When you think about estate planning, your will likely comes to mind. You may also think about powers of attorney and other types of incapacity planning. What about trusts? Alter ego and joint partner trusts are powerful estate planning tools, but they tend to be not well understood. Trusts offer significant benefits, including the potential to avoid probate and legal fees. Here are some trust basics to help you decide if an alter ego trust is right for you.
A trust is a legal relationship, often used in tax and estate planning. A formal trust is created by a document called a “trust deed.” The trust document will identify the settlor (the person who sets up the trust), the trust property (the assets going into the trust), the trustee (the person who holds and administers the trust property), and the beneficiaries (the person or people who are to benefit from the trust). A trust is not a separate legal entity, but a trust is treated as an individual for income tax purposes.
You can create or “settle” a trust during your lifetime, which is called an “inter vivos trust.” Or you can set up a trust in your will, which is called a “testamentary trust” and does not come into existence until your death. A common example of a testamentary trust is one that names your minor children as beneficiaries of your estate, but stipulates that assets from your estate be held in trust for them until they reach a certain age.
An alter ego trust is a special type of inter vivos trust allowed under Canada’s Income Tax Act. You must be a Canadian resident who is 65 years or older to settle an alter ego trust. The distinctive feature of this type of trust is that you can be the settlor, trustee, and beneficiary of the trust for as long as you are living. When you transfer assets into the alter ego trust, the trust becomes the legal owner of those assets. You no longer own those assets personally, but you continue to maintain control over the assets in your capacity as trustee. The income and capital of the trust must only benefit you as the settlor during your lifetime.
While the income and capital of an alter ego trust must only benefit you during your lifetime, it can be distributed to other beneficiaries when you pass away. For that reason, an alter ego trust is sometimes referred to as a “will substitute.” The trust document directs who you want the trust assets to go to on your death. In the trust deed, you name the beneficiaries who are to benefit from the trust when you pass away, just as you would in a last will and testament. When you die, the assets in the alter ego trust pass outside of your estate, thereby avoiding probate fees, legal costs, and the estate administration process.
An alter ego trust can help with incapacity planning if you as the settlor appoint another person or corporate trustee to act as a replacement trustee. This provides continuity and protection in the event that you lose capacity to oversee and manage the trust assets (e.g., due to old age, illness). The replacement trustee steps in if you become incapacitated. This effectively replaces the need for a Power of Attorney (though you may still need an Enduring Power of Attorney if you continue to personally hold non-trust assets).
A joint partner trust is similar to an alter ego trust. Both are inter vivos trusts permitted by the Income Tax Act. Here is where they differ: with an alter ego trust, only one person (the settlor) is entitled to receive trust income and capital in their lifetime. In the case of a joint partner trust, both the settlor and the spouse or common-law partner of the settlor can benefit from the income and capital of the trust during their respective lifetimes.
Your spouse can be named as the successor trustee to allow him or her to administer the trust after your death, or you can name another replacement trustee. A joint partner trust continues after the death of the first spouse. The surviving spouse or common-law partner benefits from the income and capital of the trust while alive. After the surviving spouse’s death, the trust assets go to the named beneficiary or beneficiaries pursuant to your instructions in the trust deed. Note that while you must be a Canadian resident who is 65 years or older to settle a joint spousal trust, your spouse does not need to be over 65.
Both receive special tax treatment. Transfer of assets into an alter ego or joint partner trust is on a tax deferred basis, at cost, without triggering a taxable disposition. This is a unique feature of alter ego and joint partner trusts. With other types of trusts, transfer of property into the trust usually draws tax consequences. The Income Tax Act treats the transfer as if it was a sale to an unrelated party at fair market value (also known as a “deemed disposition”).
In other words, transfer of assets into an alter ego trust or joint partner trust is, generally speaking, exempt from the usual rule and can be transferred on a tax deferred rollover basis. That being said, alter ego and joint partner trusts are not used for tax minimization. A taxable disposition may occur in the future when a trust asset is transferred or sold, or on the death of the settlor (in the case of the alter ego trust) or on the death of the last spouse to die (in the case of a joint partner trust). The trust will be deemed to have disposed of its assets at fair market value, and any gains will be subject to tax at the highest marginal tax rate. As such, the overall effect on tax is net neutral.
This is another area where alter ego and joint partner trusts receive special tax treatment. The 21-year “deemed disposition” rule applies to most other types of trusts. Under the Income Tax Act, there is a deemed disposition of trust assets every 21 years. That means any unrealized capital gains in the trust are taxed at fair market value every 21 years. Many trusts are specifically limited to 21 years from the date of creation to avoid the deemed disposition rule. That is not necessary for an alter ego or joint partner trust, as both are exempt from the 21-year rule until after the death of the settlor (or the surviving spouse in the case of a joint partner trust). If the trust is to continue after the death of the settlor or surviving spouse, the 21-year rule applies from the date of death.
When the settlor dies, the remaining trust assets in an alter ego trust are distributed to, or continue to be held in trust for, the named beneficiary or beneficiaries specified in the trust deed. The trust assets do not transfer into the estate of the deceased settlor, nor do they form part of the deceased settlor’s estate. The trust has a deemed year end, which attracts tax liability. However, because the trust assets pass outside of the deceased’s estate, probate fees and related time and expense are avoided.
The joint partner trust continues after the death of the first spouse. The surviving spouse or surviving common-law spouse continues to benefit from the income and capital of the trust until his or her death. When the surviving spouse dies, the remaining assets in the joint partner trust are distributed to, or continue to be held in trust for, the named beneficiary or beneficiaries specified in the trust deed.
An alter ego trust can be revocable if the settlor expressly reserves the power to revoke or modify the trust in the trust document. Consideration should be given to whether the trust deed should reserve the power to revoke the trust or contain other powers such as the power to remove trustees. Doing so can be negative from a tax perspective. It can also reduce the protective benefit that alter ego trusts offer. For example, if there is the potential for undue influence by friends or family members, an irrevocable trust is protective because the assets are not in the independent control of the individual in their personal capacity. Instead, the trustee controls the trust asset.
Depending on your circumstances, an alter ego trust can offer many benefits. Top advantages include:
The initial set up costs consists of legal fees and accountant’s fees. Legal fees depend on the time required for a lawyer to advise you on your overall estate plan and to draft and prepare the trust deed. An accountant should be consulted to determine if the plan is viable from an income tax perspective and will charge some fees for their time. There may be additional legal fees, such as conveyancing fees, and other costs, such as property transfer tax, to transfer and change title to real estate. After the initial set up, there are fees to maintain the trust, such as accountant’s fees to file annual trust tax returns, legal fees if advice or services are needed in future, such as to amend the trust, and possibly, trustee’s fees if a third-party is appointed trustee.
The decision to settle an alter ego or joint partner trust should only be made after consultation with your estate planning lawyer and tax advisor. We welcome you to contact our team of passionate and knowledgeable estate planning lawyers today at (604) 670-5138 to discuss your matter and the best steps forward.
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