Use of spousal trust or common-law partner trusts

Setting up a spousal or common-law partner trust is a very important decision that generally results from non-tax reasons. One of the common reasons for setting up this type of trust is to protect the surviving spouse from influencers who might try to gain access to the surviving spouse’s inherited assets. The set-up of a spousal or common-law partner trust can provide protection from the wants of current and future children, future spouse and their children, along with a number of other potential influencers.

When setting up a spousal or common-law partner trust, the assets being transferred to the trust and the potential future tax consequences should always be considered to maximize the after-tax cashflow to the surviving spouse and the trust’s residual beneficiaries[1].

Tax planning for use of lifetime capital gains exemption

If one of the assets transferred to the spousal or common-law partner trust is shares of a qualified small business corporation or shares of the capital stock of a family farm or fishing corporation, then additional tax planning might be necessary (we will refer to these shares as qualifying shares). Upon death, qualifying shares automatically roll over to the surviving spouse or common-law partner on a tax-deferred basis unless the executor or executrix elects out of this automatic tax treatment. The reason one would elect out of the automatic spousal rollover would be to create a capital gain sufficient to use up the deceased individual’s remaining life-time capital gains exemption as any unused exemption would be permanently lost. Electing to use the life-time capital gains exemption creates what is known as a bumped-up cost base of the shares.

The benefit of electing out of the automatic spousal rollover in order to utilize the remaining life-time capital gains exemption of the deceased spouse[2] is to reduce the capital gain on the future sale or deemed disposition by the surviving spouse as a result of the bumped-up cost base of the qualifying shares. The surviving spouse will also have a life-time capital gains exemption which can be utilized to further shelter potential capital gains from the future sale or deemed disposition of the qualifying shares.

Complications of using a spousal or common-law partner trust

This type of tax planning can be further complicated if the deceased spouse has the qualifying shares transferred to a spousal or common-law partner trust instead of directly to the spouse because trusts cannot claim a capital gains exemption on qualifying shares. Therefore, on the death of the surviving spouse, the deemed disposition of these qualifying assets held in the trust will not benefit from the unutilized life-time capital gains exemption of the deceased surviving spouse.

From 1985 to end of 2015, there was an exception afforded to spousal and common-law partner trusts under subsection 110.6(12) of the Income Tax Act. The original purpose of this subsection was to provide a spousal or a common-law partner trust the ability to elect and claim the life-time capital gains exemption utilizing the surviving spouse’s remaining lifetime exemption limit at the end of the year in which the surviving spouse died. This subsection was repealed for 2016 and subsequent taxation years.

As a result of the repeal of this exception, spousal and common-law partner trusts can no longer utilize the surviving spouse’s unutilized life-time capital gains exemption. Upon the death of the surviving spouse, the unutilized life-time capital gains exemption of the surviving spouse would be lost forever if the qualifying shares were held in a spousal or common-law partner trust.

It is important to consider the potential tax consequences of losing the ability for the surviving spouse to claim their lifetime capital gains exemption prior to establishing a spousal or common-law partner trust as part of your client’s estate planning for disposition of qualifying shares.  A more effective strategy may be to bequest some or all of the qualifying shares directly to the surviving spouse and not through the use of a spousal or common-law partner trust. Bequeathing directly to the surviving spouse would leave the door open for the surviving spouse to use their remaining life-time capital gains exemption to shelter potential capital gains resulting from a deemed disposition of the qualifying shares upon their death.

[1] The residual beneficiaries would be the beneficiaries that will inherit the property upon the surviving spouse’s death.

[2] maximum limit for 2020 is $883,384.