(From the October 2021 Edition of eFORUM)
By Kevin Wark
The Income Tax Act allows individuals to establish certain types of trusts (referred to as life interest trusts) to facilitate their estate planning. Let’s consider several tax and non-tax benefits of using a life interest trust:
- capital property will “roll over” to the trust, avoiding the triggering of capital gains;
- the first “deemed disposition” of capital property in a life interest trust only takes place on the death of the life interest beneficiary (or surviving life interest beneficiary); and
- where an inter vivos life interest trust is established, assets in the trust are not subject to probate and probate fees.
The most common type of life interest trust is established for a person’s spouse (a spousal trust). This type of trust can be put in place while the person is alive, but in many cases, is established under the person’s will. To qualify as a life interest trust, the spouse must be entitled to all the income of the trust while alive, and no other person is entitled to trust income or capital while the spouse is alive. Typically, other family members are contingent beneficiaries and will receive trust distributions after the death of the spouse.
A spousal trust under a will can be useful in cases of a second marriage where there are children from the first marriage. The testator may want to ensure that his or her estate is available to support the surviving spouse, with any trust residue passing to the children upon the death of the spouse.
Given that any gains on capital property owned by a life interest trust are triggered on the death of the surviving spouse, it would make sense for the spousal trust to own life insurance on the joint lives of the spouses to cover off any taxes arising on the death of the survivor.
However, the Canada Revenue Agency has indicated that the “mere power” to own life insurance within a trust will disqualify it as a life interest trust, on the basis that trust income and/or capital may be used to pay life insurance premiums rather than benefit the spouse. This can result in an unexpected realization of capital gains on the first death. The following case study demonstrates the “double tax whammy” that can arise where existing insurance is transferred to a spousal trust.
Ellen is age 57, widowed, and has two adult children from her first marriage. Several years ago, she married Jonathan, who also has two children from a prior marriage. They have a marriage contract that provides their pre-marriage assets are kept separate. Ellen is well off in relation to Jonathan, owning investments, a cottage, and rental properties worth $4 million (with an adjusted cost base of $2 million). Ellen is now updating her will and plans to put her rental properties into a spousal trust to provide additional income to Jonathan after her death. Her children will receive the remainder of her estate and be the contingent beneficiaries under the spousal trust. Several years ago, Ellen also purchased a joint second-to-die policy on her life and Jonathan’s, and policy projections indicate the policy will have a death benefit of $2 million and cash values of $200,000 by her age 80. Assuming Jonathan survives her, the life insurance policy will also be transferred to the spousal trust, with the death benefit available to pay tax liabilities on the investments and rental properties that will arise on Jonathan’s death.
Two major problems can arise with what Ellen is attempting to accomplish. First, while the Income Tax Act does allow for a rollover on the transfer of a life insurance policy to a spouse, a transfer to a spousal trust is not eligible. As a result, there will be a deemed disposition of the policy and, assuming the cash value of the policy exceeds its adjusted cost basis, the reporting of policy gains in her final return. Secondly, the transfer of the policy to the spousal trust will “taint” the trust such that the rollover otherwise available to her investments and rental properties will not apply, resulting in the realization of accrued gains. This could result in an additional tax bill of $500,000 or more in Ellen’s final tax return, with the life insurance only being payable upon Jonathan’s death.
The “best” solution from a tax perspective would be to transfer the life insurance policy directly to Jonathan on Ellen’s death, with the policy being subject to an irrevocable beneficiary designation in favour of the spousal trust (to ensure the proceeds are paid to the trust). This would permit the spousal rollover of the policy to Jonathan and would avoid tainting the spousal trust. However, for this plan to be successful, Jonathan would need to continue paying any premiums required to keep the policy in force. Another solution might be to transfer the policy to a “non-spousal” trust with sufficient funding to pay any required premiums, once again with the spousal trust as beneficiary. This would ensure the policy remains in force and would avoid tainting the spousal trust, but unfortunately does not avoid the disposition of the policy on Ellen’s death and the reporting of policy gains.
As can be seen from this example, great care should be taken when contemplating the transfer of an existing joint second to die policy to a spousal trust on the death of the policyowner, as it can result in a cascading tax bill to the deceased.
Kevin Wark, LLB, CLU, TEP, is the author of The Essential Canadian Guide to Estate Planning, 2nd Edition.