Since the time of tax reform back in the 1970s, estate planning rules under the Income Tax Act have gone relatively untouched and in fact have probably even been liberalized. A primary ingredient for many estate plans and especially ones for high wealth individuals are trusts embedded in wills. Such trusts can solve financial and tax-planning objectives not available with other mechanisms. Recent amendments to the Income Tax Act should cause people to take a careful look at their wills and the planning objectives contained in them—changes may be in order.

Common Uses For Trusts In Estate Planning

Until now, the most common uses of trusts have been as follows:

• A spousal trust in wills to obtain a rollover at the cost of the deceased’s assets on death, pushing the tax liability ahead to the surviving spouse’s date of death;
• Multiple testamentary trusts in a will to gain one or more applications of graduated tax rates for estate beneficiaries on a go-forward basis;
• An alter ego, joint spousal or joint common- law partner trust (as defined by the Income Tax Act) set up during one’s lifetime usually to avoid probate and maintain a level of privacy not available in a will;
• A Henson trust to maintain social assistance for a loved one with a disability after the death of the financial caregiver;
• A trust to freeze the growth in the value of assets transferred to an inter-vivos trust to family members—often used for holding growth shares of private corporations.

For simplification, this article will refer to joint spousal and joint common-law partner trusts as joint partner trusts. Both alter ego trusts and joint partner trusts are inter-vivos trusts that are allowed to be set by individuals age 65 and older. Effectively, assets moved into these trusts bypass the will.

There are other uses for trusts in planning the financial and tax affairs of families but those cited above are amongst the most common—or at least they were until the recent changes to the tax laws for trusts. Now, some rethinking is in order.

Tax Rules For Trusts

At the time of the tax reform, provisions were written into the Income Tax Act to set out the tax consequences of the most common financial transactions related to trusts. In broad terms, those rules dictated the tax treatment in the following situations:

• Transfer of property to the trust
• Transfer of property from the trust
• Tax rate on income earned by the trust (maximum or graduated)
• Flow through of income characteristics arising from trust distributions
• Other detailed rules indicating the tax consequences of various transactions—often in a way different than trust law itself would otherwise dictate.

Tax consequences also depend on whether transactions involve:

1. A spouse or partner
2. Other family members, and whether
3. The trust arose during lifetime (inter-vivos) or
4. On death (testamentary).

Does A Trust Exist In Your Current Planning?

Most people don’t think too much about whether or not a trust is included in their will or other estate planning documents because they rely on their professional advisors to guide them on that.

Here are the likely situations that may involve individuals with a trust for estate planning:

•    Life Interest Trusts

• Spousal trusts already in existence because of a death (existing)
• Spousal trusts that will come into play on death (future)
• Other life interest trusts (joint partner and alter ego)
• Graduated Rate Estates (GRE)
• Qualified Disability Trusts (QDT)

The above list distinguishes between existing and future spousal trusts because planning around the new rules is much more limited for existing trusts than it will be for trusts under a will that has not yet been established. Each requires different comments.

This article focuses on existing and future spousal trusts used in estate planning because of the need to address changes to such trusts sooner rather than later. Other life interest trusts and Graduated Rate Estates will be covered in future articles. Qualified Disability Trusts were already discussed in a March 2015 article – Trusts, Taxes and Disability. In many cases, corrective action should be taken before the end of 2015.

Life Interest Trusts

A life interest trust is a special trust under the Income Tax Act designed to hold an interest in property for the person or a spouse or common law partner. The beneficiary has the right to income and capital distributions during their lifetime. The property in the trust will then be transferred to remainder beneficiaries (usually family members) on the death of the life interest beneficiary.

Life interest trusts include the following:

• Spousal Trusts (testamentary or inter-vivos)
• Alter Ego Trusts
• Joint Partner Trusts

In general, all of these trusts provide a tax free rollover of assets into the trust but a gain will later arise on the deemed disposition of those assets on the death of the lifetime beneficiary of the trust.

Sometimes the only use of a life interest trust is to avoid probate. Use of trusts that result in minimal savings is often overdone and the new rules will probably decrease such use of trusts.

 

Alter ego and joint partner trusts will be discussed in future articles to leave more space in this one to discuss testamentary spousal trusts arising on death. While an inter-vivos spousal trust is also a life interest trust, this article is directed at a discussion of testamentary trusts and the related tax implications.

Lawyers And Will Drafting

Until now, lawyers could draft wills without too much concern about the consequential tax issues of trusts because they were reasonably well known and not particularly complex or financially threatening. All of that has changed with the new tax rules as you will see later in this article. The day has disappeared when lawyers should be drafting complex wills involving trusts without considerable tax knowledge or before consulting with a tax specialist who has that knowledge.

Trusts Are Handy Things To Have

Trusts are handy legal documents that allow the legal and beneficial ownership of property to be separated from one another. That separation of ownership achieves practical financial planning objectives beyond taxation such as the use of trusts to sustain social assistance in disability or for complex family financial planning. These holistic benefits were seemingly respected by the CRA until the recent tax amendments came along so most of that has now changed.

If gaining a tax rate advantage is the primary reason for having a trust then think again because the new rules largely eliminate that advantage. For the most part, the income flow-through and tax-free rollover advantages still exist and they will continue to be valuable tools in tax and estate planning. The use of trusts in estate planning has been shaken—they will survive but the road map has changed.

Existing Spousal Trusts

Under the new rules, testamentary spousal trusts that now exist because a death has already occurred are problematic. These trusts cannot be written out of existence or easily changed so there are no good solutions. About all that may be available is for the parties to get together and to try to plan for the wind up of these trusts in a tax-efficient manner when that day comes. That may be difficult given the conflicting interests if blended families are involved.

The New Rules

The new rules virtually eliminate the graduated rates of tax for testamentary trusts and lifetime benefit trusts will shift the tax liability from the trust to the estate of the lifetime beneficiary on the death of the lifetime beneficiary.

Here is a summary of the larger issues created by the new rules:

• Graduated tax rates will no longer be available for testamentary trusts after January 1, 2016, except for estate income for a period of three years for Graduated Rate Estates (GREs) or for trusts set up for people with disabilities who qualify for the disability tax credit.

• Testamentary trust arising out of an estate (they are not GREs) will lose several tax benefits. Some but not all of these benefits are listed below:
• Exemption from tax installments
• Exemption from alternative minimum tax
• Ability to allocate investment tax credits to individuals
• Ability to have a non-calendar year end

• All existing testamentary trusts will have a December 31 year-end starting in 2015. Most likely these trust tax returns will be required in 2015.
• On the plus side, there will be increased flexibility with respect to charitable donations but even that area will require some careful deliberations by estate executors.
• The tax liability on income arising in the last year of the trust including income on the deemed sale of assets will fall on the estate of the deceased person (who was the lifetime beneficiary of the trust) and not on the trust itself.

Since the deceased person's estate and the remainder beneficiaries of the trust can represent different families (as in a spousal trust on second marriage), the shifting of the tax liability from the trust to the estate of the life beneficiary will be very problematic. For example, the estate of the deceased person may not have any funds to pay the tax that would otherwise be levied against the trust. If steps are taken in some way to shift the tax liability to the trust, will the trustees be in conflict of their fiduciary duties? Will other beneficiaries object?

If insurance funding has been put in place in the trust to pay the tax liability on the deemed sale of assets on the death of the lifetime beneficiary, those proceeds will now pass to the remainder beneficiary and will not be available to eliminate the tax liability on death. There will also be problems with the use of loss carry overs that until now could be applied to the income of the trust in the year after death.

Fixing The Problem

Where death has not yet occurred and spousal trusts exist in wills, such trusts should be rewritten so that the estate of the surviving spouse is not saddled with a potential tax liability on death. One solution might be to add a clause to the spousal trust requiring that the trustee pay the tax. Another option would be to change the trust clause so it is not a spousal trust but then tax would be paid on capital gains in advance. Each case will require a unique solution and considerable conversation.

In the case of existing trusts, one might use a power of appointment to provide that the tax is to be paid from the trust rather than by the estate of the surviving spouse. If a power of appointment is not available, such as in very simple trusts, there may be no solution.

Don't expect lawyers to go through their files and look at every will in order to notify clients that a problem exists. You should give your lawyer a call.

Conclusion

As the many implications of these new rules start to be understood, no doubt other solutions will be developed. In the meantime, the problem needs to be analyzed and steps taken to alleviate the new tax burdens. One thing is certain. The government seems immovable in allowing trusts to have access to graduated tax rates except in two rather limited situations. The new rules have some anomalies and unfairness about them and only time will tell if there are changes to the law or to CRA interpretation but don't hold your breath.

This article is based on the best interpretation of the new rules at this time but stay tuned for possible new interpretations or direction by the CRA. There is some faint hope that this will happen.

J. E. Arbuckle Financial Services Inc.

30 Dupont St. E., Suite 205, Waterloo, Ontario N2J 2G9 Phone: 519-884-7087 Fax: 519-884-7087.

Email: jea@personalwealthstrategies.net www.personalwealthstrategies