Trusts

16.1 Trusts

Trusts play a pivotal role in estate planning in Canada, offering privacy, protection, tax efficiencies, and structured asset management for families and beneficiaries. Whether set up in a person’s lifetime (“inter vivos” trusts) or upon death under a will (“testamentary” trusts), trusts can provide a range of advantages that align closely with an individual’s or family’s financial goals. This section explains how trusts are created, the parties involved, and how to maximize their benefits in the Canadian context.

What Is a Trust?

A trust is a legal relationship involving three key parties:

1. Settlor (or Grantor) – The individual who establishes the trust by transferring assets to it.
2. Trustee – The person or institution entrusted with managing the assets.
3. Beneficiary(ies) – The individual(s) or entity(ies) who receive the benefits (income and/or capital) from the trust.

When a settlor transfers assets (e.g., cash, securities, real estate) to the trustee, the trustee becomes the legal owner of those assets. However, the trustee must manage them according to the instructions set out in the trust deed (also called a trust agreement or trust instrument) for the benefit of the beneficiaries.

Mermaid Diagram: Structure of a Trust

    flowchart LR
	    A(Settlor) -- Transfers Assets --> B(Trustee)
	    B(Trustee) -- Manages Assets for --> C(Beneficiary)

In this diagram:
• The settlor creates the trust by transferring assets.
• The trustee holds and manages the assets.
• The beneficiary is entitled to benefit from those assets.

Types of Trusts

Trusts can be broadly classified into two main categories in Canada:

1. Inter Vivos Trusts (Living Trusts) – Created during the settlor’s lifetime.
2. Testamentary Trusts – Established upon the settlor’s death through a will.

Within these two categories, several sub-types or specialized trusts exist to address specific planning objectives.

Inter Vivos Trusts

Inter vivos trusts are formed while the settlor is still alive. They are sometimes referred to as “living trusts.” Key benefits include:

• Privacy – Inter vivos trusts are generally not part of the public probate process.
• Ongoing Management of Assets – Assets held in an inter vivos trust can be managed by a professional trustee or trusted family member, particularly useful if the settlor becomes incapacitated.
• Asset Protection – In certain circumstances, inter vivos trusts can shield assets from creditors or from marital property claims.
• Income Splitting – In some cases, inter vivos trusts allow for income to be split among multiple beneficiaries, potentially reducing the overall tax burden of the family unit, subject to rules in the Income Tax Act.

Common inter vivos trusts include:

1. Family Trusts – Popular for managing and distributing assets among children or grandchildren. They often allow income-splitting if carefully structured.
2. Alter Ego and Joint Partner Trusts – Available to individuals over age 65. Assets can roll over on a tax-deferred basis, and capital gains are realized only upon the death of the settlor (or the settlor’s spouse, in joint partner trusts). These trusts also help avoid probate on the assets placed in the trust.
3. Charitable Trusts – Established to make ongoing philanthropic donations. They can help reduce taxable income through charitable tax credits and leave a lasting legacy.

Testamentary Trusts

A testamentary trust is created through the instructions laid out in a person’s will and takes effect upon their death. Many Canadians choose testamentary trusts to accomplish:

• Efficient Management and Distribution of Estate – Especially when beneficiaries are minors or have special needs.
• Tax Advantages – Testamentary trusts can offer graduated tax rates in certain circumstances (although legislative changes have affected these benefits for most testamentary trusts, spousal and qualified disability trusts can still benefit from tax advantages).
• Structured Asset Management – Minimizes the risk of minors or vulnerable individuals mismanaging a large inheritance.

Because testamentary trusts only come into existence upon death, they meld seamlessly with a testator’s will. However, careful planning and a well-drafted will are essential to ensure the trust’s provisions accurately reflect the testator’s wishes.

Common Canadian Trust Structures

Below are some of the most frequently used trust types in Canada, each offering unique benefits and considerations:

1. Spousal or Common-Law Partner Trusts
   ▪ Typically set out so the surviving spouse receives all trust income initially.
   ▪ Offers tax deferral: Assets transfer to the trust on a tax-deferred “rollover” basis until the spouse’s death, at which time gains are triggered.
   ▪ Helps protect assets from potential claims by children from a previous marriage or relationship if structured correctly.

2. Family Trusts
   ▪ Often used to split income among family members, especially for minor children or for intergenerational wealth transfer.
   ▪ The trust can invest assets in vehicles such as Canadian blue-chip stocks, RBC or TD mutual funds, GICs, or even real property.
   ▪ Potential pitfall: Must adhere to “kiddie tax” rules and other anti-avoidance provisions under the Income Tax Act.

3. Alter Ego and Joint Partner Trusts
   ▪ Exclusively for Canadians aged 65 or older.
   ▪ Avoids probate fees on trust assets, providing privacy.
   ▪ Offers a deferral of capital gains until the settlor’s death (or surviving spouse’s death in a joint partner trust).
   ▪ If the settlor becomes incapacitated, the trustee can continue managing trust assets seamlessly.

4. Charitable Trusts
   ▪ Used to distribute funds or assets to philanthropic causes over time.
   ▪ Provides significant tax advantages: Donations made by the trust can generate donation tax credits.
   ▪ Establishes a long-term philanthropic legacy, often aligned with the settlor’s values or charitable vision.

Key Tax Considerations

While trusts can unlock tax benefits, they can also trigger significant obligations or immediate liabilities if not set up correctly. Key points include:

1. Deemed Disposition
   ▪ Transferring assets to an inter vivos trust can trigger a deemed disposition at fair market value, resulting in capital gains tax if applicable.
   ▪ Certain trusts (e.g., spousal trust, alter ego trust) allow for a rollover of capital property, deferring the tax until a later date.

2. Ongoing Income Tax
   ▪ Trusts must file annual T3 returns (Trust Return) with the Canada Revenue Agency (CRA).
   ▪ Income retained in the trust is generally taxed at the highest marginal tax rate, unless it is distributed to beneficiaries (who then claim it on their personal returns).

3. 21-Year Deemed Disposition Rule
   ▪ Every 21 years, most inter vivos trusts in Canada face a deemed disposition of their assets at fair market value.
   ▪ Tax may be triggered unless assets are distributed or an appropriate tax strategy is in place before the 21st anniversary of the trust.

Trustee Responsibilities and Fiduciary Duties

Fiduciary Obligation

Trustees owe a fiduciary duty to the beneficiaries. This implies they must always act:

• In the best interest of beneficiaries
• With the utmost good faith and loyalty
• According to the terms of the trust deed

Failure to comply can result in personal liability for the trustee, underlining the importance of careful decision-making and transparent record-keeping.

Typical Trustee Duties

• Investment Management – Ensuring assets are invested prudently, following the “prudent investor” principle in line with provincial trustee legislation.
• Distribution of Income/Capital – Making distributions as outlined in the trust deed, ensuring beneficiaries receive the amounts or assets they are entitled to.
• Maintenance of Clear Records – Keeping accurate accounts of all transactions, receipts, disbursements, and investments within the trust.
• Compliance with Applicable Laws – Filing T3 tax returns, adhering to the Income Tax Act, and abiding by provincial legislation such as the Ontario Trustee Act or British Columbia Trustee Act.

Drafting the Trust Deed

A well-crafted trust deed is vital to avoid ambiguity or future disputes. Key elements include:

1. Purpose and Objectives – Explains the reason for establishing the trust, whether it be asset protection, income splitting, or philanthropic giving.
2. Beneficiaries – Clearly identifies all current and potential beneficiaries, including any conditions they must meet to receive benefits.
3. Powers of the Trustee – Outlines what the trustee can and cannot do, including investment powers, ability to encroach on capital, and whether they can delegate responsibilities.
4. Distribution Terms – Specifies how income and capital should be allocated, or under what circumstances distributions are made.
5. Contingencies – Addresses “what-if” scenarios, such as the death of a beneficiary or trustee concerns.
6. Termination Clauses – Explains when or how the trust will end.

Practical Examples and Case Scenarios

1. Family Trust for Minor Children
   Suppose a Canadian entrepreneur sets up a family trust to hold shares in her corporation. The trust pays dividends to her children. Since dividends are typically taxed in a beneficiary’s hands, the family may realize overall tax savings. However, the trustee must ensure compliance with CRA’s attribution rules and the “kiddie tax” rules.

2. Spousal Trust with RBC as Trustee
   An elderly married couple decides to transfer their home into a spousal trust, naming RBC Trust Services as the trustee. This move defers capital gains on the property until the death of the surviving spouse and simplifies asset management if either spouse becomes incapacitated.

3. Alter Ego Trust for Probate Avoidance
   A 70-year-old client sets up an alter ego trust, transferring substantial marketable securities into it to avoid future probate fees. Since the client is over 65, the transfer does not create an immediate capital gain. Upon death, the trust assets pass directly to the named beneficiaries without public probate.

Best Practices, Common Pitfalls, and Strategies

• Early Planning – The sooner assets are placed into a trust (or a testamentary trust is designed within the will), the more seamlessly the estate planning strategy can unfold.
• Professional Advice – Lawyers, tax specialists, and trust companies can help create a valid trust deed and ensure compliance with legislation.
• Trustee Selection – Choosing a trustee with expertise and integrity is vital. A corporate trustee such as one from a major Canadian bank (e.g., RBC, TD) can provide professional management but usually charges fees.
• Monitor the 21-Year Rule – Without proactive planning, a trust can incur substantial taxes on the 21st anniversary. Periodic check-ins with a tax advisor are advisable.
• Updating Legal Documents – Changes in family circumstances (marriage breakdowns, births, deaths) warrant updates to a trust deed or re-examination of trust strategies.

Additional Resources

For readers seeking deeper insights or case-specific guidance, the following resources are invaluable:

• Canada Revenue Agency (CRA) – “T3 Trust Guide”
  (https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/t4013.html)
  A comprehensive summary of how trusts and trustees must file income tax returns and account for distributions.

• Income Tax Act (Canada)
  Governs taxation of trusts, including rules for spousal rollovers, capital gains treatment, and testamentary trust requirements.

• Provincial Legislation
  Examples include Ontario’s Trustee Act and British Columbia’s Trustee Act, outlining permitted investments, trustee powers, and beneficiary rights.

• “Estate Planning for Canadians for Dummies” by Margaret Kerr and JoAnn Kurtz
  An accessible overview of trusts, wills, and the broader estate planning process in Canada.

• Society of Trust and Estate Practitioners (STEP Canada)
  (https://step.ca/) Offers advanced courses on trusts, taxation, and estate planning, along with specialized designations such as TEP (Trust and Estate Practitioner).

Summary

Trusts, whether inter vivos or testamentary, remain a cornerstone of effective estate planning in Canada. When properly drafted and administered, trusts can enable tax-efficient wealth transfers, protect assets from creditors or marital claims, avoid probate, and provide for loved ones long after the settlor’s lifetime. By understanding the duties of trustees, the importance of a solid trust deed, and the taxation considerations—especially the 21-year rule—financial planners and their clients can tailor trust strategies that align with family, financial, and philanthropic objectives.

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