Avoid these traps with alter ego and joint partner trusts

In 2001, Canada introduced two unique inter vivos trusts: alter ego and joint partner trusts. Essentially, both trusts allow a settlor to transfer capital assets into the trust on a tax-deferred basis if the following conditions are met:

• The trust is created after 1999.
• The settlor is at least 65 at the time of creation.
• In the case of an alter ego trust, the settlor must be entitled to receive all the trust’s income that arises before death. In the case of a joint partner trust, the settlor, in combination with the settlor’s spouse or common-law partner, must be entitled to all the trust’s income that arises prior to the surviving spouse’s death. (All references to a spouse include a common-law partner.)
• No person except the settlor (and the settlor’s spouse, in a joint partner trust) may, before the settlor’s death (or the survivor’s death, in a joint partner trust), receive or otherwise obtain the use of any income or capital of the trust.
• A majority of the trustees must be Canadian.

These trusts have several advantages, including probate savings and confidentiality, which will be discussed in a subsequent article. Though these two advantages aren’t unique to these trusts, the ability to transfer assets into the trust on a tax-deferred basis is.

Read: Pay probate or income tax?

This article discusses some potential traps or downsides to using such trusts.

What to watch

Incurred fees

All trusts should be professionally drafted, and alter ego and joint partner trusts are no exception—especially with their technical requirements. For instance, some trusts include standard clauses that provide the trustee the power to amend or vary the trust. However, amendments could result in the trust no longer complying with the requirement that only the settlor and/or spouse be entitled to receive all income. Changed terms could therefore result in an immediate deemed disposition.

Legal costs for creating the trust vary depending on the trust’s complexity. Immediate costs must be carefully compared to future probate and tax savings.

Potential U.S. tax exposure

Clients with U.S. estate exposure at death risk double taxation. U.S. estate tax would be applied against the settlor as it reads through these trusts, while Canada regards the trust as a separate taxpayer. There’s no tax treaty relief in these situations.

Limitation of lifetime capital gains exemption

These trusts don’t benefit from the lifetime capital gains exemption ($848,252 for 2018) on the sale of qualifying Canadian-controlled private corporation (CCPC) shares or for shares held in a CCPC, or for qualified farm or fishing property ($1M for 2018). Therefore, sophisticated planning is normally required to access the exemption. One option might be to opt out of the tax-deferred rollover on property transfer to the trust.

Family law consideration

Conveying assets to a trust could reduce assets available for property division during divorce. If the court deems that a trust’s creation was to reduce net family property, the transfer may be viewed as fraudulent.

Restrictions on charitable gifts

Charitable gifts in a will or through an insurance or registered plan are deemed to be gifts by an estate, and thus carry many advantages. For instance, a charitable gift in a will can be used as a tax credit in the year of death on the terminal return or in the estate. The tax credit applies to 100% of net income in the terminal year and the year prior, compared to the normal rule of 75%. Assets held outside alter ego and joint partner trusts also allow flexibility in donating during the settlor’s lifetime.

However, these advantages aren’t available to inter vivos trusts, as charitable gifts wouldn’t be deemed gifts by an estate. Also, because alter ego and joint partner trusts are prohibited from distributing income or capital to anyone other than the settlor (or spouse in the case of a joint partner trust) during the settlor’s (or spouse’s) lifetime, the settlor can’t use trust assets to make charitable gifts. However, income or capital received from the trust can be donated.

Where the charitable gift is structured to occur on the settlor’s death (or the spouse’s, in the case of a joint partner trust), the trust can normally claim the resulting tax credit, which can offset tax payable at the trust level for the year of death.

Two taxpayers

Since the trust is a separate taxpayer from the settlor (or spouse), gains in the trust can’t be offset by losses realized by the settlor (or spouse), or vice versa.

Future trust disadvantage

If the trust is to continue after the settlor’s or spouse’s death—for instance, the funds are held in trust for a child or grandchild—the funds are deemed to be from an inter vivos trust, with an associated tax disadvantage. If the funds passed through the parent’s or grandparent’s estate, the estate enjoys up to three years of graduated tax rates. Income taxed in the hands of the inter vivos trust, on the other hand, is taxed at the highest marginal rate and doesn’t benefit from this graduated rate period.

Ongoing administration

A trust must file an annual tax return—and reporting obligations are about to get cumbersome.

For 2021 and subsequent tax years, the 2018 federal budget proposed a new reporting requirement for certain express trusts resident in Canada and for non-resident trusts that are required to file a T3 income tax return. The budget defines an express trust as one created with the settlor’s express intent, as opposed to arising as a matter of law—as is the case with resulting or constructive trusts. That means alter ego and joint partner trusts are captured by the new reporting requirement.

Many trusts will be exempt from the requirement, most notably: graduated rate estates; qualified disability trusts; trusts in existence for less than three months; and trusts with a value of less than $50,000, provided the trust holds only deposits, government debt or listed securities.

The budget announcement is hardly surprising as it’s consistent with disclosure rules for corporations and with other countries. The reporting form has yet to be provided, and many uncertainties remain, including administrative requirements and whether corporate classes must be reported or actual individuals.

Canadians using inter vivos trusts as part of their wealth or estate planning, including alter ego or joint partner trusts, will now face a new filing requirement whether or not the trust earns reportable income. At the least, this will be an additional step for those administering trusts.

In my next article, we’ll discuss some of the benefits of an alter ego or joint partner trust. For now, it’s important to remember that these trusts aren’t a suitable solution for everyone, and the above concerns should be kept in mind before a trust is recommended.

Also read:

Let clients know about these will restrictions

3 investment rules estate trustees must know

The benefits of family trusts

Keith Masterman

Tax & Estate

Keith Masterman, LLB, TEP, is vice-president, Tax, Retirement and Estate Planning at CI Global Asset Management. He can be reached at kmasterm@ci.com.