An insurance trust is a tool that can allow a policy owner to control the timing and use of insurance proceeds following the death of the life insured. While commonly used for situations involving minor beneficiaries, using insurance proceeds to fund a testamentary trust can also be effective in many other situations. There are three methods by which an insurance trust can be created.
1. Separate trust agreement
This method has the advantage of being a document that stands on its own. It identifies the trustees, beneficiaries and the terms of the insurance trust. Its complexity should meet the objectives of the settlor and the needs of the beneficiaries and may include provisions such as:
- Broad discretionary or specific powers provided to the trustee
- The ability to make a broader range of investments
- A staged distribution based on age or some other requirement
Care must be taken to ensure that while a separate trust agreement is executed, no property passes to the insurance trust until the receipt of the insurance proceeds when the settlor dies. Otherwise, an inter vivos trust may be created with the disadvantage that income retained in the trust is taxable at the highest marginal tax rate.
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2. Insurance trust clause within a will
A person’s will may also contain specific clauses that direct the insurance proceeds to a newly formed insurance trust. The distribution of insurance proceeds could mirror the original distribution of the will or set out an entirely different distribution.
Caution should be exercised where the insurance trust mirrors the distribution in the will (i.e. the same beneficiaries) because CRA may amalgamate the trusts and thus reduce access to lower tax rates.
To ensure the proceeds do not flow through the estate, the terms of the insurance trust as well as the purpose of the insurance trust should be clearly set out within the will. In addition, the trustee should be specifically referred to in the creation of the insurance trust as opposed to simply relying upon the designation of the executor/trustee in the general wording of the will.
3. Beneficiary designation
This method makes reference to the will but actually creates a beneficiary designation in the insurance application. The beneficiary designation refers to and uses the same distribution as the residue distribution found in the will. The insurance carrier should receive a copy of the executed will.
Planning opportunities and obstacles
If properly drafted, probate may be avoided as the insurance proceeds will pass outside of the estate. This is particularly important in provinces with high probate fees. For example, after the first $50,000 of estate value the probate fees are 1.5% in Ontario and 1.4% in British Columbia.
Provisions in provincial insurance legislation provide creditor protection where there has been a designation of a spouse, child, grandchild or parent of a person whose life is insured (in Quebec the relationship is to the policy owner). This would appear to be an added consideration when creating an insurance trust as it should be noted that the class identified in the provincial legislation does not include a trustee. Therefore, where the beneficiary is a trust for the benefit of the children of the life insured, creditor protection may not be available.
A minor beneficiary cannot legally discharge the insurance company for payment of the proceeds of an insurance policy prior to reaching the age of majority (this age varies by jurisdiction). This means the insurer must pay the insurance proceeds into court, to a public trustee or to a trustee named in the policy.
Payment of the insurance proceeds to a trustee not only allows the policy owner to ensure that the funds are received for the benefit of a minor beneficiary, but also provides flexibility with respect to the terms under which the child is to benefit from the use of the proceeds and how the child may eventually receive the proceeds.
Using an insurance trust allows control or timing of distributions from the trust and to make sure fair distributions are made to all beneficiaries. A separate insurance trust allows the settlor to meet these needs without having to flow the proceeds through the estate, avoiding not only probate fees, but also the claims of creditors of the estate.
Income payable to minor beneficiaries
In most cases, an insurance trust will be a testamentary trust for tax purposes such that income retained within the trust will be subject to tax at graduated tax rates. However, it may be possible for the trustees to distribute income to the minors for tax purposes, without distributing the proceeds directly to the minors. All that is required is that the income be paid, or payable, to the minors. An example of this is where income from the trust is used to pay for athletic expenses or dance lessons.
The payment of the expenses is for the benefit of the minor and will be considered to be paid to the minor. Since the income is taxed in the minor’s hands and not at the trust level, little or no tax may be payable on the distribution.
Since testamentary trusts are taxed at the same graduated marginal rates as individuals, there may, in some cases, be an advantage in setting up multiple insurance trusts rather than a single insurance trust for a group of beneficiaries. Each insurance trust would potentially be taxed at lower tax rates on income retained in the trust, thus multiplying the advantage of having a testamentary trust.
However, under the Income Tax Act, where multiple testamentary trusts have been set up, the income of which will ultimately accrue to the same beneficiary, or group or class of beneficiaries, the various trusts may be deemed to be a single trust for tax purposes. This means that multiple trusts can only be used where there are different beneficiaries.
In conclusion, a properly drafted insurance trust, whether by means of a separate trust agreement, a clause within a will or a beneficiary designation, can provide the owner with the flexibility to meet their needs within the context of their overall estate plan. It may also offer the opportunity to create a tax-efficient estate plan for the beneficiaries.