DFK Tax Newsletter
The Use of Spousal Testamentary Trusts
Trusts can be used to protect and retain control of assets while still allowing individuals to benefit from these assets. They can be extremely useful in certain situations and can be established informally or more formally with a legal agreement.
What is a Trust?
A trust is not a legal entity, it is merely a relationship whereby a grantor (the settlor) contributes property for the benefit of others (the beneficiary or beneficiaries) and places it in the control of an individual or group of individuals (the trustee or trustees). While the trustees control the property, they cannot benefit from it in any way, unless they are also named as beneficiaries of the trust. Trustees merely act as managers to carry out the requirements of the trust as set out by the settlor or within the powers granted to them in the trust agreement. Trusts that are created during a settlor’s lifetime are inter vivos trusts whereas those created upon a person’s death through the terms of their Will are testamentary trusts.
How is a Trust taxed?
Trust income that is not allocated to a beneficiary will be taxed in the hand of the trust. An inter vivos trust is taxed at the highest marginal personal tax rate for the jurisdiction where the trust is considered to be resident.
Prior to 2016, testamentary trusts were taxed under the graduated tax rate system at the same tax rates as individuals. However, after 2015 only a deceased individual’s estate that is designated as a Graduated Rate Estate (GRE) and certain testamentary trusts created for the benefit of disabled beneficiaries will qualify for this tax treatment. A GRE can only qualify for this tax treatment for up to 36 months after the date of death. All other testamentary trusts are now taxed at the highest marginal personal tax rate for the jurisdiction.
What is a Testamentary Spousal Trust?
When a person dies, for tax purposes they are considered to have disposed of all their assets at their time of death for fair market value and tax on any resulting gains is triggered at that time. There is an exception under the Income Tax Act (ITA) that permits an asset to be transferred on death to a person’s surviving spouse without triggering a deemed disposition as long as the spouse has an undeniable right to that asset. Rather than having assets pass directly into the hands of the spouse, a testamentary spousal trust can be used and, as long as specific criteria under the ITA are met, assets transferred to a testamentary spousal trust will also be eligible for this tax deferred treatment on the death of the first spouse.
The criteria that need to be met include:
- The transfer of property occurs as a consequence of death;
- The provisions of the Will require that the property be held in trust for the benefit of the surviving spouse who is entitled to receive all of the income from the trust;
- No other person may receive or have the use of any of the income or capital of the trust during the surviving spouse’s lifetime;
- The property transferred must vest indefeasibly in the testamentary spousal trust within 36 months of the deceased’s death. This means that the testamentary spousal trust must have an undeniable right to the property that cannot be changed by a future event;
- The deceased must have been a Canadian resident for tax purposes immediately before their death; and
- The testamentary spousal trust created by the Will must also be a resident of Canada.
When would a Testamentary Spousal Trust be Useful?
A testamentary spousal trust would be useful when a person desires to:
- Keep the legal title of assets segregated after their death so that their surviving spouse does not have direct legal ownership;
- Ensure that only their surviving spouse benefits from the income generated by those assets and that no one other than the surviving spouse can benefit from the income or capital during the surviving spouse’s lifetime; and
- Ensure that after the death of the surviving spouse, certain specified beneficiaries (such as the children of the deceased individual who established the trust, or a charity) will receive any remaining capital on the death of the surviving spouse.
If the surviving spouse were to remarry or enter into a significant relationship, their assets may be at risk. Having the assets left to a testamentary spousal trust for the benefit of the surviving spouse, would restrict access to the assets unless approved by the trustees. For example, it may be desired that the surviving spouse benefit from assets during their lifetime, however, on their death the assets then pass to the children of the marriage and not be potentially passed to a subsequent spouse. The spousal trust terms may include that the surviving spouse has no access or limited access to the capital of the trust during their lifetime so that the assets will ultimately pass only to the children of the deceased on the death of the surviving spouse, and not to anyone else.
A similar situation could arise where a person was married a second time, they wished to provide income to the surviving second spouse during their lifetime, and they wished to have the capital property pass on the death of that spouse to the children from the first marriage.
Protecting assets from creditors of the surviving spouse may also be a concern and using a testamentary spousal trust may be beneficial. In this case, ensuring the surviving spouse is not a trustee and also limiting their ability to access the trust’s capital would be critical.
If the surviving spouse is not financially savvy or unable to attend to their own financial affairs, a testamentary spousal trust with trustees that are able to manage the funds on behalf of the surviving spouse may be a desirable approach.
If the deceased’s assets included shares of or assets of a business that provides an income to the family, it may be desired that the spouse benefit from that stream of income during their lifetime and that the business pass to the children after the surviving spouse’s eventual death. A testamentary spousal trust can also be used in this case. If the deceased spouse’s Will created such a trust for the benefit of the survivor, then the shares of the corporation or the business assets held personally could be transferred to the testamentary spousal trust on the death of owner. This would provide a tax deferral on any capital gains until the death of the surviving spouse and also provide an income stream through the trust to the surviving spouse, with the assets themselves (shares or business assets) ultimately passing to the children. (If a spousal testamentary trust holds business assets, rather than shares of a corporation, care must be taken to ensure that the ITA conditions regarding entitlement to income of the trust and the use of income and capital of the trust are not violated.)
If the children are involved in the operation or management of the business, it is possible that the use of a trust may cause family conflict if there are competing interests (e.g. the surviving spouse desires or needs income via dividends from the business however the children involved in the business desire to have profits reinvested). Note that these issues can also just as easily arise if the shareholder/owner is the surviving spouse directly without the use of a trust. Careful consideration must be taken to avoid or minimize family conflict in this situation. It would also be recommended that the trustees be granted the ability for any shares held by the trust to participate in a reorganization of the corporation’s share capital if necessary.
21-year Deemed Disposition Not Applicable
Most trusts are affected by a tax rule that causes a deemed disposition for tax purposes on its 21-year anniversary. Generally, assets held in trust on this anniversary date are deemed to be disposed of for tax purposes at their fair market value, and reacquired at that same amount, therefore requiring any unrealized gains to be taxed at the end of each 21-year period. Testamentary spousal trusts are not subject to this deemed disposition on the 21st anniversary. Instead, the assets of the trust are deemed to be disposed of on the death of the surviving spouse at the fair market value at that time (which may be earlier or later than the 21st anniversary of the creation of the trust). Any resulting gains will be income to the trust immediately prior to the spouse’s death and will be taxed at the top marginal rate. If the trust was created on the death of a spouse prior to 2017, then the trustee may be able to file an election to have the deemed gains taxed on the spouse’s final tax return at the applicable graduated tax rates.
Where the deceased’s assets include private corporation shares, there may be a need to redeem shares after death to prevent or minimize the double taxation of the value of the corporate shareholdings. Where the shares are being transferred to a testamentary spousal trust rather than directly to the surviving spouse, these planning measures may be hindered if the trustees and the corporation are affiliated with each other. Careful planning is required in choosing trustees to ensure maximum flexibility for post-mortem tax planning.
For certain situations, a testamentary spousal trust may be a very effective tool to permit a deferral of tax on the assets of the first-to-die in the couple while also providing a source of income and asset protection. This can provide tremendous peace of mind regarding the protection of family wealth and security. Careful planning and execution are needed in establishing a testamentary spousal trust as part of an estate plan and we strongly advise that a tax specialist be engaged to assist in any plans.
Please feel free to contact one of the partners at the DFK Canada affiliate near you if you would like more information.
The information contained herein is based on the laws of the Income Tax Act (Canada) as of this date, which may be subject to change.