disability that renders that person unable to manage their financial affairs, you can set up what is referred to as a Special Trust Type A in terms of Section 6B (1) of the Income Tax Act. This type of trust is ideal for parents of special needs children who are concerned about how they will be cared for when they are no longer around. It is important to note, however, that this type of trust must be registered for the sole benefit of a beneficiary with a permanent mental or physical disability to qualify for the favourable tax benefits enjoyed by such trusts. If correctly registered, Type A trusts are taxed at rates applicable to natural persons ranging from 18% to 45%. Further, the annual CGT exclusion of R40 000, as well as the primary residence exclusion of R2 million, is applicable.
- Flexibility
A trust structure can allow for greater flexibility in terms of providing for beneficiaries without ownership transferring directly to them, especially if setting up a discretionary trust where the trustees can exercise their discretion as to the distribution of trust capital and income, taking into account uncertainties such as death, divorce, insolvency, changes in legislation, and changes in personal circumstances.
- Dementia
As an estate planner, you can use a living trust to administer your financial affairs if you are concerned about losing mental capacity such as if you are diagnosed with early-stage dementia. While you still have mental capacity, you can transfer assets into a living trust structure to be used for your future living expenses and nominate trustees who you believe will administer those assets in your best interests.
- Transfer assets to future generations
Trusts do not die, meaning that the assets housed in your trust can transfer from generation to generation without going through the estate administration process. This means that the trust assets can evade the estate administration of consecutive estates while providing for different generations of beneficiaries. It can also alleviate the problems involved in leaving an indivisible asset to multiple heirs such as in the case of a holiday home or family farm. Further, while assets in your estate can be interrupted by events such as divorce, insolvency or family disputes, the assets held in trust are less likely to be affected by such eventualities.
- Access to capital in the event of death
When it comes to ensuring that your loved ones and beneficiaries have access to capital and income after your death, a living trust can offer an ideal solution. While your personal accounts may be frozen as part of the estate administration process, bear in mind that your trust’s accounts, which do not form part of your personal estate, will continue unaffected. The estate administration process, which is currently experiencing delays as a result of Covid interruptions, can take up to two years to finalise (sometimes longer), making a living trust an effective solution ensuring ongoing financial provision to your loved ones after your death.
- Professional asset management
Depending on the nature of the assets housed in your trust, appointing professional trustees with investment management experience can be a significant advantage, particularly if the trust is used to house investments intended for your loved ones after your death and where optimal investment returns are important to their future financial security.
DISADVANTAGES OF A LIVING TRUST
- Loss of control
As a trust founder, it is important to fully appreciate that by transferring assets to a trust, you must divest yourself of ownership and control of those assets, failing which the trust may be deemed invalid. It must be clear that you intend to relinquish control of the assets to the trustees, and that you do not interfere in their management of the trust assets. As such, be cautious of transferring assets earmarked for your retirement to a trust as you will effectively hand over control of those assets to your trustees who may have other intentions for them. Further, it is important to ensure that your trust deed is correctly drafted to clearly outline the mandate of your trustees.
- Administrative costs
When contemplating a trust structure, do not lose sight of the fact that running a trust adds a layer of complexity and costs to your financial affairs. When setting up a family trust, keep in mind that you will be required to appoint an independent trustee and, if you’re planning to appoint a professional trustee you will need to budget for their professional fee. In addition, keep in mind the set-up costs as well as the costs of maintaining the trust bank accounts and ensuring that the secretarial functions of the trust are attended to.
- Choosing the wrong trustees
It is essential to make the right decision when appointing your trustees as you will effectively be handing control of the trust assets to them. It is therefore critical that you trust them implicitly to manage the affairs of the trust in the beneficiaries’ best interest. For instance, many fiduciary experts advise against appointing your children as trustees while you are still alive as very often they have different intentions for the trust assets, and family dynamics and tensions can give way to unintended consequences when it comes to how those assets are dealt with.
- Being regarded sham or alter-ego trust
If the court feels that there is not sufficient separation of control between the trust founder and the trust assets, the courts can pierce through the veil of the trust to establish whether the trust is an alter-ego or sham trust which can result in the trust being declared void from the date of inception.
- Selling assets to the trust
If you intend to sell assets to the trust and then use your annual donations tax exemption to reduce your loan account over time it is important to remember that you can only reduce this loan account by R100 000 per year without incurring any additional donations taxes. It is also important to bear in mind that the sale of the asset will trigger a capital gains event and you may be liable for CGT when the sale takes place. Further, as the value of your loan account will reduce over time as and when you use your donations tax exemption, there may still be estate duty implications in your deceased estate should you pass away before the loan is paid off.
In closing, keep in mind that living trusts are not appropriate for everyone. If correctly set up and administered, they provide significant advantages to the estate planner, and it is always advisable to seek professional fiduciary advice before creating a trust.
