A well-executed estate plan ensures that wealth is transferred from one generation to another in a tax effective and strife-free way. Crucial to the planning process is a consideration of the many potential pitfalls that may emerge during both the planning and administration phases. These challenges can be both technical (e.g. tax considerations) and emotional (e.g. interfamily relationship) issues. A good estate planner is one who is well versed in the various technical rules that impact a plan, but is also sensitive to what are often referred to as the “softer” non-technical issues; issues such as sibling rivalries, addictions, lack of trust among family members, lack of communication, and the myriad of issues arising around blended family situations. More often than not it is the human element that creates uncertainty and the potential for strife in the estate planning and administration process as opposed to the technical issues encountered when drafting the plan itself.
In this brief article we will discuss a number of areas where an estate plan can go awry and how those challenges can be mitigated. This is not meant to be exhaustive and legal advice should be sought so that the particular circumstances of each family can be considered.
The blended family
Statistics have shown that blended families are steadily increasing in Canada. The Canadian Census of 2016 disclosed that one in 10 children live in stepfamilies and that number has only grown since that time. A blended family is one where the family structure does not fit into the traditional nuclear family concept: second marriages, common law relationships, children from prior relationships and/or the current one.
Not surprisingly, there are often conflicting objectives in blended families. On the one hand there is the desire to make sure that one’s spouse is looked after. On the other hand there is a desire to protect the children of the prior relationship and/or the current one and ensure that the wealth that has been built up ultimately flows to the children. Are these goals mutually exclusive? Can such goals coexist? The following are some of the considerations.
A spouse trust and other tax efficient strategies to transfer wealth
When an individual dies, the Income Tax Act provides that there is a deemed disposition of all of his or her assets at their fair market value as at the date of death, giving rise to tax on any accrued gains arising as a result of the deemed disposition of capital property with accrued gains. Net capital gains (gains less losses) are included in the terminal tax return of the deceased individual in respect of the year of death. Similarly, registered assets such as registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs) must be deregistered as of the deceased’s date of death with the result being that the fair market value of the assets is fully included in the deceased’s terminal tax return as taxable income. Significant tax bills usually result.
Income tax that would ordinarily arise as a result of the deemed disposition rule noted above can be deferred if assets are left to a surviving spouse or to a spouse trust created by the deceased’s will (a “testamentary spouse trust”) (other than a RRSP or RRIF which can be left to a surviving spouse, but not a spouse trust). If assets are bequeathed to a spouse or a testamentary spouse trust, the deemed disposition of assets is deemed to have occurred at the cost base (at the time of original acquisition) of the assets rather than the fair market value as at date of death and the spouse or testamentary spouse trust is deemed to have acquired the assets at their cost base. The tax on any accrued gains is not eliminated but rather is deferred until such time as the spouse or testamentary spouse trust, as the case may be, disposes of the assets or on the death of the surviving spouse.
From a tax perspective, leaving assets (especially those with accrued capital gains) to a spouse trust for the benefit of a surviving or common law spouse is an effective tool for a client who wants to specify how wealth is shared between a surviving spouse and children from a prior or current relationship. The client’s spouse would have the right to the income generated from the trust’s assets during his or her lifetime while the client’s children would ultimately inherit the assets held in the trust. Some testamentary spouse trusts permit encroachment on the capital of the trust to or for the benefit of the spouse at the trustees’ discretion. This said, leaving discretion for the trustees to exercise without providing guidelines may place the trustees in an awkward position with the residual beneficiaries (see below).
The principal residence exemption provides tax relief on death as well. Any accrued gains arising in respect of a property that qualifies as a principal residence are not taxable. If an individual dies owning one or more residences that qualify as his or her principal residence, only one can be designated to benefit from the principal residence exemption. Generally the property so designated is one that has the greatest accrued gains at the time of death.
Life insurance is also a tax efficient way for a client to transfer wealth to a spouse and/or children. Life insurance proceeds are generally transferred to the beneficiaries on a tax-free basis. If a client designates his or her spouse as a beneficiary under an eligible life insurance policy, then the proceeds of that tax-free policy will transfer to the spouse on a tax deferred basis.
These strategies can significantly reduce tax bills and also allow the client to provide a benefit to both their spouse and children. There are, however, a number of challenges. For example in a remarriage situation, problems can arise if the new spouse is close in age to the biological children or the children do not get along with each other or may not get along following the death of the spouse. Such human elements should be addressed to limit uncertainty and the potential for strife.
Trustees of a testamentary spouse trust
One of the most frequently asked questions when contemplating a testamentary spouse trust is who the trustees of that trust should be and what the optimal number of trustees is. Further questions often include whether the spouse should be one of the trustees or whether the children of the first marriage should be co-trustees with the spouse or the only trustees. In answering such questions it is important to consider potential conflicts that may arise as trustees may have a personal interest in decisions they make as trustees.
The spouse must be the lifetime beneficiary of all of the income generated from the assets held in the trust. Consequently, as the lifetime beneficiary, the spouse will want to maximize the income generated by the trust’s assets during his or her lifetime. The residual beneficiaries’ motivations may be different. The children, as residual beneficiaries, will want to ensure that the value of the capital is maintained and increased having regard to inflation and other factors during the spouse’s lifetime. These potentially conflicting objectives may impact the trustee’s investment or property management decisions regarding the trust’s assets and also impact the decisions about whether and to what extent capital can be encroached on for the benefit of the lifetime beneficiary.
In order to qualify as a spouse trust for purposes of the Income Tax Act a testamentary spouse trust must provide that the beneficiary spouse is entitled to receive all of the income earned in the trust during his or her lifetime. There is no requirement that the trust provide the trustees with the power to encroach on the capital for the benefit of the spouse but if there is a power to encroach on the capital it can only be for the benefit of the spouse during his or her lifetime. In some cases trustees are not given any power to encroach on the capital for the benefit of the spouse. In other cases while the trust may provide trustees with the power to encroach on the capital for the benefit of the spouse, the trust may provide that if the spouse remarries, the power to encroach on the capital ceases. If the terms of the trust permit encroachment on the capital in the discretion of the trustees, that discretion should be exercised having regard not only to the rights of the spouse as the life tenant, but also the rights of the residual beneficiaries.
Investment decisions are also impacted by the fact that there may be successive beneficiaries each of whom may have different objectives. For example, in the situation where there is a spouse trust for the lifetime of the spouse with a gift over to children of the marriage or of an earlier marriage, the spouse would be most interested in receiving the maximum amount of income while the residual beneficiaries would want to ensure that the value of the capital is maintained and increased having regard to inflation and other factors. Trustees must be aware of and sensitive to these potentially conflicting objectives in making investment decisions which also will impact the trustees’ decisions regarding whether and to what extent capital can be encroached on for the benefit of the lifetime beneficiary.
Generally, trustees should act with an even hand while exercising their discretion for the benefit of all beneficiaries unless there are terms which oust the even hand rule. The use of the words “absolute discretion” or “unfettered discretion” in this context often give the trustees the impression that they can exercise that discretion without regard to the effects of their exercise of discretion on other beneficiaries. However, there are a plethora of cases that make it clear that the exercise of discretion should not be taken without regard to the effects of that discretion on other beneficiaries. Discretion should be exercised taking into account only those factors which are relevant to the trust and its beneficiaries. Failure to do this opens trustees to potential litigation and personal liability. It is also helpful to provide guidance to the trustees as to factors to take into account in exercising their discretion (for example, should the separate assets of a spouse be taken into account in determining whether to encroach on the capital).
With this in mind it is important that a client select his or her trustees carefully and also provide appropriate guidance to such trustees to navigate difficult circumstances which may arise.
One other important requirement that should be considered is the residency of each trustee. In order to benefit from the rollover rules a trust must be resident in Canada. In order for the trust to be resident in Canada for tax purposes at least a majority of the trustees of that trust must be resident in Canada.
Other challenges can arise depending on the nature of the assets held in a testamentary spouse trust as will be addressed below.
The principal residence
The principal residence is often one of the assets of significant value. Due to a change in the tax rules a number of years ago, if a residence is held in trust, the principal residence exemption is only available if held by certain types of trusts, including a spouse trust. Factors to take into account are whether the surviving spouse should be responsible for repairs or just for tenant-like expenses, as well as how repairs should be paid for. Consideration should be given to setting aside a fund for the maintenance of this asset specifically.
In order to preserve the characterization of the trust as a spouse trust, any successor property must also be held for the exclusive benefit of the spouse during his or her lifetime. The use of the word “exclusive” is important. In addition the trust should provide that any funds not used for the acquisition of a successor property be invested, and the net income arising from the investments be payable to the spouse and if there is the ability to encroach on the capital that it is only for the benefit of the spouse. Generally wills contain many powers clauses to assist the trustees in carrying out their fiduciary obligations. Given the Canada Revenue Agency’s positions over time relating to such powers clauses, it is crucial that it be made clear that any such powers cannot be exercised in such a way as to taint the spouse trust.
The family cottage
There are many concerns that arise with respect to the transfer of the family cottage from one generation to another due to tax and technical issues, as well as emotional issues and competing interests in a client’s family.
Clients should be realistic and consider whether it is possible and desirable for the cottage to be kept in the family for another generation.
Miller Thomson’s Private Client Services team published an informative article addressing some of these considerations.
Shares of a family business
A number of additional factors need to be considered if the main asset of a spouse trust consists of shares in a family business. This is often the case where there has been an estate freeze and the preference shares held by the founder are set aside in a testamentary spouse trust for the benefit of the surviving spouse (whether the spouse is the parent of the children or a second spouse). While the terms of a testamentary spouse trust require that the net income be payable to the surviving spouse, what exactly is the net income where the main asset is the preference shares? If the terms of the preference shares do not have a requirement to pay out dividends (and often they do not) then the question arises as to how the spouse is to have a source of income during his or her lifetime. Further, if the payment of dividends on preference shares is discretionary then who makes the decision?
This is an area that is rife with issues especially if the children are involved in the business and the spouse is not. The conflicts of interest between the surviving spouse and children can include the desire of the family members involved in the operations of the business to leave funds in the business to facilitate growth and not make income available through the declaration of dividends to a surviving spouse through the testamentary spouse trust.
Other factors to consider include whether the trustees of the spouse trust can or should be directors of the company and involved in the operations of the business. This will depend on whether they hold a minority interest in the company or whether they hold voting control shares. If they do have power to elect directors, including themselves, and if they elect one or more of their number as directors, other considerations arise such as whether they have the duty to take into account the rights of the spouse beneficiary of a spouse trust as directors to dividends and whether it is important to consider that a decision to redeem shares or declare dividends may impact on the right of a spouse to the proceeds of redemption or dividends or whether such receipts by the trust accrue to the benefit of the spouse or the residual beneficiaries. By way of example, there is case law to the effect that dividends are treated as income of the trust and therefore the spouse is entitled to dividends declared by the corporation the shares of which are held by a spouse trust. This is the case even when the dividends come out of the capital dividend account of the corporation. On the other hand, dividends arising out of redemption of shares are considered part of the capital of the trust and thus the spouse would not be automatically entitled to such funds unless the trust permits encroachments on capital and the trustees exercise their discretion to make capital payable to the spouse.
Even if the trustees hold a controlling interest in the business questions still arise regarding whether they have an obligation to elect themselves as directors: what if they have no experience or not the right experience to run the business or live far away or are otherwise not suitable? What if they elect a nominee? What obligation do they have to supervise the operations for the business? Further, what obligations do the trustees have to disclose financial information about the business to the beneficiaries?
Often the root cause of litigation in an estate is due to lack of communication. Alternatively, too much information can also be dangerous if put in the wrong hands.
These are some of the many vexing questions that should be considered with the client when dealing with an estate plan. And it is clear that while a spouse trust is a vehicle that deals with some of the issues it is also a vehicle that raises other issues that should be addressed. These conversations are not easy and often the client does not want to face the issues. In order to avoid problems and strife in the family it is important to have this discussion with the client and offer suggestions for dealing with and avoiding such issues. It is also helpful to consider including guidance in the will to the trustees as to factors they can or should take into account in the administration of a spouse trust directly or indirectly holding shares of an operating business.
Factors to consider
Each estate plan has common features but each is also unique. The following are a few factors to consider:
- Consider separating the assets bequeathed to the spouse from the rest of the family if a testamentary spouse trust is unlikely to work for a client’s family. By way of an example, the client should consider transferring RRSPs or RRIFs to the surviving spouse on a tax-deferred basis by way of beneficiary designation to provide him or her with adequate support and give other key assets to the children outright, assets such as shares in a family business or a cottage property.
- If a testamentary spouse trust is established and a major asset of the trust will be shares in a family business, consideration should be given to the level of corporate control that the trustees will be able to exercise, as well as the level of income which is intended for the spouse’s lifetime. The client should consider providing guidance for the trustee.
- Consider whether it is appropriate to appoint corporate trustees as the executors of a client’s will and estate plan. These institutions have the skillsets required to manage complex assets and any conflicts of interest amongst family members. In assessing whether a corporate trustee is appropriate or advisable consideration should be given to the costs involved, and the experience of the corporate trustee to get involved in or supervise in some way the management of an operating business, if applicable. Supervision of any trustee is important and that is also the case with corporate trustees. Checks and balances should be considered.
- Open communication about a client’s estate plan is the best approach. This said, it is recognized that family dynamics may be such that open communication about one’s estate plan may not be the best approach for that individual. Where it is possible such communications assist in avoiding strife in the future and allow family members to voice their concerns and avoid suspicion. In this vein, it is best for a client to speak about his or her estate planning decisions with family members before death in order to address any concerns of family members.
- Additionally, a client should consider providing guidance to his or her trustees in his or her will. Such guidance should contemplate difficult circumstances which may arise when the client’s beneficiaries’ interests are in conflict. Areas of guidance would include whether the income of a spouse should be taken into account in exercising discretion about distributing capital as well as income. If shares of a company comprise the bulk of the assets of a spouse trust, then thought should be given to advising the trustees of the desire to provide a certain level of income to the spouse (and if the trustees are in a position to influence the board of directors to declare dividends sufficient to satisfy such income level).
One of our Private Client Services lawyers would be pleased to assist you or your clients with an estate plan that squarely addresses any unique family’s dynamics with the goal of wealth preservation, as well as aligning clients’ legacies to practical goals implemented through an estate plan. This can give a client’s family the best chance at harmony following a loved one’s death. Please do not hesitate to contact us.