For residents of Quebec, view our Quebec edition
Tax managed strategy 13
Alter ego and joint partner trusts are popular ways to avoid probate. What are these trusts? How do they work? These trusts can be used as part of your overall estate plan but they have downsides. Are there cost-effective alternatives?
What are they?
An alter ego trust is an inter-vivos trust established after 1999, meaning it’s set up during your lifetime. You (the settlor) must be a Canadian resident, 65 or older, and be the sole beneficiary of all income of the trust during your lifetime—no other person may be entitled to receive or benefit from the income or capital of the trust during your lifetime. While you can appoint a third party as trustee or co-trustee, you can also appoint yourself. If you name yourself as trustee, ideally you name an alternate trustee that can step in and administer the trust on your passing (similar to that of an executor). The trustee (or majority of trustees if there are multiple trustees) and the alter ego trust itself must be resident in Canada.
A joint partner trust is similar except that both spouses1 must be entitled to receive all the income of the trust, and no other persons may be entitled to receive or benefit from the income or capital of the trust. This continues until the death of the surviving spouse. For a joint partner trust, only one of the spouses (the settlor or transferor) must be 65 or older.
Alter ego trusts are created by statute, namely the Income Tax Act (ITA) and are often touted as a will substitute since the trust document directs the disposition of trust assets on your death (or the death of the surviving spouse if it’s a joint partner trust). This allows you, the settlor of the trust, to name beneficiaries that’ll benefit from the trust when they pass (or the surviving spouse if it’s a joint partner trust), which is similar to naming beneficiaries in the residual provisions of your will. On your death, the disposition of trust assets generally avoids probate and associated legal fees. While probate is a public process, the disposition of trust assets is usually private. Often these types of trusts are used for probate planning, to limit inter-provincial asset issues, and for incapacity planning.
How they work
Unlike other trusts, many assets2 may be transferred to an alter ego trust at cost rather than at fair market value (FMV), allowing you to defer taxation of capital gains until the assets are sold or you pass away (or your spouse if it’s a joint partner trust). You can elect to transfer assets to the trust at FMV, which can be advantageous if you have significant capital losses, own certain qualified small business corporation (QSBC) shares, or certain qualified farm or fishing property (QFFP). While individuals may claim the lifetime capital gains exemption on the sale of QSBC shares or QFFP, an alter ego trust can’t claim the same exemption.
Most trusts are subject to the 21-year deemed disposition rule pursuant to Subsection 104(4) of the ITA. As a result, capital assets held in trusts are considered disposed of at fair market value every 21 years, which can generate a substantial tax bill. With an alter ego trust, there’s no deemed disposition until your death, or the death of the surviving spouse if it’s a joint partner trust (unless you elect otherwise). If the trust continues after your death (or the death of the surviving spouse if it’s a joint partner trust), then the trust will be subject to the 21-year deemed disposition rule going forward.
How alter ego trusts can benefit your estate plan
It’s important to note that the assets you want to transfer to the trust must formally be transferred to the trust; legal title must actually transfer and be placed into the name of the trust. Once you transfer this property to the trust, legal title is no longer held by you, even if you (the settlor) are also the trustee. If you’re the settlor and trustee, when dealing with the trust’s assets, you must make sure to do so in your capacity as trustee and not comingle personal and trust assets.
For certain assets—such as real property—GST or HST, land or property transfer tax, and other land registry fees may be applicable on the transfer to the trust. Land or property transfer tax may also be applicable on the transfer from the trust to the named beneficiaries on the passing of the settlor, or surviving spouse if it’s a joint partner trust. In some provinces, a transfer to an alter ego trust may be exempt from the provincial land transfer levies; however, in other provinces the costs associated with the land transfer tax may outweigh the benefits of the alter ego trust.
The ITA prohibits a trust from claiming the principal residence exemption unless specific requirements are met. An alter ego trust or joint partner trust3 could be used to hold personal use property, such as your principal residence, while still allowing you the ability to designate such property as a principal residence.
Assuming there’s no fraudulent conveyance,4 transferring assets to an alter ego trust can also provide potential creditor protection.5 The effectiveness of the alter ego trust in sheltering or protecting against family law property division claims, support claims, dependents’ relief claims, wills variation, and other estate or succession litigation depends largely on the facts of the particular case as well as the applicable provincial legislation and jurisprudence.
Moreover, depending on the relevant provincial succession legislation and jurisprudence, the alter ego trust could be subject to litigation on the grounds that the trust is testamentary in nature and thus subject to the formal execution requirements for testamentary instruments and/or the provisions that allow for will challenges or variations. If the trust deed limits the settlor’s ability to encroach on capital or names someone other than the settlor as trustee, it may help to reduce this risk, but the nature and extent of this risk varies by province.
Additionally, alter ego trusts are used in incapacity planning since the trustee or trustees can be other family members. There are some advantages to using an alter ego trust for incapacity planning, especially if there are assets in different Canadian jurisdictions. For instance, a power of attorney appointed in a British Columbia power of attorney document may experience practical difficulties administering and dealing with assets in a different province. Further, depending on the power of attorney document and the province, a named power of attorney may also be able to facilitate the settlement of an alter ego trust.
So why doesn’t everyone set one up? As a formal trust, initial legal fees and setup costs could amount to thousands of dollars. Additional costs for accounting, filing tax returns (including e-filing with a trust account number), and trustee fees are ongoing and could be substantial. Additionally, alter ego trusts will be subject to the increased tax reporting and more onerous disclosure requirements once proposed legislation is enacted, which would likely increase the costs and complexities of the trust returns as well as expose you to hefty penalties for failure to file and/or filing omissions.
During your lifetime, trust income can be attributed back to you and taxed at your marginal rate. For a joint partner trust, this can be more complicated as the ITA attribution rules must be considered and, generally speaking, the joint partner trust can’t be used to shift income, so tracing may be required.
There’ll be a deemed disposition, at FMV, of trust assets on your passing (for an alter ego trust) or on the death of the surviving spouse (for a joint partner trust), which means the trust’s assets will be taxed within the trust and subject to the highest personal marginal tax rates applicable in the alter ego trust’s province of residence. The beneficiaries (on the passing of the settlor, or the surviving spouse if it’s a joint partner trust) named in the alter ego trust deed will acquire their respective trust properties at their FMV at the time of the deemed disposition.
There are other restrictions with tax and estate planning when assets have been transferred to an alter ego trust. During your lifetime, the trustee can only distribute income or capital to you (the settlor) or your spouse (if it’s a joint partner trust), which restricts charitable gifting options. Moreover, if the alter ego trust holds private company shares, has non-resident beneficiaries, has U.S. persons as the settlor or grantor, or holds U.S. situs assets, then these can cause additional tax complications, tax mismatches, and the potential for double taxation.
Alter ego trusts offer the potential to avoid probate and legal fees on death, potential asset protection, and the ability to transfer assets to the trust at cost (i.e., without the realization and taxation of capital gains when transferred to the trust). Other available options, such as a segregated fund contract or guaranteed interest account (GIA), provide similar benefits with substantially less cost and with simplified ongoing administration. The accounting work is done for you and summarized on your tax slip; all you need to do is simply add the income when filing your tax return.
As well, a segregated fund contract or GIA with a beneficiary of the family class6 offers the potential for creditor protection. When a beneficiary other than your estate is named, assets may bypass your estate and generally are paid to the beneficiary7 on your death without payment of either legal or probate fees. Their disposition usually remains a private matter.8 Distribution of assets directly to a named beneficiary is almost always faster than settling an estate.
In addition, a segregated fund contract or GIA is easy and free to set up, unlike an alter ego trust. As the owner of the segregated fund contract, you maintain complete control. Changing a beneficiary or beneficiary payout option simply requires completion of a form rather than a formal variation of the trust—which, depending on the extent of the variation, could be considered a taxable disposition of the trust’s assets.
While alter ego and joint partner trusts offer some attractive and flexible features, segregated fund contracts and GIAs offer many similar advantages, as well as some others, without the additional costs.
Investors should consider segregated fund contracts or GIAs as alternatives to alter ego or joint partner trusts if they want:
- low costs
- potential creditor protection
- tax-efficient disposition of assets at death
- potential to bypass probate
- ability to set up a testamentary trust at death
- capital guarantees on maturity or death.
If you’re looking for the features listed above in an investment:
- contact your advisor
- decide how much you want to invest
- name your beneficiaries and consider testamentary trusts
- decide what funds or GIAs meet your investment goals.
Investment options with Manulife Investment Management
Manulife Investment Management provides a range of investments and services.
- Segregated fund contracts combine the growth potential offered by a broad range of investment funds with the unique wealth protection features of an insurance contract. Through Manulife segregated fund contracts, investors can help minimize their exposure to risk through income, death, and maturity guarantees; potential creditor protection features; and estate-planning benefits—all from a single product or insurance contract.
- Guaranteed interest accounts (GIAs) offer investors the benefits from a guarantee on their principal investment and from several different investment options that can diversify and add flexibility to their portfolio. GIAs can be an ideal solution for conservative investors looking to help grow their wealth but want to minimize risk.
1 All references to spouse include common-law partners as defined in the ITA.
2 Generally, capital property can be transferred tax deferred to an alter ego trust. Capital property can include assets like portfolio investments (such as mutual funds, segregated funds, individual stocks), rental properties, your principal residence, and more. However, other assets like undeveloped land could be considered land inventory, thus, not capital property and couldn’t be rolled into the trust. As well, the transfer of an RRSP or RRIF to the alter ego trust is a deregistration of those registered accounts and is fully taxable at that time, whereas an alter ego trust may be the named beneficiary of registered accounts.
3 Limited trusts may be able to designate personal use property as a principal residence. These include alter ego trusts, joint partner trusts, and self-benefit trusts, as well as some other narrow exceptions. Certain trusts, like family trusts, wouldn’t be able to designate personal use property as a principal residence.
4 There’s no set time frame in determining a fraudulent conveyance. Instead, it’s more factually based to determine if something is a fraudulent settlement. Settling an alter ego trust and transferring assets to that trust won’t avoid creditors if this was done to defeat their claims. Creditor protection wouldn’t be available any time information is known, or should have been known, that would indicate a problem with creditors.
5 There‘s potential for creditor protection against estate creditors but much more limited asset protection during the settlor’s lifetime, especially if the settlor is also the trustee (and entitled to encroach on capital pursuant to the trust deed).
6 In provinces other than Quebec, a family class beneficiary is any spouse, child, grandchild, or parent of the annuitant. In Quebec, a family class beneficiary is any married or civilly unified spouse, descendants, or ascendants of the owner.
7 This is subject to the common law presumption of resulting trust—which, depending on the particular province’s jurisprudence, can apply to beneficiary designations. If applicable in the province and not rebutted by the named beneficiary, those assets are subject to probate, and the named beneficiary is to hold those proceeds on resulting trust in favour of the residual beneficiaries of the deceased planholder’s estate. For more information, see Guarding beneficiary designations—recent developments and Guarding beneficiary designations—impacts of the Mak (Estate) decision.
8 In Saskatchewan, jointly held property and insurance policies with a named beneficiary are included on the application for probate but don’t flow through the estate and aren’t subject to probate fees.
The commentary in this publication is for general information only and should not be considered investment or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. Manulife Funds are managed by Manulife Investments, a division of Manulife Asset Management Limited. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the fund facts as well as the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. The Manufacturers Life Insurance Company is the issuer of all Manulife Investments Guaranteed Interest Contracts, the Manulife Segregated Fund Contracts and the guarantor of any guarantee provisions therein. Age restrictions and other conditions may apply. Any amount that is allocated to a segregated fund is invested at the risk of the contractholder and may increase or decrease in value.
Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.