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ESTATE PLANING TOOLS - III

Testamentary and life interests trusts

Previous posts discussed wills and joint tenancy as they are used for estate planning. This post is about trusts. There are two different kinds - testamentary, created as a result of death of a will maker, and inter vivos, created during life time of a settlor. There are different types of the inter vivos trusts.

Trusts may be used for tax and non-tax reasons.

General

Income of the inter vivos trusts is taxed at a flat top-rate tax applicable to individuals. Income paid to beneficiaries under the trust is deductible to the trust and is taxed in hands of these beneficiaries. In order to obtain tax benefit tax rates applicable to the beneficiaries should lower that a tax rate applied to the trust.

Once the asset is transferred to a trust, the asset no longer belongs to the transferor and, thus, upon his or her death will not form a part of the estate to be administered and, thus, will not be subject to the probate tax. Prior to transfer of the asset probate tax, the property transfer tax ("PTT") and other costs and expenses should be considered.

Non-tax uses examples are:

  • Asset management and protection;

  • Avoiding compulsory succession;

  • Providing for the disabled.

Asset management and protection

Using a discretionary inter vivos trust provides for flexibility: the settlor can delegate making decisions to the trustees to be made pursuant to certain specific terms but at their discretion over time once the circumstances evolve and change rather than making those decisions once and for all. For example, giving an asset to a child, who is most likely to squander the funds, is not as prudent as, subject to the fraudulent conveyance under the Wills, Estates and Succession Act ("WESA"), transferring this asset into a trust for that child with provisions of distributing income for the benefit of the child.

It is often difficult for the creditor to attack the debtor's interest in a discretionary trust because the value of that interest depends upon decisions of the trustees. The terms of the trust may include special provisions for further protection of the asset, such as for the child to be disqualified as beneficiary if that child becomes bankrupt. Or the trust itself may be created in a jurisdiction with asset protection trust legislation which will preclude the trust from being sued or challenged.

However, in a family law context, the efficiency of a trust as an effective asset protection tool is not as certain, especially now, when the new Family Law Act came into force. The new act extended property rights and their division to common-law relationships. It also introduced an excluded property regime, which increases the uncertainty as to which property is subject to division, including interests under the trusts.

Avoiding compulsory succession

In order to avoid wills variation claims under the WESA and restore the testamentary freedom the inter vivos trusts can be used: person settles a trust for the benefit of all persons to whom he or she wishes to distribute the estate. Since there is no will, provisions in relation to its variation do not apply. Unhappy children and spouses may try to challenge the transfer to the trust as avoidance of the wills variation provisions, however, the courts usually refrain from varying trusts.

Providing for the disabled

In order to be entitled to receive provincial disability benefits a disabled person should receive a certain amount of income and if the entire asset is transferred to the disabled person outright, he or she may not qualify. Trusts are often used to provide for the disabled, they can be structured so that not to disentitle the disabled person from receiving provincial disability benefits. The benefits are not necessarily monetary, they include access to programs and services that can be invaluable, and thus, it is important to retain their use.

Types of Trusts

Testamentary Trusts

Testamentary trusts are created by the will and as a consequence of the death of the testator. Testamentary trusts, unlike inter vivos trusts, are subject to marginal rates applicable to the individuals. Before recently, application of marginal rates to its income combined with the fact that testamentary trust can endure for the lifetime(s) of successive beneficiaries for a long time after the death of the testator was the principal benefit of such trust. However, applicable to taxation years after 2015 availability of graduated tax rate is restricted to the first three years of existence of the estate, which qualifies as the Graduated Rate Estate (the "GRE"), other than an estate for a disabled beneficiary. After this three-year period expires the trust will be subject to flat top tax rate.

Only one estate can qualify as the GRE, so in situations where there are multiple wills, the decision should be made as to which estate will be the GRE. There are also rules for the GRE to keep its status and they should be carefully observed, including making sure that the GRE has enough funds to pay its debts.

Spousal Trusts

Spousal trusts may be used for inter vivos (lifetime) gifts or testamentary bequests. Spousal or common-law partner trust is a trust created for the exclusive benefit of the taxpayer's spouse or common law partner, collectively "spouse". To qualify as a spousal trust its deed must provide:

  • the living beneficiary spouse is the only one entitled to receive any and all the income that may arise during the lifetime of that spouse (spouse will pay the tax on such income received from the trust); and
  • no person except the spouse may receive, or get the use of, any income or capital of the trust during his or her lifetime. For testamentary trusts this requirement that no other person can receive or obtain the use of capital does not mean that the spouse will receive the capital. A will that sets up the spousal trust may also provide as to who will be entitled to the remainder after the spouses' death (children, for example), thus, creating a life estate for a spouse.

    A spousal trust is a will substitute, but since a spousal trust is deemed to have disposed of its property for fair market value on the date of the spouse's death setting up a spousal trust during the transferor's life will lead to premature tax liability in the event the spouse, for whom the trust is set up, predeceases the transferor. Thus, this type of trust is more often set up by the transferor in a will, so that the trust will be in effect at the time the transferor dies with the capital property rolling into the surviving spouse spousal trust on tax deferred basis.

    Alter Ego Trusts

    Alter Ego trusts may be created by persons of 65 years of age and older who wish to create an inter vivos trust for their primary benefit. The settlor(s) must be the only people entitled to receive all of the income or capital from the trust while they are living.

    Capital property can be contributed income tax-free to these trusts. The alter ego trust is not subject to 21 year rule, provided that the trust does not make an election under the Income Tax Act ("ITA") to be subject to the 21 year rule. Income from property and capital gains realized by the alter ego trust is normally attributed to the settlor.

    Joint Spousal Trusts

    Joint spousal and common-law partner trust (joint spousal trusts) are created by individuals who are 65 and older, who wish to set up an inter vivos trust for the benefit of the settlor and the settlor's spouse. Only one spouse must be 65, the other can be any age at all. The joint spousal trusts are not subject to the 21 year rule. Capital property can generally be contributed income tax-free to these trusts.

    Common Elements of Spousal, Alter Ego and Joint Spousal Trusts

    Only capital property is rolled

    Tax free (income) transfer applies only to capital property, not goodwill, inventory or resource property, for example. Transfer will automatically occur on a tax-deferred basis unless the transferor elects otherwise. The transferor may elect to do the transfer on fully taxable basis. In that event section 69(1) of the ITA will apply deeming taxpayer to have received proceeds equal to the fair market value. There is an opportunity to transfer part of the capital property on deferred basis and part on fully taxed basis. For example, if the property being transferred is shares, total number of those shares may be divided into 2 parts with one transferred on tax-free basis and the other on fully taxable basis. If the property transferred is a single house, interest in the house can be divided and transferred in 2 transactions.

    Property Transfer Tax

    Transfer of real estate into the trust is usually subject to the tax under the Property Transfer Tax Act, unless specifically exempted. The property transfer tax ("PTT") applies at a rate of 1% on the first $200,000, 2% on the value between 200,000 and 2,000,000 and 3% thereafter. Paying PTT may not be justified by avoiding probate tax at 1.4% on the value of the estate above $50,000 and incurring top tax rates on deemed disposition.

    However, there are limited exemptions from PTT, for example, transfer of principal residence from parent to a child is exempt even if the child takes the property as a trustee of an alter ego or joint spousal trust.

    Lifetime capital gain exemption availability

    Access to the life time exemption upon the death of a spouse is not available for the spousal trusts, alter ego trusts or joint spousal trusts. Subsection 110.6(12) that specifically excluded alter ego and joint spousal trusts but permitted the spousal trusts to utilize any part of the lifetime exemption the deceased spouse was entitled to use but did not use was repealed in 2014.

    If a capital gain is realized by the trust during the lifetime of the settlor/surviving spouse, they may be able to claim the capital gains exemption under subsections 75(2) (provides for attribution) and 74.2(2) (provides for application of 110.6 upon such attribution that allows the use of the exemption by the person the gain was attributed to).

    Principal residence exemption

    Principal residence exemption is available and can be claimed by the spousal, alter ego and joint spousal trusts.

    Residency requirement

    The transferor and the spouse must be residents of Canada. If the transferor leaves Canada there will be deemed disposition of the trust assets when the transferor leaves.

    Deemed disposition

    A taxpayer is usually deemed to have disposed of his or her capital property immediately before death. If the property is transferred to trust, its deemed disposition occurs at the end of the day the relevant person dies as follows:

  • Spousal trust death of the spouse
  • Alter ego trust death of the settlor/beneficiary
  • Joint spousal trust death of the surviving spouse

Attribution rules

75(2) - applies if settlor is capital beneficiary or a controlling trustee. To avoid application:

  • settlor may be only income beneficiary and not the capital one;
  • settlor may also be one of the 3 trustees with the majority rule, thus, he or she will not be a controlling trustee;

    74.3(1) - spousal attribution rules; can be avoided by:

  • Retaining capital gains in trust;
  • Selling property to the trust (consider taxable transaction);
  • Lending property to the trust (commercial loan exception under 74.5(2));
  • Making designation under 104(13.1) or (13.2): income or capital paid to the beneficiary taxed in the trust (consider top tax rate).

    Benefits

  • Tax deferral to the time of death of the surviving spouse (spousal), settlor (alter ego) or second to die (joint spousal);
  • Protection from possible abuse by greedy relatives of an elderly spouse (spousal), settlor (alter ego) or both spouses and a surviving spouse (joint spousal);
  • Capital may be left to residual beneficiaries. Especially of interest for persons in their second or third marriage, who wish to support their spouses but also want to pass their assets to the children, including the ones from their previous marriages;
  • No probate;
  • Confidentiality (since the assets will not be subject to public record as the ones that go through probate);
  • Protection of the settlor's desired distribution of his or her assets from challenges by relatives that feel left out. Those who disagree with their inheritance or lack thereof could demand a will to be varied and the will might be so varied, but current provincial laws do not favor varying a trust;

Drawbacks

  • The use of an alter ego or joint spousal trust may result in increased tax liability on death, as gains realized in the trust cannot be offset by losses or unused exemptions of the settlor or his or her surviving spouse in their final returns. Thus, if the taxpayer is expected to be in a low marginal tax bracket or to have unused losses at the date of death, it may not be tax efficient to settle the properties into an alter ego trust subject to the top rate tax. If a power of encroachment has been retained, it might be beneficial to review the trust assets from time to time and return assets to the individual if a better overall tax result would be achieved by the taxation of that asset in his or her hands. Prudent planning might dictate a search for assets with potential losses in the individual's hands that could be rolled into the trust and used against gains resulting from the deemed disposition;
  • Real estate transfers may be subject to property transfer tax in certain provinces (for example, BC);
  • Since no person except for the settlor may receive or otherwise obtain the use of any of the trust's capital or income during the settlor's lifetime, the settlor's interest in the trust may be attacked by the taxpayer's creditors. If this is a concern, the settlor should have only an income interest in the trust to protect trust assets from creditors. Such term will also prevent attribution rules from applying.

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