Alter ego and joint spousal trusts: requirements, benefits, and drawbacks

By Bilal Kathrada
Jul 18, 2022
Alter ego and joint spousal trusts: requirements, benefits, and drawbacks
Photo credit: katleho Seisa/E+/Getty Images

Since their introduction in 2001, alter ego trusts (AETs) and joint spousal trusts (JSTs) have become important wealth- and succession-planning tools for Canadians who are 65 and older. AETs and JSTs are inter-vivos trusts (i.e., created while a settlor is still living) that allow a settlor to transfer capital assets into a trust on a tax-deferred basis when they are 65 years of age or older. With an alter ego trust, only one person is entitled to all of the trust income and capital in their lifetime. With a joint spousal trust, an individual and their spouse/common-law partner (spouse) are both entitled to all of the trust income and capital in their respective lifetimes.

Requirements

An AET or JST can be settled if the following requirements are met:

  1. The trust was created after 1999.
  2. The settlor was 65 years of age or older at the time the trust is created.
  3. The trust was created during the settlor’s lifetime.
  4. The settlor or their spouse (in the case of a JST) was entitled to receive all the income that arose before their death; and before the death of the settlor or their spouse (whichever is the last life interest beneficiary, depending on the circumstances), no other person was able to receive or obtain the use of any trust income or capital.
  5. The settlor is/was a resident of Canada.

Unless an election is made under subsection 104(13.1) or (13.2) of Canada’s Income Tax Act (the Act), trust income is paid out to the settlor and taxed at their personal marginal tax rate. An election may allow for income to be taxed within the trust itself where income is payable to the beneficiary. Note that any income retained in the trust will be taxed at the highest marginal tax rate, and the trust will not be entitled to any personal tax credits.

While the settlor and/or their spouse must be entitled to receive all trust income, the trust’s capital does not need to be transferred to the life interest beneficiary(ies). The requirement is simply that no other person can receive the trust capital before the death of the last surviving life interest beneficiary.

On the death of the last surviving beneficiary, there is a deemed disposition of the beneficiary’s interest immediately before death, as well as a deemed disposition of assets in the trust at the end of the day on which the life interest beneficiary dies, pursuant to 104(4)(a) of the Act. If the AET or JST holds shares of a company, the deemed disposition on the death of the settlor will be on either the redemption value of the preferred shares or the fair market value of the common shares.

AETs and JSTs are excluded from the 21-year deemed disposition rule for trusts during the lifetime of life interest beneficiaries. Once the last surviving life interest beneficiary dies, the trust will have a deemed disposition every 21 years if the trust continues and the assets are not distributed to the beneficiaries.

AETs and JSTs generally have a tax year-end of December 31, and the tax filings are due within 90 days of this date. However, in the event that the last surviving life interest beneficiary dies, the date of their death will be deemed the tax year-end for the AET or JST, pursuant to 104(13.4)(a) of the Act. If the trust continues beyond this point, it will have a reporting period dating from the day after death up until December 31.

Associated taxes resulting from deemed dispositions within an AET or JST are due on the “balance-due date.” Pursuant to 104(13.4)(c) of the Act, the balance due date is 90 days after the end of the calendar year in which the taxation year ends. Therefore, even though there may be a deemed year-end on the date of death of the last surviving life interest beneficiary, the returns and taxes are still due on March 30 or 31 of the following year.

Benefits

AETs and JSTs provide many benefits:

Protecting assets

A trust holds the assets for its beneficiary(ies), and these assets may be protected against certain types of litigation. For example, holding assets in an AET or JST may enable beneficiaries to circumvent potential claims to the validity of a will and claims under wills variation legislation (the Wills, Estates and Succession Act of British Columbia). Therefore, AETs and JSTs are often used to help protect assets and ensure that they’re distributed in accordance with the settlor’s wishes. In addition, because probate does not apply to property held in AETs and JSTs (trust assets cannot be legally owned by deceased individuals), a will has no authority over a trust’s assets—this too ensures that assets are distributed in accordance with the settlor’s wishes.

Maintaining confidentiality

Once a will has been through probate, it becomes a public document, which means anyone can apply to the courts to view it. But, as explained in the previous paragraph, an AET or JST does not need to be probated—therefore, there is no disclosure of its assets.

Avoiding probate fees

In BC, probate fees must be paid based on the value of the deceased individual’s estate, and these fees can be as high as 1.4% of the estate’s gross value. The fees can be avoided, however, if the assets are held in a trust.

Drawbacks

There are also some drawbacks to AETs and JSTs:

Professional fees

Due to their technical complexity, AETs and JSTs require professional drafting and specialized advice. There are generally tax and legal advisory fees associated with settling these trusts, and these fees need to be weighed against future potential benefits and savings. In addition, there are compliance costs associated with filing the T3 Trust Income Tax and Information Return, which must be submitted annually.

Lifetime capital gains deductions

An individual is entitled to their own lifetime capital gains exemption at the time of sale of qualified small business corporation shares (the 2022 exemption limit is $913,630) or qualified farm or fishing property (the 2022 exemption limit is $1,000,000). AETs and JSTs cannot benefit from these deductions. However, if the capital gain is allocated to a beneficiary, the beneficiary may be able to use their lifetime capital gains exemption to reduce the associated tax.

Donations

Care should be taken when considering charitable gifts. Neither an AET nor a JST can make charitable gifts during the settlor’s lifetime as these trusts cannot distribute any income or capital to anyone other than the settlor (AET) or the settlor and/or their spouse (JST) during the settlor and/or their spouse’s lifetime. However, a donation tax credit may be available after the death of the last life interest beneficiary, provided a gift is made no later than 90 days following the end of the calendar year in which the settlor dies.

AETs and JSTs are limited with regard to charitable contributions when compared to wills. When gifting from a will, a donor may gift up to 100% of their income; however, when gifting from a trust, the donor is limited to 75% of their income for the year.

US tax issue

US citizens who are residents of Canada could be subject to US estate tax at the time of their death and could be subject to US gift tax on the transfer of any assets during their lifetime. AETs and JSTs may not be ideal for these individuals due to the different tax treatments under Canadian and US law. Therefore, careful consideration must be given before US citizens who are residents of Canada settle an AET or JST.

Final thoughts

AETs and JSTs can be powerful tools in estate and succession planning, helping to protect family assets and uphold the wishes of settlors. Before entering into one of these complex trusts, however, careful consideration must be given and a tax professional should be consulted.

 


Bilal Kathrada, CPA, CA, is a partner at Clearline Chartered Professional Accountants, where he specializes in income tax and succession planning for Canadian owner-managed businesses in various industries. Bilal is a member of the CPABC Taxation Forum and a regular contributor to the CPABC Newsroom.