Surprise Tax Changes May Undermine Estate Plans Involving Trusts

In a previous blog post, I discussed how the 2014 Federal Budget would significantly curtail the tax benefits currently available to testamentary trusts.  These budget measures were recently enacted with the passage of Bill C-43, Economic Action Plan 2014 Act, No. 2 on December 16, 2014.

To the surprise of many, the final legislation went far beyond the proposals originally set out in the Budget, fundamentally changing the way that estates and trusts will be taxed.  These changes – which will be effective as of January 1, 2016 – will likely have a broad and adverse impact on some of the most common estate-planning strategies, particularly those involving so-called "life interest trusts".  A life interest trust (which includes spousal, alter-ego and joint-partner trusts) is a trust under which a specified beneficiary is to receive all the income distributions from the trust during the beneficiary's lifetime.

Under the current rules, a life interest trust is deemed to have disposed of all of its property when the life-interest beneficiary dies.  The trust would then be responsible for paying the taxes in connection with any deemed capital gain.  Under the new rules, all of the trust's income from the year of death – including any capital gains arising on the beneficiary's death – is deemed to be income of the deceased beneficiary rather than the trust.  Any resulting taxes will be borne by the estate of the deceased beneficiary rather than by the trust.  This could lead to severely inequitable results where the residual beneficiaries of the trust are not the same as the deceased beneficiary's heirs.

Consider the example of a husband, Fred, whose Will established a spousal trust for his second wife, Wilma.  Assume both Fred and Wilma had children from prior marriages but no children together.  Under Fred's Will, income from the spousal trust is to be paid to Wilma during her lifetime with the capital going to Fred's children on Wilma's death.  Conversely, Wilma's Will leaves all her assets to her children from her first marriage.  When Wilma dies, the spousal trust will undergo a deemed disposition of all its assets.  Under the new rules, the tax liability from this deemed disposition will be borne by Wilma's estate.  Therefore, Wilma's children effectively bear the tax burden associated with the trust, while Fred's children obtain all the benefit of the trust's assets.

Notably, there is no grandfathering of existing trusts or estates under Bill C-43.  As a result, these changes will not only affect future estate planning, but will also impact structures already in place and which perhaps can no longer be changed – for example, where a trust is established by Will and the testator has already passed away.  If you have a Will that establishes a trust for the benefit of your spouse, are the beneficiary of a life interest trust, are a trustee of a life interest trust or are an executor of an estate, these changes might impact you.

There are still many non-tax reasons why a person may wish to utilize a life interest trust, including creditor proofing or protection of assets for the next generation.  However, in light of these new tax changes, it is important to review your estate plan to ensure it will still meet your objectives.