Estate Planning

Types of Trusts

Trusts are often an integral component of an estate plan. Trusts essentially permit the separation of legal and beneficial ownership of property. This may be important, for example, where there are minor beneficiaries of an estate, who are too young to properly manage their inheritance. In this case a third party who you “trust” can be appointed as trustee for the minors, to manage the property and make distributions for the benefit of the beneficiaries until they have at least attained the age of majority. The two main categories of trusts are testamentary and inter
vivos trusts.

Testamentary Trusts

A testamentary trust is a trust that arises upon the death of the testator. When the person dies, the trust begins, based on the directions of the testator as outlined in their Will. The Will appoints the trustee, identifies the beneficiaries of the trust, and sets out other terms and conditions of the trust.

There are many advantages of using a testamentary trust, including:

  • Ensuring proper management of gifts made minors and/or incapable beneficiaries;
  • Establishing a spousal trust to defer capital gains tax on death while achieving certain other estate planning goals;
  • Controlling the distribution of income and capital to beneficiaries.  Often, assets will remain in the trust until a child reaches age 25-30, subject to discretionary payments that can be made by the trustees at any time;
  • Protecting (gifts to beneficiaries from potential creditors of those beneficiaries;

Creating potential family law protection for gifted assets where there is a breakdown of the beneficiary’s marriage or common-law relationship. However, one tax benefit of using a testamentary trust has recently been withdrawn. In the past, a testamentary trust was treated as separate taxpayer and therefore eligible for graduated marginal tax rates. Essentially, this allowed “income splitting” between the trust and beneficiaries, resulting in lower taxes as compared to this income being fully taxed to a beneficiary at their marginal tax rate. But starting in 2016, all income retained in a testamentary trust is taxed at the highest marginal tax rate, eliminating this tax advantage. There is an exception for a testamentary trust that meets the requirements to qualify as a Graduated Rate Estate (GRE). A GRE is eligible for graduated tax rates on retained income for 36 months following the creation of the testamentary trust. There can only be one GRE for each deceased person, and the trust must elect to be a GRE in its first tax return to qualify for this status.

Spousal Trust

A spousal trust is a type of testamentary trust meant to provide for a spouse after the testator’s death. There are two main requirements of a valid spousal trust:

  1. The surviving spouse must be entitled to receive all the income from the trust during their lifetime.
  2. No person other than the spouse can receive, use, or have the benefits of the capital of the trust during the spouse’s lifetime.

One of the main reasons to use a spousal trust for estate planning purposes is to take advantage of the spousal rollover provision. For example, assume a husband owns shares in a company which he had started up with little capital investment (meaning the cost base of his shares is essentially $0) and those shares are now worth $10 million. On his death, he will be deemed to have disposed of those shares at their fair market value and his estate will have a $10 million capital gain, half of which would be taxable. If, however, he transfers those shares to his spouse under his will, on his death the shares will “rollover” to his spouse on a tax-free basis, thus deferring the capital gains tax liability until the spouse’s death.

However, the husband may not want the spouse to directly own those shares. For example, he may want the income from those shares to be used for the benefit of his wife, while transferring the shares to his children upon her death. In this case, a spousal trust can be used, and the transfer will qualify for the same rollover treatment available on the transfer to a spouse. Tax on the gain is therefore deferred until a later disposition of the property. Spousal trusts are subject to a deemed disposition on the death of the surviving spouse and every 21 years thereafter.

If a spousal trust is established to defer the capital gains tax, then a joint second-to-die life insurance policy may be used to fund the ultimate tax liability that will arise on the death of the surviving spouse.

Inter Vivos Trusts

An inter vivos trust, or living trust, is created and comes into existence during the lifetime of the person creating the trust, known as the settlor. The duration and terms of the trust are typically set out is a trust agreement that becomes effective once the trust is created. As part of the terms of the trust, one or more trustees are appointed to manage the property of the trust as provided in the trust agreement. The terms of an inter vivos trust may permit the distribution of the trust assets to the named beneficiaries during or after the settlor’s life. An inter vivos trust will be subject to a deemed disposition of its assets every 21 years (from the date of creation), unless planning is undertaken prior to that time. Generally, assets held in an inter vivos trust can be distributed on a rollover basis to any Canadian resident beneficiaries prior to the 21st anniversary of the trust.

The transfer of assets into an inter vivos trust typically takes place at fair market value. However, it is possible to transfer property to an inter vivos spousal trust (which meets the same criteria as a testamentary spousal trust) on a rollover basis. Instead, there is a deemed disposition of the assets held by the trust on the death of the surviving spouse and then every 21 years thereafter.

An family trust that is established as part of an Estate Freeze transaction is an inter vivos trust and as such may be subject to the 21-year deemed disposition rule without proper
advance planning.