Inter vivos trusts — those created while the settlor is alive — play a significant role in tax and estate planning, such as reducing probate fees and related estate costs, and passing on future growth in a private business without giving up control.
However, potential tax pitfalls can open up when using these trusts rather than holding property personally and gifting via a will.
First, any income retained by the trust is subject to tax at the top marginal rate. Also, the transfer of capital property to the trust will result in a disposition at fair market value (FMV), triggering the taxation of accrued gains. A longer-term problem is that a trust is deemed to dispose of its capital property every 21 years, which can create significant liquidity issues if the trust holds appreciating and illiquid assets such as private corporation shares.
These adverse tax issues can, for the most part, be mitigated where the trust qualifies as a life interest trust. A life interest trust includes an alter ego, joint partner or spousal trust. Alter ego and joint partner trusts can be created only by a settlor who is age 65 or older. There’s no age requirement for establishing a spousal trust, though, which can also be established under a will.
To qualify as a life interest trust, the following requirements must also be satisfied (depending on the type of trust):
- the settlor and/or spouse must be entitled to receive all trust income arising before the death of the settlor and/or spouse; and
- no person but the settlor and/or spouse can, before the death of the settlor and/or spouse, receive or otherwise obtain the use of the trust’s income or capital.
If the trust meets these conditions, the transfer of capital property by the settlor is deemed to take place on a rollover basis (rather than at FMV), and the 21-year disposition rule doesn’t immediately apply. Instead, the trust will be deemed to have disposed of any capital property it owns on the death of the life interest beneficiary (or surviving life interest beneficiary) at FMV. It has therefore become increasingly common for small business owners to establish life interest trusts to hold their shares in private corporations.
Given that the taxation of capital gains on property held in a life interest trust is triggered by the death of the settlor and/or surviving spouse, it would seem to be good planning for the trustee to acquire insurance on the lives of the life interest beneficiaries to ensure there is sufficient liquidity to pay any resulting taxes on death.
But the CRA takes a contrary position, indicating in several technical interpretations that providing the trustee of a life interest trust with the power to own and pay premiums on a life insurance policy can “taint” the trust. That’s because, in the CRA’s view, someone other than the life interest beneficiary has the use of trust capital or income before the beneficiary’s death.
The CRA also recently confirmed this position applies where the life insurance is on the life of someone other than the life interest beneficiary (for example, children of the life interest beneficiary).
Serious tax risks can therefore arise where the trust agreement provides the trustee with the power to own life insurance. If the CRA determines that a trust doesn’t qualify as a life interest trust, any capital property transferred to the trust — such as private shares — will be deemed to be disposed of at FMV, triggering accrued gains. Such a trust will also be subject to the 21-year deemed disposition rule.
Thus, when drafting trust agreements, the typical trustee’s power to own life insurance shouldn’t be included. Instead, life insurance could be owned and funded by a secondary inter vivos trust (which doesn’t hold appreciating property), for example, or held directly by the life interest beneficiary, with the life interest trust as beneficiary.
The CRA has also indicated that a trust could hold a fully paid-up policy without tainting the trust. However, the transfer of an existing policy to the trust would result in a disposition with tax reporting of any policy gain.
These solutions may not be ideal for all clients. The insurance industry is recommending that Finance Canada amend the legislation to clearly permit life interest trusts to own life insurance.
Meanwhile, advisors must ensure that life interest trusts have sufficient liquidity to fund the tax bill resulting from the death of the life interest beneficiary, while operating within the limitations imposed by the CRA’s position.
Kevin Wark , LLB, CLU, TEP is managing partner, Integrated Estate Solutions, and tax consultant, Conference for Advanced Life Underwriting. He’s also the author of The Essential Canadian Guide to Estate Planning.