The concept of a family trust sounds wonderfully wealthy and secure from the point of view of the beneficiary, but living trusts are not to be entered into lightly, particularly now that the Minister of Finance has them in his sights. You need to understand fully why you should transfer your assets into a trust. We consulted a panel of experts from the Financial Planning Institute (FPI) about the advantages and pitfalls of living trusts and their role in estate planning.
When it comes to trusts, the first thing to understand is that there are two basic types: Testamentary trusts, which are set up in terms of a will, come into being at your death. Inter vivos, or living trusts, operate during your life. Inter vivos trusts are often known as family trusts.
Testamentary trusts
A testamentary trust comes into effect only after you die. The founding document of this trust is contained in your will. Such a trust can contain cash, movable or immovable assets, and is run by trustees appointed in the will.
A testamentary trust allows for the management and control of assets and protects beneficiaries, such as minor children, who can't take responsibility for managing large sums of money. It can also dissolve at a given moment, say when a child turns 21.
Jenny Gordon, an FPI fellow, says one of the main reasons for placing assets in a testamentary trust for children is that by law an inheritance cannot be paid to anyone under 21. It has to be paid into the Guardian's Fund, or assets can be paid directly to a guardian as long as he or she provides security. Payment into a testamentary trust avoids this.
A testamentary trust does not help you avoid estate duty, as the trust only comes into existence after your death. At the time of death, your assets still belong to you and are therefore part of your estate.
Inter vivos trusts
Danie van Zyl, our second FPI panellist, says the term inter vivos is Latin for among the living, and these trusts are set up during your lifetime. Although they are often part of estate planning, they are also increasingly being set up to control and run businesses.
Theunis Stofberg, the third member of the panel, explains that a trust is a legal agreement - the trust deed - in terms of which one party, known as the founder or settlor, contracts with other parties, known as the trustees, that they will manage certain assets for the benefit of specified beneficiaries.
A living trust exists from the moment the document is registered with the Master of the High Court and the trustees are appointed.
The trust deed is an extensive document and reflects the wishes of the founder as to how the trustees must manage the assets, Stofberg says.
The trustees are bound by the terms of the trust deed and cannot deal with the assets outside the powers given to them.
Apart from provisions dealing with the day-to-day management of the trust, such as the frequency of trustees' meetings, the trust deed will specify the class of the beneficiaries, such as the founder, his or her spouse and their descendants. The trust deed will also specify which beneficiaries can receive income from the trust and which can receive capital.
The payment of benefits to beneficiaries is usually subject to the discretion of the trustees, Stofberg says. This means that a beneficiary can benefit from the income and/or capital of the trust only once the trustees decide the beneficiary may get a benefit. (See below: So, who pays?)
First, the good news
Why would you want to set up an inter vivos trust? One perception is that it's a great way to dodge tax, but if this is your primary reason for wanting a trust, alarm bells should ring.
Trusts do, however, serve a number of purposes, and are particularly useful in estate planning:
- A trust can protect personal assets against the risk of a business failing.
Stofberg says that if you are an estate owner with a business in your name, you can protect your personal assets, such as investments, or your family home, by putting these assets into a trust. If you become insolvent, your creditors have no claim against the assets in the trust, even if you are one of the trustees.
This is due to the fact that legislation determines that the insolvency of a trustee in his personal capacity will not impact on the assets being administered by him, Stofberg says.
The same advantage applies if you run your business through a trust, and keep your personal assets in your own name.
- A trust deals with the problems of dividing up assets, such as a holiday house or family farm, by providing a vehicle for the joint ownership of indivisible assets.
Stofberg explains that if you wanted to leave your beach cottage to, say, all three of your children, so that it is retained and managed for the benefit of your family and future generations, a trust would be the ideal holding vehicle.
Because there is no limit on the life of a trust, the holiday house will be managed by the trustees for present and future generations of the family.
The same goes for family farms. At present - although pending legislation could change this - agricultural land cannot be subdivided without the permission of the Minister of Agriculture.
An undivided share in a farm bequeathed to your children cannot be transferred into their names without the minister's consent. You could solve this problem by placing the farm in a trust.
- Trusts peg or freeze the value of an estate.
Gordon says that by transferring assets that are likely to increase in value to a trust, the estate duty payable on them when you die - currently at an effective rate of 20 percent - can be reduced or eliminated over time. The value of your estate will be frozen for the purposes of estate duty.
Stofberg adds that the first R1.5 million of an estate is exempt from estate duty. But if your estate is worth more than that, or if you believe it could grow to more than that, it could be worth freezing the value of your estate. This means that once you have transferred your assets into the trust - for instance, your home, which is likely to increase in value - your heirs will not have to pay estate duty on the house when you die.
This is because the growth in the value of the house occurs in the trust and not in your own estate, limiting the value of your estate. Because the asset remains the property of the trust and not of the beneficiaries, they too do not have to count the asset as part of their estates when they die.
- A trust protects against problems should you become mentally incapacitated.
Gordon says an existing trust could make it unnecessary for a curator bonis to be appointed to manage your financial affairs in this instance.
There is also the tax advantage of being taxed as a special trust under capital gains tax (CGT) legislation. Special trusts are taxed at the same inclusion rate as natural persons - 25 percent - whereas ordinary inter vivos or testamentary trusts are taxed at a higher rate.
- Trusts are ideal vehicles in which to house assets offshore.
According to Gordon, the relaxation of exchange controls has resulted in more South Africans having offshore assets. She says the ideal vehicle for housing them confidentially is a living trust set up in a properly regulated offshore financial centre such as Guernsey in the Channel Islands.
Such a trust brings some of the benefits mentioned above, including the protection of assets from creditors. You also avoid complex and expensive procedures to wind up your estate overseas when you die.
But she warns: Bear in mind that housing your funds in an offshore trust should not be seen as a way of avoiding tax. A number of tax avoidance measures have been introduced into the Income Tax Act to ensure that this does not happen.
Other advantages of a trust are:
- You can save on an executor's fees and other estate costs which would have been payable had the assets not been transferred to a trust;
- A trust makes it possible to distribute assets to beneficiaries quickly at far less cost and without the delays of administering a deceased estate, because it replaces your will for the purposes of the assets held in the trust;
- After your death and before your estate is wound up (a limbo that can last from six months to many years), the trust can provide a source of funds for your dependants to live on;
- Unlike wills and all the records of a deceased estate, which are public documents and open to public scrutiny, a trust remains confidential;
- A trust enables you, through the trustees, to retain a measure of control over the assets in the trust after your death;
- You can protect minor children and avoid having their inheritance paid into the Guardian's Fund by using a trust;
- A trust can provide financial protection to handicapped dependants, spendthrift children, or beneficiaries with special needs;
- A trust can get around the costs of the administration of successive estates by providing for successive beneficiaries;
- A trust can minimise the emotional stress on your family when you die, as the trust continues without any of the formalities required with a deceased estate;
- A trust potentially offers income tax and CGT savings, especially after your death, by creating a multiplicity of income taxpayers - your heirs - and splitting the income between them. They will pay tax at their individual rates, which is likely to be lower than the rate for trusts; and
- By choosing your trustees wisely, Gordon says, one of the often-overlooked and least-appreciated benefits of a trust is that you can ensure professional asset and investment management.
But beware
Every financial vehicle has its disadvantages as well as its advantages, and trusts are no exception.
- You no longer have total control over your assets - the other trustees will also have a say;
- A trust is registered and can be accessed by the authorities. It is not a place to hide grey money;
- You could choose the wrong trustees. Problems can arise if trustees are rival heirs, which is why you need one trustee to be an independent party; and
- The tax laws could change - as happened in the latest Budget, when the application of CGT to trusts was altered (see below).
How to place your assets in a trust
- You can sell your assets to the trust at market value.
The assets can be sold to the trust with an interest-free or interest-bearing loan - the most common approach. This way, Stofberg says, you sell your assets to the trust and the amount owed to you remains outstanding on loan account. This loan account will still be an asset in your estate for estate duty purposes, and any amount outstanding on the loan when you die will have to be paid to your estate and become liable for estate duty. But all growth in the transferred asset will take place in the trust.
The outstanding balance on the loan can be reduced each year by using the R30 000 donations tax exemption, with the result that the loan decreases by this amount each year.
But Gordon warns: Beware of the CGT implications where a debt owing by a person is reduced or discharged. It may not have donations tax consequences at R30 000 a year, but it will have CGT implications for the trust, which will have to pay this tax on the R30 000.
- You can make a donation to the trust.
But, as Stofberg says, a donation will be subject to donations tax, payable at 20 percent of the market value of the asset donated, subject to the annual exemption of R30 000.
The annual donations tax exemption can be used effectively, he says, by donating R30 000 a year in cash to the trust, and so reducing your estate annually by that amount. The trustees can invest this cash for the benefit of the beneficiaries, while you, the estate owner, have the advantage of reducing your estate and therefore ultimately the estate duty payable when you die. There is also the benefit of the growth in respect of investment taking place in the trust.
CGT and the 2002 Budget
Since the introduction of CGT there have been many discussions about whether it is still worthwhile to use an inter vivos trust as an estate planning tool. The main concerns are the high effective tax rate of the trust (now 20 percent, compared with a natural person's 10 percent) and the fact that the annual exclusion of R10 000 is not available, Stofberg says. This means a trust does not enjoy the annual R10 000 exemption which an individual or special trust has.
In case you're not familiar with CGT, note that tax on a capital gain is levied only when an asset is disposed of and only on gains made since the date of inception of CGT - October 1, 2001. So if your second house has increased in value from R400 000 in October 2000 to R500 000 in October 2002 when you sell it, you will pay CGT only on the portion of the gain made after October 2001. There are various ways of calculating that portion.
For individuals, or natural persons, the inclusion rate at which capital gains are taxed is 25 percent. This means only 25 percent, or a quarter of the capital gain, is taxable. Trusts are taxed more harshly, Gordon points out. The inclusion rate is 50 percent, or half the capital gain. Before this year's Budget, the rate of taxation for trusts was 32 percent on the first R100 000 of taxable income, and 42 percent on taxable income over R100 000.
So, if your trust made a capital gain of R100 000, R50 000 was eligible for tax at a rate of 32 percent. If it made a capital gain of R300 000, R150 000 was taxable, R100 000 at 32 percent and R50 000 at 42 percent. That works out at an effective rate of CGT of 16 percent for sums of R100 000 or less and 21 percent for the portion of gains exceeding R100 000. This year, the Minister of Finance tightened up on the taxation of trusts because, according to Gordon, they are perceived as a way for wealthy people to avoid paying tax.
In Budget 2002 the minister kept the 50 percent inclusion rate, but brought in a flat rate of CGT of 40 percent, which translates to an effective rate of 20 percent. This is double the amount a natural person would pay at the highest marginal rate.
So, who pays?
Not all gains are taxed in the trust, Stofberg points out. In some cases, the trust pays the tax, but in others the tax bill might be placed at your door, as the estate planner, or become the responsibility of the beneficiary. This is not necessarily a bad thing, because if you or the beneficiary pay the tax, you'd pay at the individual's rate and not at the trust rate.
When it comes to who pays the tax, one of the important issues is whether it is a vesting trust or a discretionary trust.
Gordon explains: In a vesting trust, one or more of the beneficiaries has an unconditional entitlement to income and/or assets of the trust in terms of the trust deed, regardless of the trustees' powers.
In a discretionary trust - which is more common among living trusts - the beneficiaries are not entitled to any income or capital until the trustees use their discretionary powers to award a benefit to them.
Until then, beneficiaries of a discretionary trust only have a hope that the trustees will use their discretion to benefit them in terms of the purposes of the trust, as expressed in the trust deed.
This means that:
- If an asset is vested in a beneficiary, the beneficiary pays CGT when the asset is sold, at the beneficiary's (lower) tax rate.
- If the trustees sell, and vest proceeds in the beneficiary in the same year, then again the beneficiary pays the CGT.
- If the trust sells and retains the proceeds, the trust will pay the CGT.
If the asset is transferred to a trust as a result of a donation, settlement or similar disposition, the settlor/donor will be taxed instead of the beneficiary or the trust, because the tax law deems the gain to be the settlor/donor's.
An interest-free loan could be seen as such a disposition. In this case the settlor/donor's tax rate applies.
The future of trusts
The Minister of Finance seems to be encouraging people to hold their assets in their own name instead of in a trust, Van Zyl says.
Trusts are seen as generation-skipping devices which keep money out of circulation, because the assets stay in the trust and no estate duty is payable on the death of the founder of the trust.
Gordon says that although trusts are perceived as a way for wealthy people to avoid paying tax, this fails to take into account that most trusts are set up for other reasons, such as asset protection, family and estate planning, joint holding of divisible assets, the protection of minor beneficiaries or spendthrift adults.
The 2002 Budget may be targeting the business trust environment by discouraging the use of trusts for business purposes and making it more attractive to trade via a company or close corporation which is more transparent.
But, she says, trusts are still useful provided they have not been set up only to avoid tax.
Trusts are taxed more harshly than individuals, so when one sets up a trust, the other benefits must outweigh this fact. It does ensure that trusts are set up for a proper purpose and not as a means of avoiding tax.
And trust income can be split between beneficiaries with lower tax brackets after the founder's death, to ensure taxation at a rate lower than 40 percent. But all taxable income retained in a trust will be taxed at 40 percent without the trust being entitled to the interest or the primary rebates available to individuals or natural persons, Gordon says.
I do not believe that the change to the taxation of trusts to a flat rate of 40 percent will have any meaningful bearing on the use of trusts. There are a number of reasons why trusts are still useful planning tools.
Stofberg spells them out: Using a trust for the protection of personal assets against the risk of business insolvency, solving problems with the division of assets or pegging the value of an estate are still valid reasons for using a trust as part of an estate plan.
The high effective tax rate of a trust can be managed if proper planning is done, and is no reason in itself for not using a trust as part of an estate plan.
He points out that it is important to remember that CGT is payable only when an estate disposes of an asset. When you die, in terms of the law, you are deemed to have disposed of your assets at market value and CGT is payable, depending on the size of your estate. Estate duty is payable, too.
In the case of a living trust, your death does not trigger any CGT in respect of the assets in the trust, nor is estate duty payable on assets in the trust.
When it comes to existing trusts, Gordon says: If there were sound reasons for creating that trust, a small change in the tax rate should not have any effect.
Stofberg agrees: The implementation of CGT has highlighted the need for proper planning when using a trust. Estate owners with an existing trust should re-assess the reasons for setting it up in the first place.
These reasons could still be valid and it could be detrimental to the estate owner if, for example, he transfers trust assets back into his own name.
Van Zyl recommends that people who have already established trusts get professional advice and make sure the administration of all loans and assets is up to date, and all the relevant income tax legislation is complied with.
The last word
It's the old mantra from all our panellists: get expert advice. As Stofberg says: This must take into consideration factors such as the estate owner's needs, his or her age, the growth potential of his or her estate and the tax implications if a trust is used.
Estate planning has become very specialised and estate owners must ensure they are advised by professionals in this field.
Says Gordon: All in all, a living trust is relatively simple and inexpensive to set up and can be made flexible enough to fulfil a variety of needs.
Because of its many potential benefits we believe the living trust will continue to have a major role to play in estate planning, despite the CGT implications and despite the increase in tax to 40 percent.
Van Zyl agrees. Trusts still have a role to play in planning for individuals with assets that will experience high growth, to limit the asset growth in their own hands. But he cautions: I am of the opinion that trusts are oversold to people who don't understand their purpose.
Our panel of FPI experts
The Financial Planning Institute (FPI), formerly the Institute of Life and Pension Advisers, was formed in 1982 to improve the standard of financial advice. Members must pass stringent examinations and abide by a code of conduct, and the institute's Generally Accepted Planning Practice.
Jenny Gordon
is senior legal analyst for Old Mutual's Personal Finance legal services division (marketing) in Gauteng. She has a BA LLB from the University of the Witwatersrand, an LLM (Taxation) from Rand Afri-kaans University, and is a Certified Financial Planner. Gordon is an attorney and was admitted as a Fellow of the Financial Planning Institute in 1992.
Theunis Stofberg
is an estate planning consultant with Old Mutual Trust Estate Plan-ning Services, and specialises in the provision of comprehensive estate planning advice. Stofberg is a qualified attorney with an LLB from Stellenbosch University and an LLM in estate law from the University of Potchefstrom.
Danie van Zyl
has been an independent broker at PSG Consult, based in Pretoria, since 1999. He joined the life assurance in-dustry in 1989 after obtaining a diploma in financial planning from the University of the Free State. Van Zyl lectures on the subject of financial planning and provides face-to-face training to various com-panies and brokers.