Oct 10, 2024
Introduction To Trusts: What Are They?
In Canada, a trust is a legal arrangement where one party, known as the trustee, holds and manages assets for the benefit of another party, called the beneficiary. The trust is established by the settlor, who creates a document known as a trust deed, trust agreement or trust indenture. The trust is a legal relationship created by the settlor with separate rights and obligations, similar to a corporation. The settlor contributes specific property to the trust and the trust agreement outlines how it should be managed, who will oversee it, and who will benefit from it.
Trusts are commonly used for various purposes, and one of the purposes is estate planning. Trusts can allow for individuals to address complicated issues through a creative instrument that offers considerable flexibility and certainty with respect to who will receive assets from an estate, how they will receive them, and under what conditions they will receive them.
An Alter Ego Trust Is a Different Kind of Trust
An alter ego trust is a specific type of trust in Canada permitted under the Income Tax Act, and requires the settlor to be aged 65 or over. An alter ego trust bypasses the usual rules surrounding trusts and allows you to be the settlor, trustee, and beneficiary for your lifetime. This means settlors will transfer their assets into the trust, while retaining control over those assets during their lifetime. Settlors are able to retain control over those assets through their role as trustee of the alter ego trust. The trust deed will set out that only the settlor is entitled to the assets during he or her lifetime, and will contain instructions for the distribution of the trust assets after the settlor passes away. In this regard, the alter ego trust functions similarly to a will and allows for some cost benefits over a will.
Advantages of Alter Ego Trusts
Alter Ego Trusts Function as a Will Substitute, Bypassing Probate
Assets in the alter ego trust are not part of your estate assets, meaning they do not require an application for probate prior to their distribution to beneficiaries. Bypassing probate means that estate tax will not be payable on those assets. Estate administration tax is currently approximately 1.5% of the gross value of the estate, so bypassing this tax can mean large savings for wealthier estates.
Exemption from the 21-year Deemed Disposition Rule
While most other types of trusts are subject to the 21-year “deemed disposition” rule under the Income Tax Act, which triggers a tax on unrealized capital gains at fair market value every 21 years, alter ego trusts are exempt from this rule until the death of the settlor. If the trust continues after the death of the settlor or surviving spouse, the 21-year rule will then apply from the date of death.
Rollover Treatment
Under the Income Tax Act, when property is transferred into a regular trust, it is usually treated as a “deemed disposition” at fair market value giving rise to capital gains taxation on appreciated assets. Alter ego trusts attract rollover treatment, meaning the deemed disposition does not occur until the death of the settlor rather than at the time the assets are transferred to the trust. This deemed disposition would also occur with personally held assets at the time of death if the trust did not exist, so there is no disadvantage to the alter ego trust from a capital gains occurrence point of view.
Less Delay Compared to Probate
Admitting a will to probate and distributing the assets can take a long time. Wills admitted to probate could also be subject to a 6-month freeze on distribution of estate assets to allow for the time period for making an equalization claim under the Family Law Act or a dependant support claim under the Succession Law Reform Act. Assets distributed by the will can also be subject to further freezes if one of these claims is indeed made, pending the outcome of the claim application. Alternatively, an alter ego trust will allow for the distribution of its assets to beneficiaries after the passing of the settlor without the need for delays.
Assets in the Alter Ego Trust are Shielded from Creditors
Assets in the alter ego trust pass outside of the estate and are therefore shielded from creditors who would otherwise have a claim to the assets if those assets passed through a will. These assets are not shields from all kinds of claims, however. The Succession Law Reform Act s. 71 and s. 72 contain provisions to claw back assets that would otherwise pass outside of an estate of the purposes of dependant support claims.
Enhanced Privacy
A probate application regarding a will becomes public record once filed. This means that any member of the public can view these documents upon request, including the will and a list of the deceased’s assets and beneficiaries. After death, the contents of an alter ego trust are not public records and remain private.
Avoiding Will Challenges
The contents of an alter ego trust do not pass in accordance with a will, and so the beneficiaries can avoid any potential delay or other costly issues that may arise if the will is subjected to a challenge by a beneficiary.
Disadvantages of Alter Ego Trusts
Drafting and compliance Costs
Trusts are complex instruments and require careful drafting to avoid pitfalls. There are tax and legal advisory fees involved in establishing trust, which should be considered in light of the potential future benefits and savings. Additionally, there are compliance costs related to filing the T3 Trust Income Tax and Information Return, which must be submitted each year.
No Charitable Gifts
An alter ego trust cannot make charitable gifts while the settlor is alive, as these trusts are restricted from distributing income or capital to anyone other than the settlor during the settlor’s lifetime.
Income Taxed at the Highest Marginal Tax Rate and No Lifetime Capital Gains Exemption
Income that is generated by the trust and retained in the trust rather than being paid out to the settlor will be taxed at the highest marginal tax rate. Additionally, unrealized capital gains that have accrued on assets within the trust will crystalize upon the death of the settlor and be taxed at the highest marginal tax rate. Further, the lifetime capital gains exemption that individuals are entitled to at the time of sale of certain shares or property is not available to an alter ego trust. There may be potential tax planning strategies to allocate the capital gain to a beneficiary to make use of their lifetime capital gains exemptions. Consult with an expert Canadian tax lawyer to make use of this tax planning opportunity.
Pro Tax Tip: Assets with Special Tax Treatment Can Retain That Treatment In An Alter Ego Trust
If you transfer your principal residence into an alter ego trust, the trust itself can continue to claim the principal residence exemption for that property. This means that any capital gains realized on the sale of the property, for as long as it remains your principal residence, could be exempt from taxation just as it would if you owned it personally.
FAQ
What happens to an alter ego trust when settlor dies?
When the settlor of an alter ego trust passes away, the trust becomes irrevocable. The trust is deemed to have disposed of all its capital property at fair market value for tax purposes. Any capital gains realized on that property will be subject to taxation at the highest individual marginal income tax rates in the province where the trust is considered a resident for tax purposes. However, if the trust is deemed to be a resident of a lower-taxing province by December 31 of the year of death, the income tax rates of that province may apply. To take advantage of this potential benefit, consult with a top Canadian tax lawyer when drafting the trust deed.
Can an alter ago trust be revoked?
An alter ego trust is irrevocable upon the death of the settlor. However, while the settlor is alive, one can amend or revoke the trust if one chooses, as long as they are mentally competent to do so.
DISCLAIMER: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
