Alter Ego Trusts – Hull on Estates #107
Listen to Alter Ego Trusts.
This week on Hull on Estates, Natalia and Chris discuss what Alter Ego Trusts are and the pros and cons of using Alter Ego Trusts.
Alter Ego Trusts – Hull on Estates Podcast #107
Natalia Angelini: Hello and welcome to Hull on Estates. You’re listening to Episode #107 on Tuesday, April 22nd, 2008.
Welcome to Hull on Estates, a series of podcasts for the Canadian legal community dealing with issues and insights surrounding estate planning in Canada. Hosted by the lawyers of Hull & Hull, the podcast will touch on some key considerations when planning estates and Wills. Now, here are today’s hosts.
Natalia Angelini: Hi and welcome to another episode of Hull on Estates. I’m Natalia Angelini.
Chris Graham: And I’m Chris Graham.
Natalia Angelini: So Chris, welcome today. We’ve never podcasted before although it feels like we have.
Chris Graham: Many times Natalia, but I’m sure it will be a pleasure.
Natalia Angelini: Yes I think it will and today we’re talking about a subject that is quite interesting. We’re going to cover the issue of alter ego trusts. Now alter ego trusts are a newer instrument and it’s a type of trust that satisfies certain requirements under the Income Tax Act and which are defined in Section 248 of the Income Tax Act. So perhaps I’ll just start by setting out some of the requirements for an alter ego trust. Chris, you can feel free to jump in any time here.
So this is the kind of trust that is really appropriate for an older person because the settlor has to be at least 65 years of age at the time the trust was created. And the trust must have been created after 1999. So it is, as I said, a newer type of trust instrument. The settlor also has to be able to receive all of the income of the trust that arises before his or her death and no one except the settlor may, before his or her death, receive or obtain the use of any income or capital of the trust. And I think finally the trust does not make an election referred to in the Income Tax Act and that’s, for anyone who’s interested, that’s in sub-paragraph 104, sub 4a, sub 2.1 of the Income Tax Act.
Chris Graham: That was a mouthful.
Natalia Angelini: That was a mouthful, I’m sure we’ll all be rushing to go look up the Section.
Chris Graham: Applies to pretty much any reference to the Income Tax Act.
Natalia Angelini: Exactly. So those are the requirements for an alter ego trust to exist and perhaps we can chit chat about some of its other elements.
Chris Graham: Yeah, I guess the first element that any lawyer will know, but people should also be aware of, is that a trust, including an alter ego trust, is a separate tax payer. For the purposes of paying taxes, it is its own person.
Natalia Angelini: That’s right Chris, good point. What else makes the alter ego trust distinct?
Chris Graham: Well, the rule against perpetuities which non-lawyers call the 21 year rule, some lawyers do too, of course, better than me, does not apply to deferral of capital gains tax until the settlor dies or until the capital property is disposed of during the settlor’s lifetime. So basically, if the settlor lives past age – say they create the trust at 65 and they live past age 86 which a lot of people are these days, well the rule against perpetuities in other trusts might kick in. It doesn’t kick in to the alter ego trust.
Okay, so in short, what happens is that on the death of the settlor, there’s a deemed disposition of the assets that are in the trust and capital gains taxes cannot be – they can’t be set against the settlor’s capital losses or capital losses in the trust can’t be set against the settlor’s capital gains. Since the trust is, it’s an inter vivos trust which means during the lifetime of the settlor, gains will be subject to tax at the highest applicable marginal rate.
Natalia Angelini: And that’s a good point and I think essentially income earned in the trust will be taxed as if the settlor earned it personally during his or her lifetime. So even though the 21 year rule does not apply, the trust can make an election under the Income Tax Act not to have a deemed disposition on the death of the settlor. So if that election is made, the 21 year rule will apply and there won’t be a rollover with respect to transfer of assets into the trust. And I think there’s one other element to an alter ego trust that we should cover.
Chris Graham: Yes, residence is a basic general rule, residence of the trustee will determine the residence of the trust, I think that’s pretty much trite in most cases. However here’s where the kicker comes in. If the trustee becomes a non-resident, the trust will also be deemed, in many situations, to have also ceased to be a resident of Canada and must therefore pay the deemed disposition of its assets. Now why does that matter? Well who makes these trusts? People at least 65 years of age, with a fair bit of money. What do most of those people do in the winter? They pack their bags, they’re smart people, they avoid our winters. They go down to Florida. And therein lies the risk of being deemed to have become a non-resident. We’re not immigration lawyers, we’re far from being experts in legal requirements of residency and what deemed rules are and when they kick in. But we do know there’s something out there and if you create one of these trusts or you certainly have to keep this in mind and get some highly qualified advice.
Natalia Angelini: Now I’d like to cover some of the reasons that you would want to set up an alter ego trust because this is a kind of trust instrument that is, in my view, appropriate for a narrower scope of people and not as broad an audience as some other trust vehicles. I think its best when you’re dealing with a really large estate because the best or what seems to be the best advantage to setting up an alter ego trust is avoiding probate tax. So if you’ve got a large estate and you’re potentially going to be paying significant sums in probate tax and those sums are .5% on the first $50,000.00 and 1.5% on the balance of the value of a person’s estate. So those numbers can really add up.
And one of the other great advantages of an alter ego trust is the privacy factor. The value of your assets are not made public. So if that’s important to you, then that’s one advantage of that vehicle. And something else that you can benefit from by creating an alter ego trust is creditor protection, because ownership of the asset is transferred to the trustee. However you’ve got to be careful because if it’s ultimately challenged and the purpose of the trust is found to have been set up to avoid or defeat creditors, then those assets can be clawed back and you won’t be able to protect them against creditors.
Chris Graham: Absolutely, Natalia. Federal and provincial statutes, for instance, the Fraudulent Conveyances Act contain lots of very powerful ways that creditors can go after debtors who tried or purported to enter into transactions for the sole purpose of protecting assets from claims. That’s something obviously you have to get expert advice on because it’s a case by case basis and the statutes are complex and there’s lots of case law and all the rest of it. But if you’re looking to create an alter ego trust to defraud creditors or whatever, that’s not something that they were really set up for.
Natalia Angelini: And I think one of the other advantages to setting up an alter ego trust is the prevention of litigation because it is more difficult to challenge the validity of an inter vivos trust than a Will, for instance. So that is something to be kept in mind.
Chris Graham: And one practical advantage of it, probably not really what this type of trust is designed to do, but if the settlor settles this trust, an alter ego trust, and then later becomes incapable, well that particular – the assets in the trust are self-administering. In other words, no one has to go to Court and initiate expensive and potentially contentious guardianship proceedings in order to deal with this property. You don’t have to worry about “oh my god, this person who’s been running this company is suddenly out of the picture, what do we do? Everything’s falling apart”. No, it’s taken care of, it’s in trust, there’s a trustee, these assets are well in hand and they’re also being managed in accordance with a plan laid down by the settlor already.
Natalia Angelini: So I can’t think of any other reasons for setting up a trust off the top of my head, so maybe we’ll move to reasons that you might not want to set up an alter ego trust.
Chris Graham: One of the major reasons not to, is that when you put something into an alter ego trust or any trust, you lose control of that asset, it no longer belongs to you. And it never ceases to amaze me how many people who have set up estate freezes and what not, don’t appreciate that fundamental point. It is no longer theirs when it goes into trust, whatever it is.
Natalia Angelini: That’s right. So you certainly have to be mindful of that and if, on the other hand, you do appoint yourself as trustee being the settlor, you can retain some control but you’ll forfeit your right to use the trust to reduce overall tax liabilities. So there’s a pro and con to proceeding in that way as well.
Chris Graham: This brings us back to what we were saying earlier about not being able to write off capital gains based on maybe the settlor’s capital losses on death. There’s also that aspect of tax planning, which is way beyond me.
Natalia Angelini: I’ll leave that one alone. So onto – another reason that you might hesitate to set up an alter ego trust is naturally there’s going to be legal costs and costs of obtaining tax advice. For instance, ongoing administration expenses, trustee fees and the cost of annual tax returns that need to be filed. So those are just some of the costs built in that, you know, may not be – some people may not be interested in incurring.
Chris Graham: I thought people liked paying their lawyers, their accountants, their dentists.
Natalia Angelini: Yeah I don’t think –
Chris Graham: Their financial advisors.
Natalia Angelini: So I think we’ve covered the nuts and bolts of an alter ego trust meaning what it is, what its elements are, the advantages and disadvantages of setting one up. And they certainly are, you know, a welcome edition to the tools available to people in planning their estates, particularly for the older client. However, the advantages of confidentiality and probate tax savings definitely needs to be weighed against the tax considerations and potential tax disadvantages to setting up the trust.
Chris Graham: It is a state-of-the-art statutory trust and as such, contained in the Income Tax Act, and as such it has a broad variety of advantages and disadvantages.
Natalia Angelini: If you’re interested in learning more about this subject or just in reading more on it, then there’s a couple of great papers that we can refer you to. One is by Elena Hoffstein. It’s called Alter Ego Trusts and Joint Partner Trusts: Tips and Traps. And she presented this paper at the Fifth Annual Estates and Trusts Forum. And there’s also a more recent paper by Tim Yuden, called – and it contains an annotated alter ego trust and that was presented at the Taxation of Trusts and Estates: A Practical Approach Seminar on March 3rd, 2008. So those are two great sources that we’ve certainly referred to in putting on this subject today and we hope that they help you as well.
Chris Graham: It’s nice light reading, too.
Natalia Angelini: Nice light reading. So I think that brings us to the end of our discussion this week. Thanks for listening and thanks for joining me,Chris.
Chris Graham: That was a pleasure, Natalia. I look forward to podcasting with you again soon, as always.
Natalia Angelini: Me too! So perhaps one thing we can leave you with is we’d be happy to hear from you, so you can send us an e-mail at hull.lawyers @gmail.com. Or give us a call at our comment line being: 206-350-6636.
Alternatively, you can also visit our blog page at estatelaw.hullandhull.com where you’ll get even more information and discussion on today’s practice of estate law. I hope you enjoyed the show. I’m Natalia.
Chris Graham: And I’m Chris.
Natalia Angelini: And until next time, so long.
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