Alternatives to testamentary trusts

Major changes to CRA’s treatment of testamentary trusts will take effect in January 2016.

Graduated-rate taxation will no longer apply to these trusts (as well as grandfathered inter vivos trusts created prior to June 18, 1971). Instead, they’ll be taxed at the top rate.

Read: The changing landscape of testamentary trusts

But graduated rates will still be available for testamentary trusts with beneficiaries eligible for the federal Disability Tax Credit.

And while graduated rates will continue for what the government’s now referring to as “flat top-rate estates,” starting January 1, 2016 this applies only for three years from the date of death. So, if a client passes away and the estate assets aren’t distributed within three years, there will be a deemed taxation at year-end and all trust income from that date will be taxed at the top rate applicable in the province where the trust is resident.

These changes will remove the tax incentive of establishing a testamentary trust instead of an inter vivos trust, since they’ll all be subject to top-rate taxation.

The use of inter vivos trusts, therefore, will likely increase. Specifically, alter ego and joint-partner trusts may become more popular because they have a number of attractive features.

Alter ego and joint partner trusts were first introduced in 2000 and are available to Canadian residents aged 65 and older. With an alter ego trust, only the settlor’s entitled to trust capital and income before his or her death. With a joint-partner trust, the client and his or her spouse or common-law partner are entitled to receive all the trust’s income while alive and no one other than the client and his or her spouse or partner can be entitled to the capital until the death of the last surviving spouse.

These trusts differ significantly from other types of inter vivos trusts. For example, there’s no deemed disposition at fair market value when property is transferred to an alter ego or joint-partner trust. As a result, clients can create these trusts for their own benefit (as well as their spouses’ and partners’) and transfer property to them on a tax-deferred basis, avoiding a capital gains liability.

For most inter vivos trusts, assets are subject to a deemed disposition at fair market value on the trust’s 21st anniversary and every 21 years afterwards. Alter ego and joint-partner trusts aren’t subject to this rule. Instead, there’s a deemed disposition at the time of death, so there may be tax on accrued capital gains. In the case of a joint-partner trust, the deemed disposition happens on the death of the last surviving spouse (or partner). Resulting income tax occurs within the trust.

KEY BENEFITS

Here are five benefits of alter ego and joint-partner trusts:

1. Minimize estate administration tax/probate fees: Alter ego and joint-partner trusts do not form part of a client’s assets on death because he or she is not the legal owner of those assets at that time. As a result, probate fees (or estate administration tax) are not payable on the value of trust assets on death.

Up to now, the use of alter ego and joint-partner trusts to avoid probate has been limited because income-tax savings available to heirs through graduated-rate testamentary trusts generally far exceed the value of probate savings. With the loss of graduated rates, clients will likely turn to alter ego and joint-partner trusts, which have positives that go beyond eliminating the expense, time delay, and frustration of probate procedures.

Read: Name trustees for disabled clients

2. Privacy: Unlike a will, which becomes a public document if probated, alter ego and joint-partner trusts allow client affairs to be kept private. This can be particularly valuable for high-net-worth individuals who wish to keep the value of assets as well as the recipients confidential.

3. Protection against legal claims: Beneficiaries (or those who feel they should be beneficiaries) may challenge a will if they feel they have not been treated fairly. With an alter ego or joint-partner trust, there is no will to contest and therefore, little opportunity to challenge the distribution of assets. Therefore, alter ego and joint-partner trusts may allow clients to avoid dependant’s relief legislation by disinheriting close relatives who may otherwise obtain relief by challenging a will.

4. Speedy distribution of assets: The probate process can be lengthy, causing the distribution of estate assets to take months, or even years. With an alter ego or joint-partner trust, trustees will already be the legal owners of the trust property and can proceed to distribute the assets soon after the client’s death.

5. Effective management during incapacity: Alter ego and joint-partner trusts may eliminate the need for powers of attorney. If a client loses mental capacity, the trustee (or contingent trustee) will already have control of all decisions and can simply continue with her duties. This allows clients to maintain continuity in the management of trust assets.

DRAWBACKS

There are some drawbacks that clients must consider if they’re considering alter ego or joint-partner trusts. The main ones are:

1. Capital gains on death: Since alter ego and joint-partner trusts are considered inter vivos trusts, they’re taxed at the highest marginal rate. On the client’s death (in the case of an alter ego trust) or on the death of the last surviving spouse (in the case of a joint-partner trust), there’s a deemed disposition at fair market value of all trust assets. The tax liability occurs within the trust at the top rate. Therefore, if the client (or his or her spouse) is not subject to the top rate at the time of death, there will be higher taxes payable as a result of holding the assets in the trust.

2. Increased costs: There are costs associated with establishing these trusts, as well as ongoing costs such as trustee fees, accounting and legal work and the preparation of annual income tax filings. These costs should be compared to probate savings, as well as to the value of any other benefits.

3. Impact on charitable donations: Canadians are entitled to claim a charitable donation tax credit in the year of death for donations up to 100% of net income. If donations exceed this limit, the excess may be carried back and claimed on the return the year prior to death. Although an alter ego or joint-partner trust can make charitable donations, it is not permitted to carry back the donations to the previous year. In addition, there are special requirements that must be met for the trust to qualify for donation tax credits.

Read: Don’t make estate administration mistakes

Frank Di Pietro

Tax & Estate

Frank Di Pietro, CFA, CFP, is assistant vice-president of tax and estate planning at Mackenzie Investments. He can be reached at fdipietr@mackenzieinvestments.com.