Consider alter ego trusts for wealthy clients

The term “alter ego” may conjure up images of Dr. Jekyll and Mr. Hyde. But while an alter ego trust (AET) agreement may not make an interesting read, the trust itself can be a useful estate tool.

Why set up an AET?

The primary benefit is that the assets within the trust are not subject to estate administration taxes, commonly known as probate fees. And, unlike a transfer into a family trust, the transfer of assets into an AET occurs at cost, unless the settlor elects out of the rollover (which they may do, for example, if they have losses that they want to utilize). So, assets can be transferred into the AET on a tax-deferred basis.

Here are other benefits.

• Continuity of management and liquidity: There’s uninterrupted access to the assets of the deceased since the assets don’t need to go to probate.
• Confidentiality: The trust agreement must be sent to CRA, but the terms of the trust are private. A probated will is a publicly available document.
• Power of Attorney alternative: An AET can be more comprehensive in detailing the powers of the trustee. It also continues after a client’s death, while a POA does not.
• Asset protection: An AET may reduce possible claims by creditors against assets if the distribution of capital to the settlor is impossible, or entirely discretionary by the trustee. However, the lack of power of encroachment will likely be undesirable to the settlor, since that could mean not being able to get capital back from the AET.

What are the drawbacks?

AETs are not set up for tax savings. Although the initial transfer into the AET is tax-deferred, income earned by the AET is taxed at the highest rate, which is 54% in Nova Scotia, for instance. Many AETs are subject to subsection 75(2), a tax avoidance provision that applies when a trust’s settlor is also the capital beneficiary. A trust subject to 75(2) attributes income earned in the AET back to the settlor during their lifetime, and the income is taxed at the settlor’s marginal rate.

Current life interest trust rules can create unintended issues with respect to the tax treatment of deemed capital gains upon the death of an AET beneficiary. Under current legislation, deemed capital gains on death are taxed on the final personal return, even though the assets are held by the AET. This can cause a mismatch if the beneficiaries under the will are not the same as the beneficiaries of the AET (e.g., in a second marriage situation). Draft legislation released January 15, 2016 will restore the rules that existed before January 1, 2016, if enacted. Under the old rules, there is a deemed disposition of assets on the death of the settlor, and the resulting capital gain or loss is taxed in the AET (at the highest tax rate for the province of residence of the trust).

Also, consider that, after a person has died, income earned by a graduated rate estate (GRE) is subject to marginal personal tax rates. Not so for an AET—again, the highest marginal rate applies.

Here are some other potential drawbacks:

• AETs require administration (e.g., annual tax returns), and settlors can incur additional professional fees.
• Land transfer tax or GST/HST may be applicable if real estate is put in the AET.
• Capital losses can be trapped in the AET. There is no ability to elect to have losses of the AET be applied to the final personal tax return of the deceased, since an AET is created during the settlor’s lifetime and not upon her death. However, capital losses can be carried back to the preceding three years if capital gains were realized by the AET.

Case study

Consider a simplified case study. Ontario resident Jill Smith, age 75, has the following assets:

Non-registered portfolio 1:

Cash, term deposits and bonds = $1 million

Equities = FMV of $2 million and ACB of $1.6 million (unrealized gain of $400,000)

Non-registered portfolio 2:

Cash, term deposits and bonds = $30,000

Equities = FMV of $300,000 and ACB of $200,000 (unrealized gain of $100,000)

RRIF = $500,000 (children designated as beneficiaries)

Other assets = $120,000

Assets subject to probate = $3,450,000

Jill transfers Portfolio 1 to an AET (of which she is a capital beneficiary) on January 31, 2016. Jill dies on November 30, 2016, with her investments worth the same as on January 31. Jill’s 2016 taxable income is $150,000, which includes investment income of $60,000. The trustees of the AET distribute the assets to Jill’s beneficiaries shortly after her passing (so we’ll ignore income earned after death).

The chart’s results show us:

• An AET may be ideal for a client who wants outright distributions to beneficiaries after death without the delay of probate.
• Assets with substantial unrealized gains and interest-bearing investments can be ideal assets for an AET, as there is less risk of a large capital loss going unused by the AET.
• The probate savings of $45,000 must be compared against the additional tax cost of $8,000 on death, and the setup and annual compliance costs of the AET.
• If the assets are not distributed shortly after death, income earned by the AET will be taxed at a higher rate than income earned by the estate, eroding the overall savings of the AET.
• An AET’s benefits become greater as an estate’s value gets higher. For example, a $10-million investment portfolio held within an AET will result in probate savings of $150,000, while a $5-million investment portfolio only yields $75,000 in savings. Also, consider that a multi-million-dollar investment portfolio should already be generating income taxed at the highest personal marginal tax rates, which would make the higher income tax rate for the AET irrelevant.

With an AET		Without an AET
Probate fee (Ontario)	$6,250 ($400,000 x 1.5% plus $250), payable by the estate.	$51,250 ($3,400,000 x 1.5% plus $250), payable by the estate.
Income on trust return	Deemed capital gain: $400,000 (assuming draft legislation passed) Tax bill: $107,000	None
Income on terminal return	Other income: $150,000RRIF income: $500,000 Deemed capital gain: $100,000 Tax bill: $311,000	Other income: $150,000RRIF income: $500,000 Deemed capital gain: $500,000 Tax bill: $410,000
Total tax cost to estate	$418,000	$410,000
Total cost to estate (incl. probate)	$424,250	$461,250
Savings	$37,000	None

AETs can be a useful estate planning tool, but weigh the benefits and costs.

What is an alter ego trust?

An AET is an inter-vivos trust created after 1999 by an individual (the settlor). It must also meet the following criteria:

• at the time of the trust’s creation, the settlor was at least age 65 and resident in Canada;
• the settlor is entitled to receive all the trust’s income before death; and
• only the settlor can receive or obtain any of the trust’s income or capital before the settlor dies.

by Stephanie Dietz , CPA, CA, CFP. She specializes in tax and estate planning at Stephanie Dietz Professional Corporation. steph@dietzcpa.ca