A matter of trusts

It is enough to keep anyone who has a sizable estate awake at night.

Well-heeled clients who want to rest easy and be sure their estate capital is preserved — and the needs of their intended beneficiaries are met — may want to include a trust in their estate planning.

Generally, this is a strategy for high net-worth clients. To justify the costs (see “Setting up a trust,” p. B7), the trust assets to be managed should be in the $500,000-$2 million range. Setting up a trust requires working with a lawyer to draft a trust document. It may be a lawyer that works exclusively in trust and estates law and can handle the required tax planning. (One place to find this expertise is the Society of Trust and Estate Practitioners Canada at www.step.ca.) In smaller communities, advisors often work with a client’s lawyer, as well as a local accountant who has the specialized tax expertise required for setting up a trust.

However, saving on taxes is only a small part of setting up a trust. “The non-tax considerations are more important,” says Barbara Novek, lawyer and partner with Sweibel Novek LLP in Montreal.

First, you have to examine the issues. This will help you determine the appropriate family trust solution.

A Disabled Child

“Elderly parents who have been caring for adult disabled children are concerned about what will happen if the children survive them,” says Heather Evans, lawyer and partner with Deloitte & Touche LLP in Toronto.

They want to put aside funds that will meet the needs of the child, and appoint someone to look after the funds in accordance with the child’s needs.

Usually, this takes the form of a testamentary trust, Evans says. A testamentary trust is triggered by a will at the death of the person establishing the trust. It is taxed at the graduated rate that applies to the annual amount of the trust’s income.

The basic idea of such a trust is to protect the capital, ensuring there is an income stream to deal with the child’s needs. However, Evans says, there should be some flexibility so the trustees of the trust can use some of the capital in certain circumstances. For example, the child might need a specially equipped motorized chair.

Parents of a disabled child often use what’s known as a “Henson trust,” says Christine Van Cauwenberghe, a lawyer and director of tax and estate planning with Investors Group Inc. in Winnipeg. This type of trust is named after a deceased Ontario father who had a disabled daughter. He created a testamentary trust in his will, giving “absolute discretion” to the trustees regarding any payouts from the trust.

This element of absolute discretion generally allows parents to leave assets for the benefit of their disabled children without disqualifying the children from provincial disability benefits, says Van Cauwenberghe. However, not all provinces permit this protection. Moreover, Van Cauwenberghe adds, provinces have different rules about how much of the trust assets can be paid out or used for the child’s benefit. “The lawyer will deal with these details,” she says.

The best choice for the trustee for a disabled child’s trust may be an institutional trustee, such as one of the trust divisions of the major banks. The fees may be higher than those of a trustee who is a relative or a friend, Evans says. But an institution will provide more checks and balances to preserve the capital and ensure an income stream.

An institutional trustee is also going to be around, Evans adds. Even though individual trust officers handling the trust may change, the client/trustee relationship will be based on a stronger sense of long-term certainty. If a friend or relative who is a trustee dies, there may be lack of continuity.

@page_break@Trustees are responsible for ensuring the assets in a trust are invested prudently. That’s where investment counsel such as Phillips Hager & North Investment Management Ltd. comes in. “A lot of the time, the trust is already in place,” says Mike McIntosh, a PH&N investment advisor in Calgary. “We’re involved because the parents were clients and they have stipulated that we be used to manage the trust assets.”

PH&N supports the trustees’ efforts, he says, reporting to them, the beneficiaries and other professionals involved in the trust’s management, such as an accountant.

The trust portfolio will have predetermined performance benchmarks based on well-recognized market indices. The trustees closely monitor performance, says McIntosh.

Generally, because of the parents’ concern about capital preservation — as set out in the trust document — the assets are often invested conservatively. For example, McIntosh says, 50% might be in bonds and 50% in equities.

Spendthrift Adult Child

Even if your client’s child is an adult, there may be several reasons for your client to set up a trust to protect the child from mismanaging the inheritance so it’s preserved for the child as well as for any grandchildren. Perhaps the child is a perpetually failed entrepreneur. Perhaps he or she is a gambler, alcoholic or drug addict. Or perhaps the adult child simply has poor financial judgment.

Offshore trusts have been used in the past for the purpose of building wealth for a spendthrift child. But in recent years, Ottawa has tightened the tax noose on offshore trusts. It brought out new rules in 1999, which are still not law, and there have been five revisions in the meantime.

Practitioners are waiting to see what the new federal government will do. Nevertheless, they say, it’s looking less and less tax-efficient to set up offshore family trusts.

Instead, says Van Cauwenberghe, looking ahead to the time when the parents won’t be around, a testamentary trust is a useful estate-planning tool for parents in one of these worrisome situations.

“It can provide for some control beyond the grave,” she says.

The trust document can direct that assets held in the trust not be given to minor children until well beyond the age of majority, she says. In the case of a spendthrift, a trust can be set up for adult children into their 40s and 50s, she adds. With this type of trust, a certain level of income is given to the adult child during his or her lifetime, but the capital is preserved for the grandchildren.

“We’re seeing more and more of the drug-addicted child situations,” says Novek. “It’s a real concern. The last thing parents want to give out is cash.”

Any income given to an adult child is also open to attack from creditors, says Margaret O’Sullivan, the principal of Toronto trust and estate law firm Margaret O’Sullivan & Associates, and deputy chair of STEP Canada. “You would want the trustees to make payments to third parties for care and upkeep.”

Another reason to use a testamentary trust, says Van Cauwenberghe, is that it can provide a layer of protection from a spousal claim if the adult child goes through a divorce. The adult child can argue that assets are held by the trust, and he or she is merely the beneficiary.

It will be important that your client get help from his or her trust tax advisor in examining the potential tax impact of payouts from the trust because there can be complications. For example, regular payouts to an adult child in a high tax bracket obviously would be highly taxed.

It might be better for the trust, as a separate taxpayer, to pay taxes on the trust’s annual income. This is something that can be worked out after the death of the parents. The trustees and beneficiaries can have the trust pay the taxes.

If they go that route, says Van Cauwenberghe, the trustees must file an election with the Canada Revenue Agency.

The ability to make this election is one of the reasons that the family trust is a popular estate-planning tool. It allows for income-splitting between the trust and the children, says Van Cauwenberghe.

One thing users of trusts must keep in mind, however, is that the trust will have to comply with the “21-year rule” in the Income Tax Act. It states that every 21 years there is a deemed disposition of all the assets in the trust, and the according amount of taxes must be paid.

Finally, the choice of trustee in this type of family situation is likewise crucial. Dealing with the beneficiaries may involve many years of headaches and present significant challenges for siblings or other relatives who are made trustees, says Novek. A professional advisor, such as the family lawyer or accountant, could be named as co-trustee, she says.

An institutional trustee provides a sense of financial security and accountability that an individual trustee cannot, adds O’Sullivan. An institutional trustee will also carry insurance to cover any claims made by the beneficiaries that the trust has been mismanaged or that the trustee has breached its fiduciary duty to the beneficiaries.

Spousal Care

With a spousal trust, one spouse can roll his or her assets over to the other spouse and defer taxes. Taxes are due after the surviving spouse has died. To take advantage of the tax-deferred spousal rollover, the assets are left to a trust for the spouse’s benefit, and he or she is entitled to all the income. But to preserve capital for the client’s children, restrictions are placed on the spouse’s ability to withdraw capital.

A spousal trust will be useful for income-splitting between a spouse and the trust, says O’Sullivan: “It’s done commonly when the estate is large enough to justify an ongoing spousal trust.”

This type of trust is often used in one of two situations. The first involves an elderly wife who may not know much about managing the finances and who could be vulnerable after her husband’s death.

The second scenario — one that is becoming increasingly common — involves setting up a trust to provide income for a second wife while protecting the capital for the children from the first marriage. But a spousal trust may not always be the best solution in this scenario, Van Cauwenberghe says. If the second wife is young, for instance, the children from the first marriage have to wait until the stepmother dies before they inherit any money.

“Even in a situation in which you are dealing with the first wife and kids, your client may still want to ensure that the wife doesn’t use it all up,” says Novek.

Another option, Van Cauwenberghe says, is to leave the estate to the second wife and buy a large insurance policy for the children of the first marriage.

The insurance proceeds could be be paid out to the children. Or they could be used to set up a testamentary trust for the children — especially if the children are young or your client doesn’t want them to get a huge lump sums all at once. In this latter scenario, your client would have to make a designation in his insurance policy that the trustee of the trust will be the beneficiary of the proceeds upon his death.

The Family Business

A small-business owner may want to ensure the family business is preserved so it can be passed on to the children. One way to do this is to undertake an “estate freeze” of the company using a family trust.

The trust acts as a buffer, preventing the children from obtaining immediate ownership. Their shares of the business are held by the trust. Meanwhile, the parents can retain control of the trust by appointing themselves as the trustees. It gives the parents time to sort out what they want to do — especially if their children are still young.

Under the freeze, the parents exchange their common shares for preferred shares, frozen at the present value of the underlying business. They won’t be participating in the future growth of the business. Instead, the future growth will go to newly issued common shares, held inside the trust, with the children as the beneficiaries.

As time passes, one of the children may show an interest in taking over the business. The parents could then decide to change the terms of the trust so all the shares go to that child. Or if it appears none of the children are interested in the business, the parents can sell the business.

Deciding when to undertake this strategy may be the toughest choice facing your client. “It’s a hard decision,” says Novek. It will depend on the age of the parents and children, and on the children’s ability to take responsibility for the business, she says.

Depending on changing circumstances, Novek says, it’s likely that your client will have to redo the trust document and will at least once.

And since this type of trust is set up while the parents are alive, the trust is “inter vivos” — between living people. The person who establishes the trust is getting the benefit of income-splitting while he or she is alive. Therefore, the income of an inter vivos trust is taxed at the highest marginal rate.

However, as with a testamentary trust, an election can be made to have the inter vivos trust or the beneficiaries pay the taxes. It would be a judgment call that your client would make with the help of a tax advisor, depending on the family and company circumstances.

For example, if the children are young adults with little income — university students, perhaps — the parents could split the income with them, says Van Cauwenberghe. A dividend could be paid out to the children’s common shares. The children would be in a low tax bracket and would owe little — if any — taxes.

However, if the children are minors, the “kiddie tax” — added to the Income Tax Act in 2000 to discourage income-splitting with minor children — will be applied. Dividends received by minors through a trust are taxed at the highest marginal rate.

One of the big benefits of a small-business family trust is that it will enable the family to multiply the capital gains exemption available to Canadian-controlled private companies. For example, if Mom and Dad plus two adult children are shareholders, each of them could claim the $500,000 capital gains exemption — a $2-million tax benefit.

The Family Cottage

Many parents have rosy notions about how the children will share the family cottage, says Evans. Using a trust to pass on the cottage “is often requested.”

However, this is one situation in which the experts don’t favour using a trust.

To begin with, capital gains taxes will be due on the cottage upon the death of the parents. It will be due again in 21 years, because the property is in a trust and will be governed by the Income Tax Act’s 21-year rule.

Meanwhile, the trust document will have to set out specifics, such as maintenance, payment of property taxes and shared usage among the children and their families.

It may not deal satisfactorily with family realities, practitioners say. For example, one of the children might live far from the cottage and would not benefit much from the trust. And some children may be less able than others to pay a proportional share of the expenses.

This could get messy, says Van Cauwenberghe, as the trustees often are the children.

It would be better for your clients to sit down with their children and ask them what they really want. Perhaps the cottage could be left to one or more of the children as co-owners, and the other children could be compensated from the remainder of the estate.

Probate Avoidance

In 1999, Ottawa created two trust vehicles that allow people to pass assets outside their estate, thereby avoiding probate fees.

One is known as an “alter ego” trust, in which the client puts assets in the trust with him- or herself as the sole beneficiary. The other is a “joint partner” trust, in which a spouse or common-law partner puts assets in the trust for the other as sole beneficiary.

Neither trust triggers capital gains until death — the death of the individual for alter ego trusts, and of the second partner for joint partner trusts. For both, the person who establishes the trust must be 65 years of age or older.

These trusts have not turned out to be popular estate-planning instruments. Probate fees in most provinces, except Ontario and British Columbia, are low. Second, these are inter vivos trusts, so when the trust assets are finally passed on, they are taxed at the highest marginal rate. The client is forgoing the use of lower-taxed testamentary trusts, O’Sullivan says.

Unless the client hasn’t got long to live and the estate is very large, such trusts are not commonly used. This type of trust might be viable when the costs involved will not go on for long, O’Sullivan says, and when avoiding probate outweighs the costs. IE

Setting up a trust

A trust is a legal relationship that is established when the person setting up the trust (the settlor) transfers title of specified assets to the people who will manage the trust (the trustees) for those who will benefit from it (the beneficiaries). This relationship implies two ownership interests: the trustees have legal ownership of the assets, but the beneficiaries have beneficial ownership of the assets.

As a result, the trustees are held to several duties in managing the trust for the beneficiaries. Trustee duties are established in Canada under provincial trustee statutes. For example, in recent years, most provinces have adopted “prudent investor” rules, which dictate that trustees must do more than invest the assets conservatively; they must also maximize the value of the trust for the beneficiaries.

Meanwhile, trustees must also maintain the trust in accordance with the settlor’s wishes, as set out in the trust document. For example, a trust might have been set up to provide a lifetime income for a spouse, while preserving the capital for the children. Trustees also must regularly provide an account of their management of the trust to the beneficiaries.

The trust document must be drafted by a lawyer and reflect three certainties: the objective of the trust; the assets to be transferred; and a clear intention to establish the trust.

The costs of setting up a trust will vary, depending on the amount of assets and the complexities in the trust, and, therefore, the level of professional expertise required. Initial set-up could cost $2,000-$15,000. The ongoing cost for managing the assets will depend on the amount and type of assets held by the trust, and the trust’s objectives. It would be comparable to management of a personal portfolio. The cost of preparing the trust’s annual tax return also will vary.

Trust taxation is complex. It’s best if you and your client work with a tax advisor who is experienced in trust taxation — before the trust is set up.

The basic government concern is setting a level of taxation appropriate to the amount of income-splitting between the settlor (usually a parent) and the beneficiaries (usually the children). For example, an inter vivos trust — a trust created while the settlor is still alive — will attract the highest level of taxes. A testamentary trust, which is triggered by the settlor’s will upon death, will be taxed at the graduated tax rate applicable to its level of annual income.

The trust is liable for income that it has not distributed at the end of the year. If income is distributed, it will be taxed in the hands of the beneficiaries. However, if the trustees and beneficiaries decide to make an “election” to have the taxes paid by the trust, they can do so. Again, it is important for the trustees to get advice from a tax advisor who understands trust taxation.

The trust is a separate taxpayer, but not a legal entity unto itself. It cannot be sued. Nor can it initiate a lawsuit. Instead, the trustees will represent the trust during litigation. For example, they might be sued by the beneficiaries for negligent mismanagement.
— Stewart Lewis