Trusts are among the most effective estate planning tools. They have been a staple of estate planning in the common law world for centuries because of their unique structure and flexibility. Trusts have remained relevant because they easily adapt to various social and cultural changes. Originally created to address land ownership issues, today trusts are well suited to address significant taxation of income, complex family structures and a desire to protect vulnerable family members.
Despite their benefits and timelessness, trusts are often misunderstood, underappreciated and, as a result, underutilized. We are, however, beginning to see a trust renaissance as clients and wealth planners rediscover just how relevant trusts are to today’s realities. Trusts are valuable estate planning tools because they allow a person to define and therefore retain a measure of control over how assets are managed and ultimately transferred to beneficiaries, often in the most tax-efficient manner.
Read: Income trusts are back
For a trust to be valid, you need three certainties: the intention to create a trust; the property to be held in trust; and the beneficiaries of the trust. All three must be clear and identifiable. It is the potential lack of certainty in one or more of these elements — most frequently intention — that often makes informal trusts problematic.
Running parallel are the three parties to a trust: the settlor; the trustee; and the beneficiary. The person who establishes the trust is known as the settlor (inter vivos trust) or testator (testamentary trust). Legal title to the trust property is transferred to the trustee, who manages the property for the beneficiary.
In most cases, the parties are clearly identified in a written trust indenture or will, along with the terms of the trust, but there can also be oral trusts and trusts which arise by operation of law. In all cases, the transfer of title to the trustee imposes a fiduciary duty on the trustee. It is the relationship among the parties and the unique bifurcation of ownership that facilitate certain estate planning goals.
Types of trusts
There are two main types of trusts: a trust that takes effect during the settlor’s lifetime (an inter vivos trust), and a trust that is established in a testator’s will and comes into effect as a result of the testator’s death (a testamentary trust).
In Canada, testamentary trusts are much more common than inter vivos trusts for a few reasons. First, a trust is often not required until the testator’s death.
For instance, the parents of a child with a disability may be prepared to care for their child during their lifetimes, but are understandably concerned with the child’s well-being once they are gone. A cottage trust to ensure the succession of the property to succeeding generations on the death of the current owner is another example. In most cases, there is a desire to ensure the secure transfer of the property down the road, but no present desire to surrender ownership.
Second, testamentary trusts receive more favourable tax treatment than inter vivos ones. The transfer of property to an inter vivos trust will trigger taxation of any accrued capital gains (different rules apply to qualifying spousal trusts). Moreover, the income of an inter vivos trust is taxed at the highest marginal rate.
In contrast, the establishment of a testamentary trust does not involve a premature deemed disposition (although the usual deemed disposition at death rules apply) and, most significantly, the income generated by a testamentary trust is taxed at the usual graduated rates given to individuals. In other words, there are tax advantages to establishing a testamentary trust.
It is helpful to think of trusts as falling into one of two categories: necessary or optional. Necessary trusts include trusts for:
- benefit of a minor beneficiary
- benefit of a disabled beneficiary
- protection of a beneficiary who is faced with issues that may make an outright transfer of ownership ill-advised (e.g., difficulty handling money, matrimonial concerns, an addiction or creditor concerns)
Optional trusts or trusts that may be advantageous in specific circumstances include trusts created to:
- ensure a current spouse is provided for while, ultimately, benefiting children from a prior relationship
- facilitate income splitting
- enhance charitable giving
- protect an asset such as the family cottage or business
- provide incentive trusts.
Both inter vivos and testamentary trusts are seeing a revival. Let’s review a few examples of the most common situations where a trust may be the preferred wealth transfer vehicle.
Protection of a special needs beneficiary
In most provinces, an absolute discretionary trust, generally known as a Henson Trust, can be created to provide a mentally or physically challenged beneficiary with access to income and perhaps capital, without disqualifying the beneficiary from receiving provincial disability benefits. This is the classic situation where leaving money outright may not be in the beneficiary’s best interests.
Complex family situations
A gift cannot have strings attached. You can, however, allow someone to benefit from an asset without ever surrendering ownership. This technique is frequently employed where a spouse wishes, on his or her death, to provide a benefit to the remaining spouse, while ultimately benefiting their children from a prior marriage.
A trust can provide an income stream for the surviving spouse, while ensuring that some, or all, of the capital is preserved for the testator’s children from a prior marriage. Properly structured, a spousal trust can also qualify for a beneficial tax rollover on the death of the first spouse.
Asset preservation or protection
A trust can be used to protect assets such as a family business or cottage from potential claimants, such as a widow’s new partner or children’s spouses, in the event of a marriage breakdown and/or to ensure succession of the property to the next generation. Protection from a beneficiary’s potential creditors may also be possible with a fully discretionary trust, under which a beneficiary has no enforceable right to the property, and may in fact forfeit any right to the property in the event of their subsequent bankruptcy.
Significant tax savings can be realized via income splitting using testamentary trusts. “The quarter-point return is not everything” (AER, March 2011) provides an example of this.
Some of my clients have decided providing a lump-sum windfall is not in the best interests of their children. In some instances, my clients have decided to stagger distributions in the hope that the children would mature and learn over time to properly manage the money. The parents chose to stagger the inheritance and/or provide their children with an income stream, with the capital passing to grandchildren.
An incentive trust is a variation on this theme. Incentive trusts are used when the settlor wishes to influence or modify behaviour via the trust. Trust terms provide that distributions can either be provided or withheld depending on the beneficiary’s actions. Common distribution thresholds include education, employment and philanthropic endeavours.
In today’s increasingly complex financial and personal realities, a trust may be the right tool to help clients effectively plan, preserve and transfer their wealth.
Elaine Blades is Director, Estate and Trust Products and Services, Scotia Private Client Group.