The Use of Trusts in a Tax and Estate Planning Context

The Use of Trusts in a Tax and Estate Planning Context Calgary CFA Society 2011 Wealth Management Conference Dennis Auger (KPMG LLP) and Sandra Mah (Gowlings LLP) September, 2011

Trusts - Useful Applications What is a Trust and how is it taxed? Corporate Ownership Retirement & Will Planning Vacation Property Ownership Creditor Proofing Tax Benefits Other Useful Trusts 2

What is a Trust? Settlor Living Inter Vivos Deceased - Testamentary Trust or Estate Assets Investments Business Trustees Owns & holds property Discretionary or Non- discretionary Income Beneficiary Capital Beneficiary 3

Trust Elements Three parties Settlor; Trustee; Beneficiary Fiduciary relationship which the trust creates between the trustee and the beneficiaries The Settlor creates the trust by transferring property to the trustees to hold in trust Trustee holds legal title to property for the benefit of another - the beneficiary Trustee manages, administers and invests the property Beneficiaries have the use and enjoyment of the trust property 4

Testamentary Trusts Arise as a consequence of the death of an individual (numerous trusts are possible) Taxed at marginal rates Fiscal year end Taxation of income earned in the trust reduced by amounts paid or payable 5

Inter Vivos Trusts Set up during lifetime Taxed at highest tax rate with a December year end Reduced by amounts paid or payable Can save probate fees in jurisdictions (probate fees in Alberta are a maximum of $400 may be more applicable in other provinces) Can deal with international estates (settlor lives in multiple jurisdictions, has assets in several jurisdictions or if laws of more than one jurisdiction might apply) Can save income taxes in certain situations (Alta trust) Slight advantage for older settlors - avoids clawback on excess income 6

Trust Taxation Taxation of trust possibilities Conduit Taxable as a separate taxpayer Combination Trust documentation and trustee powers Three certainties to establish a trust 1. Intention: Settlor must have the intention to create trust by the transfer of property in trust 2. Subject matter: The property being transferred must be clearly identifiable 3. Objects: The beneficiaries must be ascertainable Outline the trustee powers otherwise the provisions of the applicable Trustee Act apply 7

Review of Key Issues in Taxation of Trusts Trust normally treated and taxed as a separate individual Trust income is taxed in the trust at top personal rates for inter vivos trusts and graduated rates for testamentary trusts, unless allocated to beneficiary Allocations are deductions from taxable income: Must be income taxable to beneficiaries Amounts paid or payable unless preferred beneficiary Imperfect conduit on allocations/distributions: trust income retains its character: dividends, capital gains, foreign income to beneficiary Can not allocate: losses, donations 8

Review of Key Issues in Taxation of Trusts Assets transferred to trusts usually occur at fair market value with tax consequences to transferor unless exemption (alter ego, joint spousal, bare) Assets transferred to spouse or spousal trust can be rolled over tax free at transferor spouse s ACB unless exempted (elect out, FMV consideration) Attribution back to transferor for assets transferred to spouse or spousal trust (74.1/.2/.3) unless exemptions (no reversion or control) Capital trust property may be rolled out to beneficiaries at trust cost base (unless 75(2) trust) 9

Review of Key Issues in Taxation of Trusts Trusts deemed to dispose of assets at FMV every 21 years unless exempted Accumulating income (tax paid) accrues to capital Trusts are resident/taxed where the central management and control is located (see Garron) and not necessarily where the trustees are located Deemed disposition at fair market value if trust residence leaves Canada Need to watch out for reversionary trust rules - often unintentional application 10

Trusts Corporate Ownership Utilization of trusts in the corporate ownership structure Benefits: Creditor proofing Income splitting/estate (succession) planning Multiply the QSBC capital gains exemption Control 11

Trusts Corporate Ownership Holdco Structures Examples (Conventional) Trust Holdco Trust Holdco Opco Opco 12

Trusts Corporate Ownership Corporate Beneficiary Structure - Example Holdco Family Benefits: -Creditor Protection -Purification -Multiply CGE - Trust Opco 13

Trusts Retirement & Will Planning Utilization of trusts in retirement and Will planning Possible uses: Alter Ego/Joint Partner trusts Life insurance trusts Support obligation trusts Disability trusts (less utilized in Alberta although popular in other jurisdictions) Spousal trusts Charitable giving or remainder trusts/foundations Minor or spendthrift trust Multiple testamentary trusts 14

Trusts Retirement & Will Planning Alter Ego/Joint Partner Trusts Requirements: Transferor must be 65 or more and Canadian residents Only transferor/spouse can receive income or capital from trust during lifetime Advantages No FMV disposition on transfers in Reduced provincial and probate fees possible Asset management in event of incapacity Possible creditor protection Avoid spousal or dependent relief claims No 21 year rule Can be structured to avoid 75(2) [other trustees; irrevocable; capital at death to ] 15

Trusts Retirement & Will Planning Alter Ego/Joint Partner trusts Disadvantages No rollovers on death to spouse or spouse trust or testamentary trust On death, trust assets are treated separately resulting in no utilization of losses or gains in trust against estate losses or gains No 164(6) election available for any losses No QSBC deduction Any gifts at death are not eligible for gift by Will benefits 16

Trusts Retirement & Will Planning Insurance Trusts Requirements: Created upon death as testamentary trust Settled by insurance Advantages: Avoids probate and creditor attachment Avoids public trustee involvement for minor children Separate trusts for different people or objectives Disadvantages Subject to 21 year rule 17

Trusts Retirement & Will Planning Spousal testamentary trusts Requirements: Trust set up by Will Spouse must be entitled to receive all income during his/her lifetime No person other than spouse may receive or otherwise obtain the use of the income or capital of the trust during lifetime of spouse Spouse must be Canadian resident at taxpayer s date of death Advantages: Avoids deemed disposition of assets on death of taxpayer (executor can elect out for some assets) Access of spouse to capital could be restricted or at discretion of trustees during his/her lifetime Not subject to 21 year rule 18

Trusts Retirement & Will Planning Spousal testamentary trusts Disadvantages: Only spouse can access trust funds ( but can then give to others) No tax free rollover if spousal trust not properly set up or tainted (asset must vest in spouse/trust within 36 mo.) Tainted: Trust able to lend funds at non-commercial terms Trust required to pay life insurance premiums on spouse Un-Taint: variation of Will or trust or beneficiary disclaimer CRA permits some payments to third parties without tainting spousal trust status funeral expenses, taxes, debts of estate 19

Trusts Retirement & Will Charitable giving or remainder trusts Requirements: Planning Gift of equitable interest in trust to charity without expectation of benefit Transfer must be irrevocable Property must vest in charity at time of transfer Advantages: Registered charity will receive property after expiration of all prior life interests Settlor entitled to current charitable tax credit at time of transfer equal to the discounted present value of the remainder interest Settlor entitled to all income and enjoyment of property during their life No capital gain or probate on death No dependent relief issues 20

Trusts Retirement & Will Planning Charitable giving or remainder trusts Disadvantages: Tax credit limited to 75% of donor s income in year of transfer (but 5 year carry-forward available) Capital gain at time of transfer to trust on total gain of property but s.118.1(6) election possible Appropriate Situations Significant donation planned at death and concern that full advantage of donation credit will not occur Desire for fixed income, concern over significant capital gains at death (public or private shares, rental property) Older settlor that can maximize present value of gift and utilize alter ego trust to transfer property into trust tax free 21

Testamentary Planning (multiply the ability to access lower tax rates) Assume Mrs. A has 2 children; child 1 and child 2 She establishes in her Will a trust for each child; Example of savings in 2011: Direct Inheritance at marginal tax rate of 39% Testamentary Trust at graduated rates Portfolio $ 1,000,000 $ 1,000,000 6% Interest Income $ 60,000 $ 60,000 Taxes Payable $ 23,400 $ 13,015 Income Retained $ 36,600 $46, 985 Net Annual Savings through a testamentary trust $ 10,385 22

Testamentary Planning Assume Mrs. A has a son with a successful business, but does not have much wealth; Mrs. A establishes a testamentary trust for the benefit of her son, daughter-inlaw and children and provides a contribution of $1.00 to the trust; Son undertakes an estate freeze; the testamentary trust uses the $1.00 to acquire new common shares of son s business Income earned by the testamentary trust is taxed within the trust at its marginal tax rate Since the income is taxed in the trust, no income is allocated to the beneficiary to attract the kiddie tax for minor beneficiaries 23

Trusts Vacation Property Utilize trusts to hold domestic vacation property for future generations Utilize trusts to hold US vacation property to avoid US estate tax 24

Domestic Vacation Property Benefits: Transfer future growth, set up children ownership/succession while retain control during lifetime Estate planning Avoid probate Creditor protection Avoid variation of Wills or confidential issues Shelter future gains by principal residence exemption Disadvantages Transfer in creates disposition of property unless rollover possible Possible GST and transfer fees/taxes Subject to 21 year rule (roll out at ACB if not 75(2) trust or if 75(2) contributor is deceased) 25

Domestic Vacation Property Issues: Operating costs funded by trust CRA admin position not to assess 105(1) taxable benefit to trust beneficiaries/related persons if personal use property CRA admin position not to assess 105(2) taxable benefit unless trust pays maintenance and upkeep expenses out of trust income Attribution 75(2) possible if transferor is sole trustee or a capital beneficiary, resulting in no tax-deferred rollout to beneficiary Consider gold coin settlement and loan to trust 74.1/2/3 26

Domestic Vacation Property Issues: Principal residence exemption At least one specified beneficiary or a qualifying family member of a specified beneficiary who ordinarily inhabits No corporation or partnership as a trust beneficiary Designation in prescribed form and manner No other property designated by a specified beneficiary or a qualifying family member Trust designation could prevent beneficiaries and family members from claiming PRE in respect of their own personal residence - consider only non-minor children as trust beneficiaries to allow parents to designate property as principal residence 27

Foreign ownership of Canadian Vacation Property Canadian Trust utilized to hold directly Canadian vacation property for non-residents Advantages: Results in non-resident being able to access principal residence exemption No Canadian withholding tax on capital distributions Disadvantages: Subject to 21 year rule US person has interest in foreign trust which may require annual reporting on form 3520 Income of trust is subject to 36% Part II.2 tax and Part XIII Canadian withholding tax on distributions 28

Ownership of US Real Property with a Canadian Resident Trust Advantages Avoids shareholder benefit issues Preserves ability to obtain beneficial US long term capital gains rate on sale Avoids US estate tax for Canadian residents Disadvantages 21 year rule Death of beneficiary spouse before settlor spouse surviving spouse should rent at FMV 29

Trusts Advantages Useful situations Income splitting Minimize probate Provide creditor proofing/creditor protection Matrimonial and dependent claim protection Confidentiality Charitable giving Minors/spendthrifts/disabled Asset management without power of attorney Family law support obligations Immigrants to Canada Incorporation or estate freezes (family trusts) Holding vacation homes 30

In Trust Accounts A brokerage/bank account where the parent/ grandparent invests funds with the intention that the funds in the account belong to and be invested for the minor Account is registered in the name of the parent in trust for minor There is no formal trust deed 31

In Trust Accounts What is this? Gift: Transfer of property to the child is a gift right to control or deal with the property probably rests with the public trustee Bare Trust: The parent, as trustee, is the child s agent; the parent's only function is to hold legal property to the title; the child can take the full control of the funds at 18 years True Trust: Subject to the common law and statutory rules regarding trusts 32

Taxation In Trust Accounts Gift: Capital gains taxable to the child; s.74.1(2) attributes interest or dividends to the parent; Bare Trust: Capital gains taxable to the child; s. 74.1(2) attributes interest or dividends to the parent; True Trust: T3 tax return; 75(2) may apply depending on who the settlor and trustee is; capital gains taxable to child provided capital gains are paid or made payable to the child by the end of the year in which the gains were realized; interest or dividends attributed to donor parent 33

Age 40 Trust Non-Discretionary (subsection 104(18)) The Age 40 Trust allows a parent to utilize a child s lower marginal tax rates until the child turns 21 years of age Age 40 Trust: Minor beneficiary is vested with the right to income and taxable capital gains of the trust on an annual basis Income and taxable capital gains earned by the trust before the minor turns 21 can be retained in the trust until the minor turns 40; after 21, the income and taxable capital gains is paid to the beneficiary, however, everything earned before age 21 can be retained in the trust until age 40 34

Trust Income Splitting Income splitting opportunity Take advantage of marginal tax rates Lock interest in at CRA prescribed rate Prescribed rate currently 1% 35

Trust Income Splitting Parents Loan Beneficiaries TRUST 36

Assume Client Has... $1,000,000 invested at 6% Spouse, two children with no income 37

Trust Income Splitting 1. Loan to the Trust @1% Interest to parent $10,000 2. Income in Trust $1,000,000 @ 6% $60,000 Interest paid to parent (10,000) $50,000 Paid to beneficiaries (50,000) Taxable income NIL 38

Trust Income Splitting 3. Income To Beneficiaries (3) $50,000, SAY 1/3 RD EACH. EACH WOULD PAY ~ $1,000 TAX 4. Tax Savings: $50,000 @ 39% $19,500 Tax paid by beneficiaries (3,000) $16,500 39

Trusts Creditor Proofing Utilize trusts for creditor proofing purposes Advantages - Domestic trusts Creditor s ability to seize is limited unless transfers made with insolvency issues present Settlor can still retain enjoyment of property through life interest or from irrevocable transfers to spouse or children Disadvantages - Domestic Settlor has to give up property rights in order to ensure protection Foreign trusts in jurisdictions with favourable legal protection of settlor Additional legal protection for assets in foreign jurisdictions Frustrate ability of creditors to access assets 40