trusts: the good, the bad & the ugly…
Trusts can be very useful if they are set up for the right purposes and run correctly. But they can cost you more than you bargained for if you haven’t done your calculations, says Harry Joffe, the head of legal services at Discovery Life.
Joffe was speaking at the recent Risk Protection seminar.
“If you set up a trust, you must be aware of what you are getting into and why you have created it, Harry Joffe advises. You need to be aware of the good, bad and ugly aspects of trusts, and ensure that a trust is the most appropriate solution to your needs. While a trust may assist you in estate planning, it may not necessarily be appropriate. You should remember that there is another way to resolve the problem of the estate duty that your estate may face on your death. A life policy to cover the tax may be a more cost effective and suitable solution to your needs”, Joffe says.
“Trusts can also be useful for preserving assets for the ongoing benefit of a family or to protect your wealth. But you should bear in mind that they are generally suitable only for assets you plan to hold for the long term. And, while you can use trusts to preserve wealth, you shouldn’t set up a trust and hope it will help you to hide assets from your creditors or your spouse on divorce. Nor should you set one up to avoid income tax. Unintended tax consequences are one of the ugly FINANCE features of trusts, but the high tax can be minimised by using the right investments, such as shares or endowment policies”, Joffe says.
IS A TRUST APPROPRIATE?
Before you place your assets in a trust, you should establish if it will be appropriate for your needs. Joffe says you should ask yourself the following questions:
♦ Are you happy to give up control of certain assets, such as your business, and allow other people to control them?
♦ Is it worth the costs associated with transferring the assets (for example, transferring property), the potentially higher taxes and the professional fees involved in the administration of the trust?
♦ Are you placing the correct assets in the trust and not opening yourself to tax problems?
♦ Are you creating capital gains tax (CGT) problems for yourself by placing short term assets in the trust? For example, if you place your primary residence in a trust and later sell it, you won’t enjoy the R1.5 million rebate on capital gains on the property, /or if you place a franchise business in a trust that you plan to sell in three or four years, you will pay CGT of 20 percent on the gain instead of the maximum of 10 percent that applies to individuals. Joffe says you can minimise this capital gain by having the trust pay the gain to the beneficiaries of the trust in the same tax year as it was made, thereby moving the tax burden to them at their lower rate.
However, the question then becomes what was the point of using the trust in the first place. Joffe says, as the assets or gains have now had to be moved out of the trust. “Traditionally, trusts have been used to freeze estates that have high asset value and as protection against insolvency”, Harry Joffe says.
THE GOOD – SECURITY
“Usually, an asset, the value of which is expected to grow, is transferred to the trust, but because the trust can’t pay for the asset, it takes it on a loan from the seller of the asset. A loan account is set up, and the trust needs to one day repay the seller for the asset that was transferred. Only the loan account remains in the founder’s estate. The loan account does not grow, but remains fixed in value. In this way the estate is frozen. Any growth in the value of the asset now occurs in the hands of the Trust”, Joffe says.
For example, shares worth R1 million may be transferred to a trust on a loan account. In 10 years, the shares are worth R4 million, but the value of the loan account is still worth only R1 million. In this way, Joffe says, (ignoring the fact that the first R3.5 million in your estate does not attract duty) estate duty on the R3 million of growth in the estate will be avoided. This saves you R600 000.
Moving assets into a trust also, protects you against insolvency. To continue the above example, if you went insolvent, your creditors could attach only the R1 million loan account in your estate and not the full R4 million of shares in the trust. However, the caveat is that you cannot move assets into a trust to avoid paying your creditors, for example, shortly before going insolvent. In such a case, the transfer is likely to be unwound.
“There is also no point in setting up a trust when you are old and have already amassed a large amount of assets – for example, at age 78 when you already have assets of R150 million”, he says. This is because at death the loan account will probably equal most of the value of what the estate would have been on death if you hadn’t transferred assets to a trust, so you would have achieved nothing. You need to set up a trust before you accumulate the bulk of your wealth.
“Another benefit is that a trust does not die, but can go on forever and ever”, Joffe says. “As a result, estate duty, and other costs, such as transfer duty, executor’s fees or conveyancing costs, can be avoided by leaving assets permanently in a trust. You can also avoid capital gains tax (CGT) if the trust does not sell the assets”, Joffe says. However, if the assets are in your name, when you die you are regarded as having disposed of your assets and your estate will be liable for CGT.
“Another benefit of a trust is that assets held in a trust are not frozen when you die as is the case with assets held in your name”, Joffe says. Some estates take a very long time to wind up.
THE BAD – Higher Taxes
“The downside of setting up a trust relates mainly to the taxation of trusts. Firstly, a trust pays a higher rate of tax than an Individual does. Trusts are traditionally the highest taxed vehicles in South Africa”, Harry Joffe says. Trusts pay income tax at 40 percent from the first rand earned, unlike Individuals, who pay no tax on the first R46 000, tax at 18 percent on the next R76 000 and so on until the highest tax rate of 40 percent applies to earnings above R490 000. The exceptions to the high taxes are special trusts and testamentary trusts.
A special trust is set up for a person who suffers from a mental illness as defined in the Mental Health Act or a serious physical disability that prevents him or her from earning enough to support him-or herself.
Testamentary trusts are set up in terms of your will for the benefit of minor children. These trusts pay tax at individual rates but with no rebates. Trusts also pay capital gains tax (CGT) at a higher rate than do individuals. Trusts pay CGT at an effective rate of 20 percent, unlike individuals, who, at the highest marginal tax rate, pay an effective rate of 10 percent. Individuals also enjoy an annual exemption on capital gains of up to R16 000.
“Again, a trust can avoid the consequences of these high taxes by owning investments that generate no income or capital gains”, Joffe says. Alternatively, the trust can make payments to beneficiaries in the same tax year that the income or capital gain is earned. This will move the tax burden down to the beneficiaries, he says. However, this would mean the capital gain or income would have to come out of the trust. Secondly, Joffe says, the South African Revenue Service (SARS) has a host of anti-avoidance provisions that it can throw at you if you put assets into a trust to avoid tax. For example, in terms of section seven of the Income Tax Act, if you, as a parent, donate to a trust assets that earn an income for your minor beneficiaries, SARS can levy income tax on you as if you earned the income.
THE UGLY – Loss of Control
The “ugly” aspects of trusts mostly relate to the practical difficulties that arise once you have put your assets into a trust. Harry Joffe says the practical issues are often the most important ones. . The first practical difficulty is that when you put your assets in a trust, you have to give up control over those assets, he says.
In order for your trust to be legally recognised by the authorities, you cannot control the trust. Therefore, the trust should have at least two trustees besides yourself. You can be a trustee and a beneficiary of a trust, but you cannot be the sole trustee or the sole beneficiary, because then the trust structure can be disregarded. For example, Joffe says, the South African Revenue Service can disregard the trust and levy estate duty on the assets in the trust when you die. Also, the trust deed should not bestow veto powers over the decisions of the other trustees to one trustee. A trustee can be given limited powers relating to a specific transaction – for example, to sign for the purchase of property in a particular city, because the other trustees reside elsewhere.
But beware of granting any absolute powers to one trustee. Joffe says, according to a recent court case, if a trustee is given powers relating to a specific transaction, it must be done by way of resolution in writing before the transaction takes place.
A “sham” trust will also be open to attack in terms of common law – if, for example, you use a trust to deny creditors what they are due. And even under South African law, there is precedent for the courts to look through a trust being controlled by divorcee to hide assets from a former spouse, says Joffe.
It is important that you can trust the other trustees you appoint with your assets. You should be careful about appointing your spouse as a trustee, Joffe says, because if you subsequently divorce, your former spouse may vote against your decisions as a trustee.
You can, under certain conditions, add or remove beneficiaries of the trust – for example, if you have a fall-out with one of your children, he says. However, there are strict rules that need to be followed here as well.
Make sure the trust’s tax returns are filed, and that resolutions and decisions are minuted and filed. To minimize and restrict these pitfalls it is important to appoint an independent trustee on your trust like trustfin™ which will manage the risk and make sure your wealth and legacy is protected and preserved over time.
© Copyright reserved, Discovery Life – Personal Finance, Life Focus, 2009.