Trusts: a powerful wealth planning tool

How one couple planned for future financial support while protecting capital

Steven and Peter are married. While they don’t have children together, Steven has several nieces and nephews to whom he has been providing ongoing financial support. They are all still under the age of majority.

Steven is reviewing his estate planning. In discussions with his lawyer, he expressed his intention to have Peter benefit from his assets if he predeceases him, but for his assets to ultimately be divided between his nieces and nephews after Peter’s death.

Steven told his lawyer that he would like to defer income taxes for as long as possible, given that he wants Peter to benefit from his assets when he has passed.

When drafting a new will, his lawyer suggested including a provision for a testamentary spousal trust which will only come into effect once Steven dies. All or a portion of the assets in Steven’s estate can go into the spousal trust. Assets that go to Peter, whether directly or into a spousal trust for his benefit, may qualify for a tax-deferred rollover.

The spousal trust will require income earned in the trust to be distributed to Peter annually, and the trustees may have discretion to distribute capital from the trust to him while he is alive. Any capital remaining in the trust, once Peter dies, will be distributed based on the instructions provided in Steven’s will and go to his intended beneficiaries — his nieces and nephews.

If Steven had instead left all his assets directly to Peter, there could be exposure to Peter’s creditors and other future claims. Peter could also change his own estate plan and gift the assets to someone other than Steven’s relatives.

A quick overview

In the event of Steven’s premature death, the provision of a spousal trust in his will helps to:

• Provide financial support to his partner for his lifetime
• Protect his capital for his nieces and nephews over time
• Guarantee that his assets will go to his intended heirs

How one woman minimized the risk of estate litigation

Mary is 70 years old and is widowed. Unfortunately, the family dynamics between her adult children have started to deteriorate following the passing of her spouse a few years ago. She is fearful that when she is gone, her children will seek to challenge her will in court if they are not satisfied with the distribution plan she has set out for her estate.

In addition to her principal residence, she has significant investments that have accrued capital gains which will be taxable on her death. While she is capable right now, she acknowledges that she is getting older and may need someone to help manage her assets if she becomes incapable. Fortunately, she has a trusted long-time friend who is younger than her who could help in the future.

She lives in a province with high probate fees and, having had to deal with probate in the past for her parents, would like to minimize the time delays and costs on her own estate.

Since she is over age 65, her financial advisor suggested that she talk to her lawyer about the possibility of setting up an alter ego trust.

Mary’s lawyer explains that an alter ego trust can hold non-registered investments and real estate. Registered assets cannot be transferred in, but the other assets can be transferred into an alter ego trust on a tax-deferred rollover basis.

While Mary is alive, she is the only individual entitled to all the income and the capital of the alter ego trust. She can name herself as the initial trustee, and then include other trusted individuals, like her friend, to act as alternate trustees if she becomes incapacitated. This offers an alternative to having a power of attorney to manage assets.

The alter ego trust can provide instructions on how its assets are distributed once Mary passes away and therefore acts as substitute to her will. This may achieve her objective of reducing the risk of litigation by her children, compared to having the assets form part of her estate and part of her will. Assets in the alter ego trust will not form part of Mary’s estate, which allows her to reduce provincial probate fees on the value of the assets.

A quick overview

In Mary’s situation, the alter ego trust structure will help her to:

• Minimize the risk of prolonged estate litigation
• Avoid probate^[1] at her death
• Allow her trusted friend to manage the assets if she becomes incapable in the future

[1] Probate fees are not applicable in Quebec.

How one woman achieved tax efficiency by income splitting through a family trust

Ashley recently sold her business to a third party and has significant after-tax funds available from the sale proceeds. She is ready to retire and is looking forward to enjoying her retirement years with her three adult children and five grandchildren.

After Ashley and her spouse worked with their financial advisor to prepare a wealth plan, they realized that they do not need a significant portion of the after-tax proceeds from her business sale for their own retirement needs. The financial plan also showed that Ashley is expected to be at the top marginal tax bracket throughout her retirement.

Ashley would like to share some of her wealth during her lifetime with her grandchildren, but they are still minors and she is not yet ready to make outright gifts to them. She is more comfortable with retaining control over her assets at this stage. Ashley is wondering how she can provide support to her grandchildren, particularly with their education costs, in a tax-efficient manner. Ashley would also like a consolidated and unified method to manage these assets, given that there are multiple family members that she wants to assist.

Her financial advisor suggested that she implement family trust planning.

In this case, the family trust would be an “inter vivos trust” as it is set up during Ashley’s lifetime to invest funds provided by her. The beneficiaries of the family trust would include her grandchildren and could also include her spouse and her children.

To avoid “income attribution” rules that could otherwise require the trust’s investment income distributed out to other family members to be taxed in her hands, Ashley is advised to lend the funds to the trust at the “prescribed rate” at the time the loan is created. The prescribed rate is updated and published by the Canada Revenue Agency on a quarterly basis.

Ashley has decided to loan an appropriate amount of funds to the new family trust at the prescribed rate applicable at that time. The trustees of the family trust will invest the borrowed funds and can then pay the net investment income to the beneficiaries. The payments can be used to cover the beneficiaries’ education and other extracurricular expenses. Each year, the family trust will pay Ashley the prescribed rate of interest that will be taxable to her as income.

The overall tax impact of this strategy is that Ashley will pay tax on the interest income on the loan at her marginal rates, while the beneficiaries will pay tax on the net investment income from the trust, at their marginal rates. If the beneficiaries pay tax at lower marginal rates than Ashley, then the family will benefit from overall tax savings.

A quick overview

Using a prescribed rate loan to the new family trust will help Ashley:

• Reduce investment income taxed at her high marginal tax rate
• Provide gifts to her family members in a tax-efficient manner
• Allow the trustees of the trust to decide when and how much to gift over time

How one couple used a “Henson Trust” to ensure their son’s financial needs are supported

Lisa and Mark’s son, John, suffers from a mental illness. They have received confirmation from the Canada Revenue Agency that John’s illness qualifies him for the “disability tax credit.” John currently lives with Lisa and Mark at home, and they provide him with financial support. It is unlikely that John would ever be capable of managing his own assets. John is enrolled in the disability support program in his province and that has provided much-needed assistance to him.

Lisa and Mark are getting older and want to organize their estate plan so that John is provided for when they both die, while continuing to maintain eligibility for the provincial disability support program.

To provide an influx of funds to support John’s financial needs after their death, Lisa and Mark have a joint last-to-die life insurance policy. They have currently named John as the beneficiary of the policy

Lisa and Mark can consider setting up a testamentary trust in their wills for John’s benefit.

Given John’s inability to manage assets, the use of a trust and the appointment of trustees can avoid the intervention of the public guardian that could otherwise occur if assets were left directly to him.

Since preserving John’s eligibility for the provincial disability support program is an objective, the trust could be structured as a “Henson trust.” Henson trusts are permitted in several provinces and provide the trustees with full discretion on distributing income and capital as they see fit. Because John, as beneficiary, cannot enforce payments from the trust, he is not considered to own the trust assets for the purposes of determining eligibility for the provincial disability support program.

Assets held in a Henson trust can provide a secured fund for John. The trustees appointed will manage the property for his benefit.

Since this Henson trust would be a testamentary trust for a beneficiary eligible for the disability tax credit, it may also be considered a “Qualified Disability Trust” (QDT). A QDT is unique from other testamentary trusts because it qualifies for graduated income tax rates, allowing more flexibility for the trustees to retain income in the trust to be taxed at marginal rates and create tax savings.

Lisa and Mark were also advised that keeping John as the beneficiary of their life insurance policy meant that the proceeds would flow directly to him upon their passing and would not be governed by the trust that they plan to set up in their wills. Therefore, they have updated the beneficiary designation on the policy to name their estate as the beneficiary of the proceeds so that the insurance proceeds will form part of the trust. Lisa and Mark recognize that this may result in provincial probate fees applying on the insurance proceeds, but they feel it is more important that the proceeds flow into one trust.

A quick overview

Now that they have executed new wills and changed the beneficiary on their life insurance policy to their estate, Lisa and Mark can be confident that:

• Insurance proceeds will be used to fund a Henson trust on second death that can also be treated as a QDT for tax planning purposes
• Appointed trustees will manage the funds in the trust for John’s benefit
• John will continue to benefit from provincial disability benefits