By Hilary Dudley, Managing Director, Citadel Fiduciary Proprietary Limited
Increasing focus on trusts by revenue authorities, both locally and offshore, has created the perception that trusts are being targeted – especially from a tax perspective – and that they are going to become obsolete. The question now is should trusts still be used in estate planning, or has their star faded?
According to Citadel Fiduciary (Pty) Ltd Managing Director Hilary Dudley, trusts still have an important role to play within estate planning if they are formed for the right reasons, offering benefits such as asset protection and continuity.
“That said, it has become much more expensive to hold assets within a trust, and there are less tax planning opportunities now than during the 1970s, when trusts were not even subject to tax,” she notes.
“If your sole objective in forming a trust is to obtain a tax benefit, then you are likely to be disappointed at some point in the future.”
She notes, however, that trusts still offer a number of other highly attractive benefits, and can be an extremely useful tool within estate planning.
“Ultimately, the trust concept has been around for a long time and is unlikely to die any time soon. There are many issues to take into account and we recommend that you speak to a fiduciary advisor before making the decision to form a new trust or to terminate an existing one. This is especially relevant if you or your heirs are planning on emigrating to another country, as tax residence and exchange control issues would become particularly important.”
Key changes to the taxation of trusts
The main change in the taxation of trusts in recent years was the introduction of section 7C of the Income Tax Act, which came into effect from 1 March 2017. This section applies the official rate of interest to low-interest or interest-free loans made to trusts. This was presumably implemented in order to make it more expensive for individuals to transfer assets to trusts.
From a tax point of view, this legislation has made it more costly to fund a trust by means of a loan account. However, it should be noted that this is not the only way to fund a trust, says Dudley.
The only other major change implemented in recent times is the introduction of a stepped rate of estate duty and donations tax. From 1 March 2018, the value of estates and donations above R30 million are taxed at 25% rather than 20%.
The introduction of a stepped rate of estate duty perhaps strengthens the argument for the use of trusts in estate planning, particularly where multi-generational assets such as farms or holiday homes are involved, she explains.
“Although a trust is taxed at a higher rate on, for example, income (45%) and capital gains (36%) than an individual, a trust is a legal person rather than a natural person or a human being, and accordingly it is not subject to estate duty or death taxes. If a holiday home or a farm is held in the name of the individual family members, the family would be liable to pay estate duty on that asset on the death of each individual owner as it passes from one generation to the next. This could become particularly onerous from a liquidity perspective if large amounts of estate duty are paid every generation,” she says.
Additionally, growing awareness of global issues such as situs tax further evidences the value of trusts in estate planning. Situs tax is the name for a death tax levied on assets located in countries such as the United Kingdom and United States, even when they are owned by non-residents of that country.
Although there are rules in place to prevent paying tax on the same assets twice (double tax), an issue may arise if the tax in the foreign country is levied at a higher rate than in South Africa. In the UK and the US the rates of death tax is up to 40%, whereas in South Africa it is a maximum of 25%. Individuals could therefore end up paying death tax on their assets at a higher rate.
Given the exchange control restrictions on holding direct offshore investments in local trusts, South Africans may consider the use of offshore trusts to achieve the same estate planning objectives.
Additional key benefits of trusts:
Dudley notes that there are a number of other key benefits to using trusts in estate planning, including:
1. Access to funds:
While a deceased breadwinner’s estate is being wound up, it may be difficult for his or her dependants to obtain the required maintenance from the estate – which is a growing concern given the increasingly prolonged process around finalising deceased estates.
However, if the breadwinner founded a trust during his or her lifetime, the dependants would have access to a separate source of maintenance that is not affected by the process of winding up the deceased estate.
Of course, an alternative source of income may be a life insurance policy payable directly to the beneficiaries, but this can present its own issues such as possibly increasing the estate duty payable (depending on who is the beneficiary), being expensive and potentially proving difficult to obtain if the life insured has pre-existing health issues.
2. Avoiding curatorship issues:
A trust can help individuals who are incapacitated through a disease or disability such as Alzheimer’s or senile dementia. If you have formed a trust during your lifetime (an inter vivos trust), and the bulk of your assets have been placed into trust, then your family’s financial well-being will be assured even if you are no longer able to manage your own financial affairs.
Entrepreneurs and businesspeople oftentimes do not have the time or skill to dedicate to the proper management of their personal affairs, which are consequently neglected. By forming a trust and appointing skilled trustees to actively administer assets and provide objective advice and governance, your personal affairs can be managed with minimal attention from you during your lifetime and minimal disruption after your death. This also reduces the difficulties frequently suffered by heirs who suddenly have to make decisions on matters of which they have little or no knowledge.
Trusts provide a fortification for the protection of assets against attack, for example by business or personal creditors, disgruntled spouses, delinquent heirs and so on. Save for any assets vested in or a loan owing to an individual, trust assets cannot be attached to satisfy a person’s or beneficiary’s debts. This is because they are not owned by the individual or the beneficiary, but rather by the trustees in their capacity as such. In the case of a discretionary trust, a beneficiary’s creditors cannot even attach any potential income owing to the beneficiary from the trust.
5. Special needs family members:
You may wish to form a special trust for the sole benefit of a family member who has special needs, or a mental or physical disability which renders them incapable of earning enough money for their care or managing their own financial matters. The requirements for the registration of a special trust with SARS are stringent and must be supported by evidence such as doctors’ reports confirming the beneficiary’s physical or mental challenges, but the benefit of a special trust is that it is taxed at the individual marginal rate of tax, rather than at the flat trust rate of 45% on income and effective 36% on capital gains.
Individuals who do not qualify for a special trust, but who are practically unable to manage their finances owing to alcohol or drug dependency, old age and so on, may also benefit from the structure, mentorship and oversight provided by a well-governed trust despite not receiving the same tax benefit as a special trust.
6. Wealth preservation:
The Davis Tax Committee was of the view that the intergenerational transfer of wealth dampened commercial activity and entrepreneurial spirit by creating “trustafarians”. On the contrary, a well-run trust allows succeeding generations to participate in and benefit from the wealth created in one generation by allowing wealth to be managed and distributed to beneficiaries across generations.
By creating a trust, a preceding generation can improve their descendants’ lifestyles without creating a dependency on inherited wealth, thus avoiding a situation where talent is wasted because there is no financial need to develop it, or where one generation’s wealth becomes a disincentive for the next generation. In practice, trusts generally tend to exist for no more than two or three generations before vesting occurs.