Until recently, the use of inter vivos trusts in estate planning was not common because of the negative tax consequences of establishing a regular inter vivos trust. However, the recent amendments to the Income Tax Act that permit “alter ego” and “joint partner” trusts will make estate planning with inter vivos trusts much more advantageous for many Canadians. This newsletter contains an overview of these types of trusts and their applicability in estate planning.

What is a Trust?

A trust is a legal arrangement whereby a person (the “settlor”) gives property to another person (the “trustee”) to hold for the benefit of one or more persons (the “beneficiaries”). Trusts established while a settlor is alive are called “inter vivos trusts”. A legal document which sets out the terms of an inter vivos trust is usually necessary. “Testamentary trusts” are trusts that are created by will and arise on death.

The terms of the trust can provide for the payment of income or capital or both to the beneficiaries. Either the interests of the beneficiaries can be fixed, or discretion to allocate the income and capital among the beneficiaries can be left to the trustee.

Although the beneficiaries of the trust have an interest in the trust assets, the trustee is the legal owner of the property held in the trust and has the authority to control the management of the assets. The trustee’s obligations include making decisions about the investment of the trust assets and preparing and filing tax returns on behalf of the trust. As a fiduciary, the trustee has a duty to act in the best interests of the beneficiaries.

What is an Alter Ego Trust?

An alter ego trust is an inter vivos trust that meets four requirements set out in the Income Tax Act.

First, it must be settled by an individual who is at least 65 years old at the time the trust is created.

Second, it must be settled after 1999 - an older trust cannot be used for this purpose.

Third, both the settlor - you - and the trust must be resident in Canada. (The residence of the trust is linked to where the trustees reside.)

Fourth, the terms of the trust must provide that the you are the only person entitled to receive any capital or income from the trust during your lifetime, and you must be entitled to receive all of the income arising during your lifetime.

If these simple requirements are met, the trust will be an alter ego trust under the Income Tax Act. There are no restrictions on the other provisions of the trust, such as what happens to the trust property after your death. For simplicity, this newsletter only refers to an “alter ego” trust. The tax attributes and issues relating to “joint spousal or common law partner trusts”, commonly called “joint partner trusts”, are essentially the same. The main difference is that in a joint partner trust only you - the settlor - and your spouse or common-law partner may receive income from the trust arising before the death of you and your spouse or common-law partner. All other attributes are essentially the same.

Why is an Alter Ego Trust Attractive?

The main benefit to using an alter ego trust instead of a regular inter vivos trust is the favourable income tax treatment of the transfer of assets to the trust. For other trusts, transfers to the trust result in a disposition at fair market value, often resulting in capital gains. With an alter ego trust, a rollover is available to a “qualifying transfer” under the Income Tax Act. Under the rollover, capital property is deemed to be transferred to the trust at its adjusted cost base, thereby triggering no gain on the disposition to the trust.

No election form is required. However, a trust can elect out of the rollover treatment for some or all the capital property transferred to the trust. This may be appropriate if you have capital losses which can be used to offset gains on the disposition or if the assets transferred to the trust include qualified small business corporation shares where the enhanced capital gain exemption of the Income Tax Act may be available.

An additional benefit to an alter ego trust is that the 21 year deemed disposition rule in the Income Tax Act that applies to other trusts does not begin to apply until your death. While there is a deemed disposition within the trust on the day you die, to the extent assets remain in the trust, the 21 years only starts running from that date. This can provide an advantage over a regular inter vivos trust where the 21 year rule begins when the trust is created.

An alter ego trust (but not a joint partner trust), can elect out of this treatment so that the 21 year rule starts running from the date of settlement. This may be attractive where the alter ego trust is structured as a charitable remainder trust (see discussion below). In that case, you would also elect out of the rollover, creating a capital gain on the transfer of assets into the trust but with the offsetting donation tax credit issued by the charitable remainder beneficiary. Electing out of the 21 year rule avoids an additional taxable disposition on your death, assuming you will not live at least 21 years.

A trust which does not receive rollover treatment on transfers to it and has the usual 21 year rule is generally no different than a regular inter vivos trust. As a result, there is probably no restriction on distributions to other beneficiaries during your lifetime. If this is your situation, an alter ego trust is not required.

Taxation of Trust Income and Gain

Generally, all income and any capital gains will be taxed in your hands during your lifetime as the settlor of an alter ego trust. On your death, the trust is deemed to dispose of its assets at the then fair market value and any accrued gains or losses will be realized in the trust and taxed at the highest marginal rate at that time. In some cases this will result in more tax being paid on the capital gain than would have been the case if the gain was taxed in your hands. Further, this can create problems where losses may be trapped in the trust. Capital losses at that time cannot be transferred to your estate to offset gains. These disadvantages must be weighed against the significant advantages of using an alter ego trust.

Why Would An Alter Ego Trust Be Used?

There are several reasons why an alter ego trust might be appropriate for you:

• 1. Probate avoidance - because the assets in the trust pass on your death under the terms of the trust and not through your will, alter ego trusts avoid probate. Therefore, no probate tax is payable on the value of those assets. Currently in Nova Scotia, probate tax of 1.3% is payable on assets passing through your estate. Further, administration of the assets held by the trust can be maintained by the trustees without any change in continuity. Finally, the distribution of the assets and their value remain private. (For more details on probate avoidance planning, see John Arnold’s article “Avoiding Probate Part I” on our website.)

• 2. Creditor protection - using an alter ego trust may provide some measure of creditor protection to your estate. This can include claims under the Testators’ Family Maintenance Act (because the property does not pass through your estate) and possibly the Matrimonial Property Act. Further, an alter ego trust can achieve a measure of protection from your general creditors, both during life (at least with respect to the capital) and upon death. Provided the necessary prerequisites are met, those assets may escape claims that arise after the date of settlement. Significantly, the Provincial Government through the Department of Health when enforcing payment of nursing home costs is also a creditor of your estate. If you establish an alter ego trust that is irrevocable, and there is no power of capital encroachment, the capital value of the assets in the trust should be protected from nursing home claims. However, the income from the trust would be available to pay the nursing home costs. Care must be taken to address the two year “look-back” period. For more information on nursing home planning, see our recently updated article called “Protect Your Property From Nursing Home Costs”

• 3. Incapacity planning - an alter ego trust can function as an alternative for an enduring power of attorney for property in the event of your incapacity. As long as the trust agreement permits the appointment of substitute trustees in the event of your incapacity as sole trustee (or, alternatively, has other trustees appointed at the outset), using the trust will ensure continued administration of the assets in the trust notwithstanding your incapacity. An attorney for personal care is still required.

• 4. Confidentiality - trusts are not a matter of public record. The identity of your beneficiaries and the value of the property you put in an alter ego trust generally can be kept confidential.

• 5. Beneficiaries with special needs - the terms of an alter ego trust can provide continued protection after your death for beneficiaries with special needs. This can include spendthrift beneficiaries, minors or disabled beneficiaries.

• 6. Charitable giving - an alter ego trust can operate as a form of charitable remainder trust. Such a trust may be appropriate if you want to leave a portion of your estate to charity but need those assets to support your current lifestyle. A charitable remainder trust is created by putting assets into an irrevocable trust. The charity is named residual beneficiary of the trust. As the settlor of the trust, you will qualify for a tax credit equal to a portion of the value of the assets transferred to the trust. The older you are, the higher that portion will be. In order to obtain these tax benefits, you cannot have access to the capital of the trust. The trust provides income to you for your lifetime and the capital (the residual interest or remainder) passes to the charity on your death.

Other Considerations

There are many other considerations that you should take into account when deciding whether an alter ego trust is appropriate for your circumstances. These include:

1. Cost and complexity - in addition to legal fees to advise you on the details of the operations of the trust and to draft the trust agreement, there is a cost to the transfer of assets to the trust. Legal fees vary depending on the degree of customization necessary in the trust agreement and the time required to transfer assets to the trust. Likely, there will also be accounting fees for doing tax returns each year for the trust. An alter ego trust, as a separate taxpayer under the Income Tax Act, must file a tax return each year commencing with the year in which the trust is settled. Finally, there will be trustee fees if a professional trustee is used.

2. Loss of control - transferring assets to a trust means some loss of control over those assets. This may be greater or lesser depending on various factors including the number and identity of trustees, whether the trust is irrevocable and the degree of capital encroachment available to you during your lifetime.

3. Testamentary trusts - because an alter ego trust is a probate avoidance mechanism which passes assets pursuant to the terms of the trust and not through your will, assets in an alter ego trust cannot be transferred to a testamentary trust. This can be a significant drawback if your overall estate plan would benefit from the tax savings available through a testamentary trust. The probate tax savings by using the alter ego trust can often be offset with one to two years of income tax savings by using a testamentary trust. If, however, your estate plan does not contemplate ongoing trusts after your death, an alter ego trust may be advisable. For more information on testamentary trusts, see our article called “Tax Planning With Testamentary Trusts” on our website.

4. Charitable gifts - the treatment of charitable gifts made through a trust rather than by you outright is more limited. Principally, the trust (unlike an individual) is not allowed the one year carry-back for donation tax credits that an individual is, nor can the trust use the donation tax credit to offset 100% of income in the year of death as with an individual - only 75% can be offset. If an alter ego trust is intended to make specific gifts, but is not a charitable remainder trust, special care must be taken in drafting the trust agreement. More information is available in our article “Year End Tax Planning Through Charitable Giving” on our website.

5. Integration - care must be used when drafting an alter ego trust to ensure that the provisions of the trust fully integrate with the provisions of the your will. Although an alter ego trust is often considered a form of “will substitute”, it is always recommended that a separate will be prepared to catch any assets that are not transferred to the trust. If the vast majority of your assets are transferred to the trust, but debts remain outside the trust, a situation could arise where your estate is insolvent. In this case, it is important for the trust agreement to permit the trustees to use trust funds to satisfy estate debts and possibly to pay bequests in your will.

Conclusion

The creation of alter ego trusts is an important development in the fields of tax and estate planning. The many estate planning benefits of using a trust are now facilitated by changes in the Income Tax Act which make alter ego trusts much more tax effective.

For further information about this or other Estates and Trusts issues, click here to contact Richard S. Niedermayer.

This article is provided for information purposes only and is not intended to constitute legal advice. Do not rely upon or apply its contents to your situation without first consulting a lawyer.