To Trust Or Not?
Updated: Oct 6, 2021
I have zero experience or prior knowledge of trusts. However, when I wrote about Wills an American friend asked me if I was going to touch on trusts as a means of estate planning and avoiding the dreaded USA "death tax”? I’m up to the challenge of learning something new, and will try to put my own, hopefully-simple, spin on trusts.
Estate tax (death tax) is a unique outcome of dying in the USA. Canada has no estate tax, but it does have something called disposition tax, which is similar and equally concerning if not planned for properly. In the USA, there are federal taxes applied immediately against the estate of someone who dies. There may also be state inheritance taxes, which are levied against a person who benefits from the estate settlement. In Canada, we have something called disposition tax. If we hold assets, stocks for instance, they are considered immediately sold on our death. Any capital gains or deferred taxes will be automatically applied to the value as part of the settlement, and this can be substantial depending on the (bad) timing of death and (poor) planning. I’m going to talk as a Canadian from now on, though the benefits and types of trusts in the USA are likely similar, and you’re going to have to investigate them and any differences yourself.
So what are trusts? Trusts are essentially a relationship and another account you can set up to pay a beneficiary on your own terms, when you are either living (termed inter vivo), or after you die (termed testamentory). Within any trust there are 3 players. You have the settler, trustee, and beneficiary. The settler is the person who set up the trust, the trustee is a person you have designated to administer the trust, and the beneficiary is the person receiving the benefit from a trust. Trusts allow the ability to control the amount of distributions to beneficiaries, and the timing of them. They also provide opportunity to reduce taxes on your estate via income splitting, and can avoid probate and associated fees depending on type of trust that was used. There are different defining qualities of trusts. They can be set up as discretionary or nondiscretionary trusts. A discretionary trust allows the trustee to make some decisions, while a nondiscretionary trust has all the decisions already made and firm. There are also family trusts where the beneficiaries are all family members, and charitable trusts where the beneficiary is a charity.
Many financial institutions will offer and assist you in setting up a trust. As the settler, or the person transferring money into the trust, you need to designate a trustee and a beneficiary. For example, the trustee could be one of your children, and the beneficiary could be one of your grandchildren. When a trust is created you no longer have control over, or own, the assets. The capital, growth, or income is transferred into the beneficiaries hands, and the overall trust control into the trustees hands. Because of this arrangement, trusts are not considered part of your estate for the purpose of an settling a Will. In all reality, your grandchildren are making no money pre-trust, therefore they are starting in the lowest tax brackets. If you can limit the annual distributions from a trust to a beneficiary appropriately, it’s easy to see how taxes can be reduced by putting money in the hands of family members that are in much lower tax brackets.
However, if no payments are made from trusts to the beneficary for terms exceeding 21 years, a 21 year rule comes into effect through the CRA, which is in place to prevent indefinite deferral of tax. At this time, whether you leave it all in trust or roll it all out of the trust to the beneficiary, it gets taxed. And tax levied in this fashion could be very high. Also, whether a trust is set up inter vivo or testamentory at the time it gets rolled out will affect the taxation. If you are forced into rolling out an inter vivo trust the income is taxed at 55%, while in a testamentory trust the income is taxed on a graduated system. Trusts and tax situations can be complex, so consulting an accountant and lawyer when setting them up is advisable.
Inter vivo trusts have several benefits, and are used the most rarely. Many people have a very hard time parting with money before they die, and as a result lose the benefits of these types of trusts over time. More than 50% of Canadians die without a will, and to a much, much lesser extent do Canadian have trusts set up as part of their estate plans.
Without getting into the weeds, there are a fews ways an inter vivo (before death) trust may benefit you. One way is it provide the benefit of income splitting and associated tax benefit with family members before death. Another way, is if you are an owner in a corporation, you can do an “estate freeze”, locking in the value of your shares and creating preferred shares from which value can be spun off in the future. A trust can hold these shares and distribute the value per your wishes. And besides the obvious income splitting advantages, setting up these types of trusts from corporations can provide a capital gains loophole providing they qualify for the “lifetime capital gains exemption to small business corporation shares”. The tax savings could be significant, at over $100k per beneficiary depending on the values of the trusts. There are also alter ego and joint partner trusts. Without getting into specifics, because I’ll probably get it wrong, these two types of trusts are somewhat similar, have some age limits, and are set up primarily to escape probate issues and probate fees. When you move money into these trusts they are removed from your estate to provide income to the beneficiaries, and again have different taxation rules from the rest. One last type of trust is a foreign inheritance trust, which are trusts that be set up outside of Canada by a person living outside of Canada, and also having a trustee outside Canada. These types of trusts have very unique tax advantages, with the ability to avoid total taxation in Canada and possibly worldwide tax if held in a non-taxing country.
So as you can see, trusts may have a place in your estate planning. Again, it is best to seek professional counsel if you think a trust may benefit you because they have complexities and the tax situations are always changing. It seems obvious to me that one of the biggest mistakes people make in estate planning is assuming all matters of inheritence happen only at death, and there are no alternatives to take action earlier to minimize your current tax situation, future estate tax, and probate fees. Waiting too long to give money away may mean lost opportunities to income-split to reduce your tax hit, and the CRA does not care much about your poor planning. If you want to pay more tax, they are more than happy to take it from you. It is possible an inter vivo trust can help you lower your tax bill plus give you the satisfaction of seeing your money benefit loved ones while you are still alive. At any rate, trusts can make estate settlements and spending go according to your plans, and not the plans of others with holes in their pockets, metaphorically speaking. Also notable, you can gift money to family members in Canada limitless and tax-free too, and sometimes this can make just as good sense to do earlier rather than later, to benefit lower income earners and get taxable income off your plate. Especially if you are in higher/highest tax brackets and/or want to avoid OAS clawbacks. In this scenario you simply need a thoughtful gifting plan and do it when you are alive. There are fees for setting up and managing trusts which can be upwards $2-3k for set-up and 1 to 1.5% of the trust value for management fees every year. So they are not cheap to establish and maintain.
This is my simple take on trusts. I'll likely edit or correct this post as I learn more.