This article was first published in STEP Insider.
Historically, individuals have taken comfort in the knowledge that their last will and testament is a statement of their final wishes for the disposition of their accumulated wealth. However, in the face of increasing wills litigation and fees payable in connection with obtaining probate, advisers are now seeking planning alternatives to traditional wills. One such alternative is the alter ego trust, a tool which integrates tax consequences during lifetime with planning for the disposition of assets after death.
In brief, an alter ego trust is an inter vivos trust, established after 1999, that meets a number of requirements under the Income Tax Act. A summary of these requirements highlights why the trust is aptly named. The Canadian-resident settlor of an alter ego trust must be at least 65 years of age when the trust is created, the settlor must be entitled to receive all trust income until his or her death, and no person other than the settlor can receive or otherwise use the income or capital of the trust before the settlor’s death. On the death of the settlor, a deemed disposition of the assets in the trust at fair market value occurs. In other words, the trust is taxed in a manner that simulates continued ownership of the subject property by the settlor of the trust. The requirement that the settlor be at least 65 years of age when the trust is created reflects the fact that these trusts were creatures of tax law designed to facilitate estate planning later in life.
Status as an alter ego trust confers a number of advantages. First, from an income tax perspective, the transfer to the alter ego trust of appreciated assets will occur on a rollover basis and will not result in the realization of accrued gains (in contrast to the tax treatment of a transfer to an ordinary inter vivos trust). Second, in the absence of making an election to have it apply, the 21-year deemed disposition that is applicable to other inter vivos trusts does not apply. Again, these results are consistent with those that would have occurred if the settor of the trust still owned the subject matter of the trust. Finally, alter ego trusts are one of the newly restricted types of trusts to which the principal residence exemption continues to be available.
From a non-tax perspective, there are also numerous advantages to alter ego trusts. Historically, the primary reason for establishing an alter ego trust was the reduction of probate fees, as the trust assets will not form part of an estate passing under a will. Today, however, the reasons for establishing an alter ego trust are farther reaching. It is becoming more common to use these trusts to avoid will challenges. In the increasingly litigious environment surrounding the dispositive provisions in wills, often in the context of non-traditional or blended families, it may be a sensible strategy to reduce the number of the assets to which a will applies (and thus reduce the financial incentive for a challenge). In addition, some statutory regimes that apply to the challenging and varying of wills do not currently apply to alter ego trusts. While potentially reducing the risk of a challenge, the alter ego trust still affords its settlor the flexibility to provide for the ultimate disposition of assets in the manner that he or she sees fit.
An alter ego trust may also provide some protection from creditors, although the factual circumstances surrounding the trust’s establishment may detract from this protection.
Finally, in a world in which people are increasingly concerned about privacy, an alter ego trust may provide comfort for its settlor because, unlike the contents of a will, the contents of an alter ego trust are not made public.
As the title of this blog suggests, however, the establishment of an alter ego trust does present some difficulties. First, although an alter ego trust is treated for income tax purposes as being similar to its settlor, the same may not be the case for other types of taxes. Land transfer tax, goods and services tax, and harmonized sales tax could be payable on the transfer of assets to the trust, even if income taxes are not payable. Second, the establishment and maintenance of an alter ego trust can be costly: professional fees as well as transfer costs must be considered in the cost-benefit analysis. Third, despite the fact that the lifetime tax consequences to the settlor are the same under the alter ego trust as they are for the settlor, the same is not true of the income tax consequences associated with the death of the settlor.
In particular, any gain realized on the death of the settlor will be taxable in the trust, at top marginal rates, whereas the gain on assets held personally on death would benefit from marginal tax rates when reported on the settlor’s terminal return. In addition, if capital losses are realized in the trust on the settlor’s death, these losses cannot be used to offset any gains reported on the terminal return and the trust’s ability to utilize them in the future may be limited.
If assets are retained in the alter ego trust after the death of the settlor, the trust will have an ongoing calendar year end and be subject to the highest marginal rates on future income and gains. In contrast, if assets are retained in the estate, income and gains may benefit from marginal rates for up to 36 months.
While a consideration of the advantages and disadvantages of an alter ego trust may lead to the conclusion that the establishment of an alter ego trust constitutes wise estate planning, the circumstances of the individual client are of paramount importance. Some clients, particularly aging ones, may not understand the concept of a trust and may find the notion of giving their assets away to a trust and receiving nothing in return distasteful. These feelings can lead to skepticism and anxiety, especially in clients whose experience tells them that they should accumulate assets over the course of their lifetime, and then dispose of these assets on death by means of a will.
An adviser’s role is to use the tools available to develop the plan that best serves the client’s needs. In doing so, the adviser should never assume that all clients are willing to overlook the existence of thorns for the sake of holding a rose.