Types of Trusts

Trust law is complicated, and as such there are many different types of trusts. Two of the main categories of trusts are testamentary and inter vivos.

Testamentary Trusts

A testamentary trust is a trust that arises upon the death of the testator. When the person dies, the trust begins, based on the details that are outlined in their Will. The Will appoints the trustee, the beneficiaries, and other terms of the trust.

There are many advantages of a testamentary trust, including:

  • They are often used where a minor beneficiary is not capable of managing assets received directly at the time of the testator's death.
  • Can be used to defer capital gains tax if the trust qualifies as a spousal trust;
  • Control over distribution of income and capital by directing how the trustees shall distribute income and capital of trust. Often, assets will remain in the trust until a child reaches age 25-30, subject to discretionary payments that can be made by the trustees at any time;

  • Creditor protection (from future creditors) from a beneficiaries potential creditors;

  • Potential family law protection from the breakdown of marriage between a beneficiary and their spouse; and

  • Preferential tax treatment (subject to new legislation discussed below).

 In 2014, tax legislation was introduced that will effect the taxation of testamentary trusts. In the past, testamentary trusts were taxed in graduated tax brackets. Essentially, this allowed income earned in a testamentary trust to be taxed as a separate person and was eligible to be taxed at graduated tax rates resulting in lower taxes as compared to a beneficiary taxed at the highest marginal tax rate. However, as a result of the recent legislative changes, all income in a testamentary trust is taxed at the highest marginal tax rate, other than for a testamentary trust that meets the requirements to qualify as a Graduated Rate Estate, which will allow the trust to receive graduated rate tax status for 36 months following the creation of the testamentary trust. These rules are scheduled to come in effect in 2016.

Spousal Trust

A spousal trust is a form of testamentary trust meant to provide for a spouse after the testator’s death. There are two main requirements of a valid spousal trust:

  • 1. The surviving spouse must be entitled to receive all of the income from the trust during their lifetime.
  • 2. No person other than the spouse can receive, use, or have the benefits of the capital of the trust during the spouse’s lifetime.

One of the main reasons to use a spousal trust for estate planning purposes is to take advantage of the spousal rollover provision. For example, a husband owns shares in a company which he had started from scratch (meaning his cost base on the shares is essentially $0) and those shares are now worth $10mm. Then, on his death he will be deemed to have disposed of those shares and his estate will have a $10mm capital gain, half of which would be taxable. If, however, he establishes a spousal trust in his will, then on his death the shares will be allowed to "rollover" to his spouse tax free, thus deferring the capital gains tax liability until the spouse's death. Although the spousal rollover would also be available if the shares were transferred to the spouse directly, the deceased, although they want to provide for the surviving spouse during their lifetime, they may not want the spouse to have access to the capital directly.  This is common for example in cases where the deceased has children from a previous marriage or where the surviving spouse may not be capable of managing the capital directly. Spousal trusts are subject to a deemed disposition on the death of the surviving spouse and every 21 years thereafter.

If a spousal trust is established to defer the capital gains tax then a joint 2nd to die life insurance policy may be used to fund the ultimate tax liability that will arise on the death of the second spouse.

  

Inter Vivos Trusts

 An inter vivos trust, or living trust, is created and comes into existence during the lifetime of the person creating the trust, known as the settlor. The duration and terms of the trust is decided at the time of its creation. As part of the terms of the trust, trustees are appointed to manage the property of the trust as provided in the trust agreement. This type of trust may distribute the assets to the named beneficiaries during or after the settlor’s life.  An inter vivos trust will be subject to a deemed disposition of its assets every 21 years (from the date of creation), unless planning is undertaken prior to that time.  Generally, assets held in an inter vivos trust can be distributed tax-free to one or more Canadian resident beneficiaries prior to the 21st anniversary of the trust.  In the case of a spousal trust (either inter vivos or testamentary),  there is a deemed disposition of the assets held by the trust on the death of the surviving spouse and then every 21 years thereafter

An inter vivos Family Trust that is established as part of an Estate Freeze transaction is an inter vivos trust and as such may be subject to the 21-year deemed disposition rule without proper advance planning.