How does a living trust differ from a trust in your Will?

Leanne Kaufman:

When we talk about trusts, people often assume we must be discussing planning options that would only apply to the ultra-wealthy, or perhaps trusts for children or grandchildren who haven’t yet reached the age of majority. And not everyone is familiar with the difference between a trust that’s created in your Will, which only comes into effect when you pass away, and a trust that’s created during your lifetime. Today we want to talk about those trusts that are created during your lifetime, usually referred to as either a “living trust” or if you want to use the old Latin phrase, an “inter vivos” trust. While generally the concepts are the same, regardless of how or in what document the trust is created, they can serve different purposes and have different advantages and disadvantages.

Hello, I’m Leanne Kaufman and welcome to RBC Wealth Management Canada’s Matters Beyond Wealth. With me today is Barbara Kimmett, a partner at the law firm of Bennett Jones in Calgary, who specializes in the area of estates, trusts and incapacity planning.

Barbara, thanks for being here with me today to discuss what the difference is between living trusts and Wills and testamentary trusts and why this all matters beyond wealth.

Barbara Kimmett:

Well, thanks so much for having me, Leanne. I’m happy to be here.

Leanne Kaufman:

Well, we’re glad to have you as such an expert in this area, and we’ve worked frequently with you on exactly this kind of structure before. So beyond what I’ve said in my very brief opener, what at a high level, how would you describe the difference between a trust while someone is alive versus a trust that only comes into effect upon their death?

Barbara Kimmett:

Well, the main difference between a testamentary trust, that is a trust that comes into effect upon a person’s death, which is normally found in their Will, and non-testamentary or inter vivos trust is just that. One is in effect on death and the other is in effect during the person’s lifetime, although it might continue even if the person dies. That said, I think the biggest difference I see between inter vivos and testamentary trusts comes down to tax rules. For inter vivos trusts, if you gift assets to a trust, you might trigger a tax. And also Canadian tax policy tries to dissuade Canadians from using trusts to split income amongst family members or to indefinitely defer the payment of tax. So therefore, there are many complicated tax roles that come into play.

Now, all trusts, whether they’re inter vivos, those are the living trusts, or testamentary are governed by different laws. Trusts are really old concept. In fact, they trace all the way back to the Middle Ages, which is between 500 and 1500 A.D. A trust isn’t the same as a company or a corporation because it isn’t considered an entity unto itself. Instead, it is a relationship where one person holds and manages assets for another person or for many people, or even charities for example. But it’s a bit confusing because even though a trust isn’t an entity, it is treated the same as an individual for Canadian tax purposes. And because trusts have been around for so long, they’ve developed and changed over time.

That means that there are several layers of laws that govern how trusts work:

• The Federal Income Tax Act would be one layer, and it has many complicated rules that deal with the taxation of assets that are contributed to a trust or managed by a trust.
• Then we have the common law, which is decisions by judges about, for example, how trustees ought to act and that sort of thing or the interpretation of what a trust means.
• Then finally, we have legislation that’s made by elected governments. In Canada, every province or territory has its own legislation that sets out the rules about trusts, and they can vary significantly amongst the different provinces and territories.

But the legislation applies to all trusts, whether they’re living or testamentary trust. So, from that perspective, whether it’s in your Will or not, the laws apply equally to all trusts.

So, suffice to say that whether we’re talking about a living trust or a testamentary trust, there’s a lot to know and anyone who’s thinking about setting up a trust should probably get some advice before doing so.

Leanne Kaufman:

It does feel like, as you mentioned, they’ve been around since the Middle Ages and in some instances it feels like the laws date back to that time as well and the level of complexity.

Barbara Kimmett:

Yeah, the legislation feels like it was built in the Middle Ages for sure. Now, I will say that in Alberta we have modern legislation that came into effect just in February of 2023. New Brunswick also has modern legislation, but everybody else is stuck in the Middle Ages.

Leanne Kaufman:

Literally and figuratively. So we talked about the testamentary trusts or the trusts that only come into effect on your death, usually being in a Will and the other, the inter vivos in a separate standalone trust document or trust indenture. What about the structure of those trusts, like comparing those two types of trusts or the type of assets that can be placed into trust? Is there any real distinction around what either the structure of that looks like or the assets that can go into trust?

Barbara Kimmett:

Sure. So, I guess I’ll preface my answer a bit by starting with the idea that one of the best tax strategies is to delay having to pay tax for as long as possible. Sometimes that’s the best we can hope for. We’re going to have to pay tax, but we’d like to delay it for as long as possible. The idea is that it’s better to have our tax dollars in our own pockets so that we can invest them in earn interest or so that we can buy the things we need or we want for our lifestyles. We don’t want to have to pay tax before it comes due.

Now to your question about differences between what assets can be placed in trust and keeping in mind my comments about delaying paying tax, paying tax. If someone wants to set up an inter vivos trust, they should think about what assets they want to give to the trust because if they contribute cash, there’s no problem. But, if they contribute assets that would result in tax if the asset were sold, then they’ll likely have to pay tax on the gifting of that asset to the trust, the same as they would’ve had to pay if they sold the asset.

A good example is someone who would like to gift their cottage—out west we call it a cabin—to a trust, the cottage is real property, and unless it qualifies for the principal residence exemption, it will be taxed based on the increase in value since the time that it was purchased, and this is called capital gains tax. Currently, a person who gifts their cottage to a living trust will have to include half of the gain in their taxable income for the year.

Now, the federal government has recently announced changes to the capital gains tax, which could increase the amount of tax a person would have to pay if they gift their cottage to an inter vivos trust. The new proposals also mean that trusts themselves that hold assets would be—the assets that are subject to capital gains tax—the trusts might have to pay more tax than individuals when that asset is sold. So there’s those things to consider when you’re thinking about what assets to put into the trust.

And the same tax treatment applies of a person gifts other capital property to a trust such as marketable securities—so investment accounts or private company shares if you have your own business and it’s a corporation. And people can’t get around that by liquidating the securities or the shares first and then gifting the cash to the trust because they’ll pay the same tax when they do the liquidation.

So a key difference between setting up an inter vivos trust and a testamentary trust is tax considerations.

On death, there are different rules around taxes, but they apply to a person’s estate when they die. Which means that there isn’t usually much tax planning to do and the executors of the Will set up the testamentary trust. So when assets go from the estate to the testamentary trust, the tax has already been paid. It’s not the same concerns that we have when we were setting up the living trust.

Another difference between inter vivos trusts and testamentary trusts is that practically speaking, the document that sets out the inter vivos trust, which is usually called the “trust deed” or “trust indenture” or the “settlement agreement,” it’s lengthier and more complicated than a testamentary trust, which is the words that you find in the Will, which somehow looks simpler, but really they’re both trusts and they both have all the same legal complexities. Other than the documents looking different and more complicated, they actually do have the same or similar complexities and legal considerations.

Leanne Kaufman:

So in simple terms, the structure really isn’t different other than the way and when it’s created. Is that fair to say?

Barbara Kimmett:

Yeah, that’s right. It’s the same thing however it’s created. The documents that maybe are the roadmap for how the trust should play out might look a little different, but the laws and how they work are the same.

Now to your question earlier about thinking about what assets can be placed in a trust. I talked about some of the pitfalls of transferring capital property to a living trust, but another type of asset—well, you would normally see that type of asset contributed to a trust, you just have to be careful of the tax treatment—but there is one type of asset that you wouldn’t normally see gifted to a trust, whether it’s an inter vivos or a testimony trust, and it’s any sort of registered asset such as an RSP or a RIF.

So this issue often comes up if I’m advising clients, and let’s say they’re in a second marriage situation, they’re trying to figure out how to leave assets to their second spouse, but also trying to ensure that there will eventually be an inheritance for their children from the first marriage and they want to be tax efficient and there’s lots of balls in the air in terms of objectives.

So, I advise them that one of the options there is they could, rather than giving their assets to their second spouse outright, they might want to create a testamentary trust that is referred to as a spouse trust. So that way they can control what happens to those assets when their spouse dies. If they had just left the assets outright to their spouse and he or she inherits, and then later, many years later, the second spouse dies, well, they might leave it all to charity or their own family members and not to your own children.

Leanne Kaufman:

Or give it away during their lifetime.

Barbara Kimmett:

Yes, exactly. So, a spouse trust has lots of benefits in that you can control how it goes. It can be tax efficient and it can be very helpful.

Sometimes people’s RSP or RIF is one of their most valuable assets, and if a person designates his or her spouse as the beneficiary of the RSP or the RIF on the person’s death, the RSP rolls over to their spouse on a tax deferred basis.

So, this is important because the entire RSP is considered income on the death of the annuitant. For example, if a person has an RSP valued at $500,000, in the year of death tax return, $500,000 would be added to the person’s income, which would roughly result in about half of it going to taxes.

So, designating one’s spouse as the beneficiary of the RSP can be very valuable. But and here’s really where I wanted to get to, if a person gifts their RSP or their RIF to a testamentary spouse trust, the tax deferral is not allowed. Tax would be payable on death. So from that perspective, you do want to consider what assets you give to a trust, even testamentary trusts.

Leanne Kaufman:

So there’s tactical reasons or strategic reasons that certain types of assets may or may not be a good fit for a trust. But for the most part, other than registered plans, there isn’t really a difference about the, in theory, the kind of asset you can put in: real estate, investable assets, cash, etcetera. It should be neutral regardless of whether you’re talking about a testamentary or an inter vivos.

Barbara Kimmett:

Yeah, for the most part. There are some rules around putting your principal residence into a trust. So just people should always be getting advice and the laws change over time too, so yeah, we should always be checking in on that.

Leanne Kaufman:

Especially the tax rules, and that’s what drives a lot of this conversation, I think.

So why do people create living trusts rather than just putting everything in their Will and doing testamentary trusts?

Barbara Kimmett:

That’s a really good question, and there’s lots of reasons why people create a living trust. It all depends on the facts of the situation.

So, for example, sometimes people create a living trust for business restructuring and tax efficiency. The example there is that an owner of shares in a family business might undergo a restructuring of their business so that the founder exchanges his or her shares for fixed value shares and then creates a trust that owns the shares that will increase in value over time. This is a way to save or delay tax on the death of the founder and to transfer ownership to kids and grandchildren. It’s referred to as an estate freeze.

Another reason to create a living trust is for creditor protection. But keep in mind that in order to protect your assets from creditors, the more you give up ownership and control of the assets held in the trust, the better the protection. Most people don’t really want to give up ownership or control, so it’s really important to discuss objectives with advisors. They think that if they just put the assets in a trust, they can still be the trustee or they can still be the beneficiary, but that would make the trust of limited value for creditor protection purposes.

Another reason that I see quite commonly these days for the use of trusts is some people who are buying homes in the United States. So, the United States has a hefty death tax, and these clients are therefore often choosing to buy their U.S. home through a trust that takes into account the U.S. tax rules on death and prevents the application of the U.S. estate tax. Generally speaking, the US estate tax will only apply to pretty wealthy individuals, so a living trust isn’t always necessary.

But even for Canadians who don’t fall into that category, they might want to explore ownership through a living trust in order to avoid the probate in the relevant state wherever they buy their home. Some states such as California have really complicated and expensive probate processes that are worth avoiding if you can.

The last thing, although there’s many reasons, but the last one I’ll mention is that sometimes people just want to give with a warm hand, as they say. So they set up trust during their lifetime.

An example of that is I had a client who wanted to create a trust for each of his grandchildren during his lifetime. He wanted to be able to tell his grandchildren about the gifts and what he had in mind, why he had put the provisions in place. In this case, he had it in mind that there wouldn’t be any ability of the grandchildren to receive any of the capital of the trust until they were 50. The reason for that is he wanted to make sure they had a little nest egg for when they retired, but they were still incentivized to work.

Now, there’s lots of considerations to wanting to set something up like that. There are lots of management and tax filing obligations to take into account to make sure it works for you, but it did in that case. So, by gifting funds to a trust, in my client’s case in the years before his death, he also had the benefit of transferring the tax on the income earned on the trust investments to the trust and its beneficiaries rather than to himself. He did give up control and ownership. It was a bona fide trust that he just wanted to put in place for his family. So there’s lots of different reasons for setting up a trust.

Leanne Kaufman:

You mentioned the high probate costs in certain states. We have that in certain provinces in Canada as well. I know Alberta is not as impacted because your probate fees are so nominal that people don’t plan around it, but I know that probate planning is another reason that some people outside of Alberta do inter vivos trusts. Are there other advantages beyond probate planning and the things that you’ve mentioned like the grandfather who wanted to be able to both explain and see his children benefit from the trust that he has set up during his lifetime. Are there any other advantages or disadvantages of one type of trust over another in Canada?

Barbara Kimmett:

Yeah, no, you’re right. Every trust does serve its own purpose, and we really have to understand what the objectives are in wanting to create a trust. As you’ve mentioned, many Canadians really think it’s an important thing to do to avoid probate. And to your point, Ontario charges a probate tax of 1.5 percent of the gross—basically of 1.5 percent, of the gross value of a person’s estate. B.C. charges 1.4 percent. We’re lucky here in Alberta so far, the maximum fee will pay is $525. I like to say even if you’re Warren Buffett and you move all your property to Alberta and you die here, when your executors apply for grant to probate, they’ll only pay $525. So far so good. Maybe don’t let the government of Alberta know about that, but it’s really good in Alberta. So even 1.5 and 1.4, taking it into perspective, those are pretty low rates when you compare them to income tax rates. But nonetheless, you’re right—if people can avoid them, they prefer to do so.

If you transfer your assets to a trust during your lifetime, then on your death, those assets aren’t part of your estate and they won’t be subject to the probate tax. But as we discussed earlier, you have to be careful about transferring your assets to a living trust because you might incur tax now rather than later when you die. And why would you pay capital gains tax of about 25 percent now when you could keep that cash in your pocket until you die, even if it means that your estate will pay the 1.5 percent probate tax on that asset, it doesn’t necessarily make sense.

It’s not just tax that you have to take into account when considering setting up a trust. There are management considerations and you have to decide, for example, who will be the trustee. The trustee always has a big job. So many times I hear people say when they’re doing their planning that they don’t think the trustee will have much to do. And that is never the case in my experience. It’s always more than anybody ever bargains for.

Leanne Kaufman:

It’s never a strictly ceremonial rule.

Barbara Kimmett:

Well, and if it is, it’s at the trustee’s peril because inevitably something goes awry and the trustee is the person in charge and they will be responsible for not having properly managed the trust.

So there there’s significant risk to trustees as well. I mean, trustees have fiduciary obligations to beneficiaries to account for their actions and provide financial information. They have to make sure assets are properly managed and invested. They have to consider beneficiary requests for distributions. So sometimes they really have to have a strong spine and say no to beneficiaries who are asking for money from the trust, and they have to adhere to tax filing and disclosure obligations. So you really have to make sure that you’ve appointed someone as the trustee who can manage all of these responsibilities.

So practically speaking, it’s not always advantageous to create a living trust for the purpose of avoiding probate. But there is one kind of trust that is often used to avoid probate because it’s basically tax neutral and this is an alter ego trust, or if it involves a couple, a joint partner trust, and you can only set these types of trusts up if you’re 65 years of age or older and you’re a Canadian resident.

I could go on, but honestly we could probably dedicate a whole session just to alter ego and joint partner trusts.

Leanne Kaufman:

I think you’re right, but it’s important to at least put the little asterisk in there and say there is one special trust. I think the other thing people would need to know before going to researching that too deeply is that you have to be 65 or older. So it’s of limited applicability to anyone under 65, at least at this stage of their planning. And I think that the probate point is a good one.

The other thing that people don’t always understand about probate is that it’s a public process, and we sometimes see people interested in using an inter vivos trust, ideally an alter ego for the tax neutrality that you’ve demonstrated. But if they’re not 65 yet, that might be an option. All I mean by that is if anyone probates a Will, then it does become a public document that people can go and if they understand how to do it, can research and get access to those files. And they don’t have to prove any sort of connection to the deceased or to the family. Correct?

Barbara Kimmett:

Yeah, that’s absolutely correct.

So even in Alberta where we’ve mentioned we don’t have the high probate fee, there is that privacy advantage to using an alter ego or joint partner trust to take assets out of your estate because you’re quite right when you file the application for the probate that application includes an inventory of all of your estate’s assets at the time of death, and usually any member of the public—I think it’s a $10 search fee in Alberta—can just go to the court and search your file and get a copy of the whole application, including the inventory.

Also, the people who get that inventory in Alberta are people who are beneficiaries or somebody, a family member who might have a claim against your estate. In provinces like British Columbia, when you apply for probate, you also have to give notice to people who would inherit if the Will wasn’t valid. So, a lot of people are getting information about what’s in your estate, and some people really don’t like that for good reason.

I mean, that leads to another thing, which is if you’ve got assets—this ties into the creditor protection a little bit—if you’ve got assets that are in a trust, an alter ego or joint partner trust in particular, because these are often thought of as Will substitutes, that’s kind of what they do. All the jurisdictions across Canada have legislation sort of referred to broadly as dependence relief legislation and that’s social justice legislation where anyone who qualifies as a dependent—and the definitions vary across the provinces and territories. But if you’re a dependent, you can make a claim against the Will if you feel it doesn’t properly provide for you. And a court has very broad authority to vary the terms of the Will to provide more to anyone who’s a dependent.

There’s still good case law in place that says that if you have transferred property to a trust during your lifetime, those claims don’t apply to the assets in the trust. So, it’s a good way to protect your estate against some dependence claims to the extent that those are spurious, or I don’t want to encourage anyone not to provide for their dependence, but sometimes those claims are just spurious. So, it’s a good option.

Leanne Kaufman:

And what happens to a living trust when you do pass away? We know that the Will kicks in and that’s when it starts. But what happens to the assets in the trust when the person who created the trust passes?

Barbara Kimmett:

So, if you create a living trust and then you die, your death does not affect the continuance of the trust unless the trust says otherwise.

So, for the person who gifted money to a living trust, which then purchased shares in the family business, that’s that corporate reorganization I mentioned earlier, the person’s death doesn’t ordinarily affect the trust. It will carry on as if nothing had changed.

But for alter ego or joint partner trusts, which as I’ve said are sort of referred to as Will substitutes, the tax rules apply a deemed disposition on the assets of the trust the same as it does for individuals. So it’s common to see those trusts wind up by their terms in the same manner that a Will would direct that assets be distributed.

Leanne Kaufman:

Right. Yeah, it’s all very complex. I mean, you and I have spent years both studying and working in this area, you make it sound simple, but of course it isn’t. Whether you’re talking about the legal implications or perhaps even more impactfully, the tax implications. But Barbara, based on our very broad sweep of this topic today, if there’s one thing that you hope our listeners take away from the conversation, what might that be?

Barbara Kimmett:

I guess it would have to be that trusts can satisfy many objectives. They’re a way to protect privacy, to be tax efficient, to achieve family business succession and to steward money for later generations. But they’re complicated, as you’ve said, both in terms of how they’re set up, they’re managed, and the tax rules that apply. So, it’s important to discuss your objectives with your advisors. If you don’t need a trust, don’t create one. But if you do, do your best to do it right by using the right structure, making sure you have the right trustees to properly manage the trust.

Leanne Kaufman:

Great advice, and definitely this isn’t something people should try to DIY by any means. You definitely want to have really good legal and tax advice, I would say, on these structures.

Barbara Kimmett:

Yeah. You just don’t know what you don’t know.

Leanne Kaufman:

That’s right.

Thank you so much, Barbara for joining me today to help us better understand living trusts and how they may differ from your Will and the trusts that are created there and why this matters beyond wealth.

Barbara Kimmett:

Thanks, Leanne.

Leanne Kaufman:

You can find out more about Barbara at bennettjones.com.

If you enjoyed this episode and you’d like to help support the podcast, please share it with others, post about it on social media, or leave a rating and review.

Until next time, I’m Leanne Kaufman. Thank you for joining us.

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