As a family’s wealth rises, thoughts turn to preserving and transitioning the funds to the next generation, which is often done through a trust. While many people think of this as something that will kick in after they die, trusts can also do a lot of good when you’re very much alive.
Trusts allow for flexibility and control over where, when and under what conditions someone’s assets are used to provide a benefit to someone else. That can happen through an inter-vivos, or living, trust, which is created and takes effect during the lifetime of the settlor, the person who establishes it.
The Canada Revenue Agency lists 33 types of such trusts that can be established for a variety of purposes and for different beneficiaries. Some are quite specialized, associated with insurance, pensions and real estate. Others cover spouses and common-law partners, children with special needs and retiree nest eggs.
Perhaps the most common inter-vivos trust that most people are aware of is a family trust, although that is only a colloquial term and “typically means a trust that you set up while you’re alive for your family members,” says Jamie Golombek, managing director of tax and estate planning for CIBC Private Wealth Management in Toronto.
A useful function of such a trust can be to split income among family members who pay lower tax rates, says Golombek. He notes that there used to be opportunities to use trusts to divide income from private companies among family members, but those have been mostly eliminated (for those who don’t work in the family business) by the tax on split income, known as the TOSI rules.
But someone in a high tax bracket can lend funds to a family trust at the government’s prescribed rate of interest, currently at an all-time low of 1 per cent. That can be invested and pay out an income that is used to cover expenses for beneficiaries, such as children and grandchildren, who are responsible for paying tax on the amount generated but typically at a much lower rate.
For example, a person can lend $1 million to the trust and appoint a spouse as trustee, with their children as beneficiaries. The person would need to pay $10,000 of interest on the loan each year, but the funds would earn perhaps a 5-per-cent dividend yield, invested in a portfolio of Canadian blue-chip bank stocks.
This would bring $40,000 a year of income to “use on their behalf,” Golombek says. “That could pay for their private school, for a portion of their vacations, for hockey, summer camp, clothes, anything like that.”
Money should benefit the kids
It’s important for the higher-income family member to charge, collect and pay tax on the interest, and for the investment income to be taxed in the hands of the beneficiaries, Golombek says, otherwise the income is “attributed” back to the lender. It must be payable to the kids and used for something that benefits them, he cautions. “You shouldn’t use it to pay your mortgage.”
So-called income attribution regulations are among important rules to be aware of and obey when dealing with trusts, says Scott Binns, a partner at Richter LLP who specializes in tax and estates as well as the emerging technology advisory. He is based in Montreal.
Be aware of current rules and seek professional legal and accounting advice in drafting a trust deed, he says. Keep things up to date, especially in the case of life changes such as the death of a spouse or child, a divorce or marriage that affects the trust, or perhaps a shareholder agreement.
“Those all have to work together,” Binns says. “If you’re not getting a holistic approach, and you have tunnel vision with one of them, you’ll fall offline.”
Setting up inter-vivos trusts can minimize disputes among heirs, Golombek says. A will could be contested on the basis that a person may have lacked mental capacity or was unduly influenced when it was drawn up.
“That is less likely to occur with a trust set up during your lifetime, when you directed and carried out the trust settlement,” he says.
Setting aside funds for a partner
Terms in an inter-vivos trust can take effect in your lifetime and continue after your death. For instance, a spousal trust can begin while you’re alive, setting aside funds for your partner to use, then continue after you pass away.
Golombek says that some trusts, known as life-interest trusts, can actually transform significantly between an inter-vivos and a testamentary trust, providing income for one or more beneficiaries during their lifetimes and then a “residual” beneficiary after your death. The most common of these might provide for an individual, the individual’s spouse or partner during their lifetime(s), then the assets remaining in the trust at death go to other beneficiaries, such as children from a first marriage or a charity.
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Another type of life-interest trust, an alter-ego trust, is established by a settlor who is 65 or older, mostly for probate-planning purposes, says Rachel Blumenfeld, a lawyer in the tax, trusts and estates group at Aird & Berlis LLP in Toronto who is deputy chair of the Society of Trust and Estate Practitioners (STEP) Canada. She says, for example, that property such as a family cottage can be put into an alter ego trust so that when the person passes away, it does not face probate.
Inter-vivos trusts are also commonly used in the case of beneficiaries with addiction and disability issues. Blumenfeld notes that there are important considerations in setting up such a trust, such as who should manage it and how to ensure that people with special needs are not disqualified from receiving government benefits.
Cost: a few thousand dollars
A Henson trust, named for a legal case in the 1980s, ensures that a beneficiary can continue receiving funds, medication, accommodations, dental and other services through provincial disability support programs and pensions, she says. Where the trust is also a Qualified Disability Trust under the Income Tax Act, the income in the trust can be taxed at graduated rates, says Blumenfeld, noting that it’s important to seek advice on such trusts, set up them up carefully and follow all rules.
Establishing a basic trust can usually be done for a few thousand dollars, she says, which mostly goes to spending time talking through your situation and wishes, then deciding matters like appointing the trustee or trustees and deciding how much discretion to give them. There are also ongoing costs, such as filing a tax return each year, preparing trustee resolutions and keeping accounts.
The choice of a trustee or trustees “is a huge decision,” she says. “Who will be the trusted friend or family member to deal with the assets and ensure they are properly cared for, as well as deal sensitively with beneficiaries?”
Trustee choice often depends on the purpose of the trust, she points out. For instance “if it’s really to protect your kids, then a lot of times it’s going to be a family member.”
And it makes sense to have trustees with professional expertise if there’s a business involved. “You’re choosing who’s going to be the next person in control,” Blumenfeld explains, noting that family accountants, trust companies and other professionals can also fill the role.