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It can be challenging to manage finances between spouses in second marriages.

Add two sets of children to the mix—and often some mutual children—and things can get even more complicated. And it doesn’t necessarily get any easier as those children become adults, or even if they are already adults when the new relationship develops.

Beyond the day-to-day issues, attention will eventually turn to what happens when one spouse dies. While there are common interests between them as spouses, the desire of each to provide for their respective children adds a layer of complexity to the estate planning exercise.

The spousal trust has been used for decades as a tool to address these concerns. Let’s illustrate with the hypothetical example of Jay and Pat. Pat is Jay’s second spouse; Pat and Jay each have their own children from previous marriages. If Jay wants to provide for Pat after his death, let’s consider two options:

  1. Jay’s will can make some immediate bequests to various beneficiaries, and then set up a spousal trust with Pat as lifetime income beneficiary. Pat may or may not be allowed to encroach on the capital, with Jay’s children being the ultimate capital beneficiaries on Pat’s death. According to rules that are effective until December 31, 2015, the spousal trust would have access to graduated tax rates.
  2. Jay could settle a joint-partner trust created during his lifetime. In that case, this inter vivos trust would be a top-bracket taxpayer, though income distributions would be taxed in Pat’s hands.

Either route would result in a spousal trust into which capital assets could be transferred at their cost base. This defers tax recognition of gains to that point, and allows for continuing deferral on future gains. Some gains could be triggered and taxed to Pat if there is an encroachment, but, otherwise, the gains will be deferred until Pat’s death.

Tax changes after 2015

A couple of wrenches were thrown into the machinery of this planning, with changes to the rules for trust taxation that passed into law in 2014 and become effective January 1, 2016.

Let’s assume Jay dies, with the trust provisions having been established in Jay’s will. First, Jay would have thought that Pat could have optimized her income by co-ordinating it with the testamentary trust’s graduated tax brackets. But after 2015 (unless Pat is disabled at Jay’s death), such a testamentary trust will be subject to top bracket taxation. That means there will be less spendable income than the plan intended—possibly an insufficient amount to sustain Pat based on Jay’s expectations when the will was executed.

The second key change relates to the capital-gains-related tax on the deemed disposition of trust assets upon Pat’s death. Under prevailing rules, the trust is responsible for that tax, following which it distributes the net remainder to Jay’s children as capital beneficiaries.

Under the new rules for deaths occurring after 2015, the capital gain is deemed to be Pat’s, not the trust’s. Pat’s estate is responsible for paying the tax: If it is insolvent, however the trust has contingent liability. Subject to that proviso, Jay’s children will likely receive the trust capital, while Pat’s children will bear most of the taxes in the form of a depleted estate. Even if the trust documents state that the trust is supposed to pay the taxes, this will likely be considered a contribution to Pat’s estate that immediately disqualifies it from using graduated tax rates (which otherwise would be available for three years under the new Graduated Rate Estate rules).

Any reprieve ahead?

These issues were acknowledged by CRA at this year’s annual conference of the Society of Trusts and Estates Practitioners. It appears the mismatch problem on death of the spouse-beneficiary was unintended. It remains to be seen whether the government will take any action to address this.

Regardless, spouses in the planning stages may wish to reconsider, redraft or possibly completely unwind their plans, provided both spouses still have testamentary capacity. It’s likely not so easy for trusts that have already come into existence, potentially requiring a court application to vary trust terms.

Doug Carroll, JD, LLM (Tax), CFP, TEP, is vice president, Tax and Estate Planning, Invesco Canada

Originally published in Advisor's Edge Report

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