The Use of Trusts
Trusts offer flexibility in financial and tax planning. They are often used to gift assets to various beneficiaries without relinquishing all assets or full control over to them all at once. They are not tax shelters, but they allow for control of finances, timing of disbursements, income splitting potential, allows for many beneficiaries, can last for generations, and allow for financial privacy. Assets in a Trust are not deemed a part of the “estate” for probate, which can minimize probate fees and are less likely to be contested. This information I provide is intended to outline the various choices available. Please consult an estate lawyer/tax expert before implementing any of these suggestions. Trust laws vary by province and Quebec has its own very different set of laws beyond the scope of this article and this information is not intended for Quebec residents or others with dual US and CDN citizenship.
Main Constructs of Trusts:
- A legal relationship between three parties – the Settlor, the Trustee(s), and the Beneficiaries.
- The Settlor contributes assets to the trust and sets out the instructions on how the assets are to be managed and used, and who will benefit from the Trust.
- The Trustee is a person, or group of people that is appointed to follow the rules set out by the settlor. The settlor can also be a trustee. In fact, the settlor can be all three – settlor, trustee, and beneficiary.
- Beneficiaries are person(s) who will benefit from the Trust. Beneficiaries can also include people not yet born – such as great grandchildren and beyond.
- In most provinces, Trusts are deemed disposed every 21 years for tax purposes on income and capital gains.
Two Main Types of Personal Trusts:
A personal Trust is where the assets are transferred as a “gift” to the trust. Beneficiaries do not pay for the benefit of being included.
- Testamentary Trust – created through the Will, and activated upon death of the Settlor.
- Inter-vivos Trust – created by the Settlor, and activated during the Settlor’s lifetime.
Testamentary Trusts were used more often due to the graduated tax rates previously allowed. However, as the tax benefits are being tightened now, in many cases it makes sense to transfer assets to a Trust while still alive (Inter-vivos) for added control and earlier income splitting potential. An example of income splitting is with minor children who are in a lower tax bracket. One could use income from the Trust to pay expenses – such as private schooling or summer camps, which would be taxed in the lower bracket child. Consult a tax expert to understand when “kiddie tax” or attribution rules might apply.
- Discretionary Trust – is where the Settlor has given discretion to the Trustees to decide when/or how much to distribute from the trust to the beneficiaries of either income or capital.
- Non-Discretionary Trust – is where the Trustee does not have discretion and must follow the rules as set out by the Settlor in the Trust Agreement.
- A Trust can have features of both, discretion and non-discretion – such as distributions of income or capital of the trust. This would be noted in the rules of the Trust during its set-up. For example, a Trustee may have to flow all income to the beneficiaries each year, but may be allowed discretion on when and how much capital to distribute. Rules such as age of the beneficiary or life circumstances can be outlined in the doctrine.
- The main purpose is to pass assets to certain beneficiaries while Settlor is still alive without passing full control to the beneficiary.
- Useful for family financial planning and tax planning objectives.
- The Trust must file annual taxes like an individual. However, there are no personal tax credits, tax rates are no longer graduated, and are typically at the highest rate.
- Taxes on income can be passed to beneficiaries hands as opposed to the Trust (with certain conditions)
- Often used for transferring non-income producing assets such as real property or investments likely to produce capital gains – although it can be used to supply income needs as well.
- The Trust is set up through provisions made in the Will.
- There is little chance of income attribution rules back to Settlor.
- More than one Trust can be set up. However if they are similar, the CRA can look at it as one Trust for tax purposes.
- This Trust can have a year-end that does not coincide with a typical calendar year end which can be beneficial for deferral taxes for a year on income received by beneficiaries.
- These Trusts will no longer benefit from graduated tax rates after 2016 – except for the first 36 months, unless at least one beneficiary qualifies for the Federal Disability Tax credit – also known as Qualified Disability Trusts.
Like the previous Trusts mentioned, there are three parties to this Trust as well. The key difference is that the Trustee doesn’t really have any active duties except to take instructions from the beneficiaries. Often the beneficiary is also the Settlor.
- Bare trusts are usually used to hold title to real property – such as land or building and often used in cases where many beneficiaries are involved and title is being transferred, or a new purchase is being made.
- The Trustee has no significant real powers.
- The Trust is ignored for tax purposes (does not file a return) instead, the assets are reportable for tax purposes to the actual owner (s) (person). It can be viewed that there is full attribution of taxes to beneficiaries.
This type of Trust can be Inter-vivos or Testamentary. It can be discretionary or non-discretionary. This Trust is used to benefit existing and un-born family members. Trusts of this nature can be very beneficial for wealthy families to keep assets within the family, and potentially away from marital asset calculations if a beneficiary gets a divorce from a spouse, or if other legal issues arise with creditors. A separate Trust should be used for other purposes such as a charitable Trust in order to benefit from charitable tax credits.
Alter Ego Trusts:
- Set up while alive (Inter-vivos).
- Settlors must be sole beneficiaries of income and capital from the Trust during their lifetime.
- Can be joint with a spouse (or common law)
- Upon last to die, if joint with spouse, the Trust is deemed disposed for tax purposes and the assets go to the ultimate beneficiaries.
- One spouse must be at least 65 years old in order to set-up this Trust.
- By-passes estate for probate purposes, and is harder to contest.
Recent tax changes upon last to die may prove difficult for some using this Trust, as the deemed disposition taxes are paid by the “estate” of the last to die and no longer from the Trust. If the assets of the Trust have been passed onto the beneficiaries this may complicate things for other non-Trust beneficiaries of the estate. For example, children from a previous marriage could be named in the Will to inherent a property not listed in the Trust, yet the property may have to be liquidated to pay for the taxes risen from the Trust, diminishing the value of the estate, but not the Trust.
- Usually done as a Testamentary Trust on a tax rollover (no deemed disposition until Spouse dies).
- The spouse may benefit from income or capital or both, depending on the rules governing the Trust.
- Caution is warranted if done Inter-vivos because income may be attributed back to the Settlor for tax purposes.
- Often beneficial for second marriages, as the assets of the Trust will eventually be passed to the ultimate named beneficiaries of the Settlor after the death of the spouse.
- In some situations, it can be beneficial to avoid the co-mingling of assets in a situation where the spouse re-marries another after the death of the Settlor.
- Sometimes known as an “Estate Freeze”.
- The current common shareholder takes the current value of shares and transfers them to preferred shares at the established value. The preferred share holder can draw upon the value of the preferred shares to live on.
- New common shares are issued and future growth of the corporation is attributed to the new common shareholders.
- Often the common shares are put into a Family Trust.
- If shares are from a qualified small business, the beneficiaries of the common shares will also benefit from the lifetime capital gains exemption in the future.
- A “freeze” also reduces the taxes on an estate. A Trust is not necessary for an effective “freeze”.
Borrowed Funding for Trusts:
- Once the Trust is established, a loan can be used to fund the Trust. Interest must be at the prescribed rate, and should be paid using income derived from the Trust to avoid attribution back to the Settlor.
Charitable Remainder Trusts:
- When a gift is to be made to a charity and income is distributed for a long period of time, or for a specified amount of time such as 10 years. After which the remaining assets are given to the Charity in full.
- This Trust is irrevocable – meaning it is a true gift and cannot be taken back.
- The donor receives an immediate charitable receipt for the value of the donation made.
- It’s possible to initially start with a spousal trust and have the remainder of the assets upon last to die immediately go into a Charitable Remainder Trust. The tax credit can be applied to the final tax bill of the first to die (however, the value of the credit may be subject to “time value” actuarial estimate of life expectancy of surviving spouse).
- Set up by corporations or wealthy families.
- Must be approved and granted Registered Charity Status by the CRA
- Extensive set-up and ongoing accounting and auditing.
- These are not “private” and are subject to public scrutiny.
- The foundation can issue tax receipts to the donors.
- Most donations are considered given without conditions – however it’s possible to establish some conditions, in which case the donation is termed an endowment.
- Can have a charity as beneficiary
- Can be used to fund a Trust upon death.
- Can be used to pay for estate taxes resulting from various deemed dispositions
In general, a Trust is used to distribute assets and income in a very specific and controlled fashioned and at a specific time in the Settlor’s life – during, or upon death. It is usually creditor proof, allocated to intended beneficiaries only, private, typically by-passes the estate for probate purposes, difficult to contest, and can last for generations. There are still income splitting opportunities, especially useful if the Settlor is currently in a high tax bracket, and can pass some of the tax liability to others in the family, but it is not a tax shelter, however some deferral of tax is possible.
There are other Will substitutes that can be used to distribute assets easily and quickly by-passing the Will – such as beneficiary designations on TFSA’s, RRSP’s and insurance policies. Other methods are holding assets jointly, or simply gifting assets over time.
In order to establish the benefits or the necessity of a Trust, I always start with a personalized financial plan. This gives an indication of the time value of net growth of certain assets, along with its income potential and longevity of income. A financial plan will also give a good estimate of the size of a potential estate as well as tax liabilities at different age points of a Settlor. A discussion of goals and objectives are crucial when deciding on Trusts and/or Will substitutes as well as an examination of rules in the province that the Trust is being set up in.
For more information regarding your personal circumstances contact me directly
Susan Mallin, CIM, CFP
Associate Portfolio Manager, Vice-President of Financial Planning
Lorne Steinberg Wealth Management