Publication
TITRE
Tainted Spouse Trusts
DATE
1 mai 2007
When planning their Wills, most people understand that the capital gains tax that normally arises on death can be deferred if everything is left to one's spouse or to a trust for the exclusive benefit of the spouse. In some situations, however, this does not produce the best result. The only assets that require this deferral treatment are those with accrued capital gains. Many people have assets at death which are not in this category, including investments which have underperformed, cash in the bank, term deposits and GICs, many bonds, insurance proceeds, and real property that qualifies as a principal residence. Leaving these assets to a spouse or to a spouse trust does not save any tax. On the contrary, in many situations it will result in the spouse paying more income tax than necessary over the ensuing years. Many readers will be familiar with the concept of splitting income with family members, particularly those who do not have significant income of their own, in order to take advantage of lower rates of tax. A single parent with a number of children who are financially dependent would be a classic example of someone who could benefit from income splitting. Consider a hypothetical Canadian taxpayer who dies leaving a spouse, three young children, and a $5 million estate. If the entire estate is left to the spouse, either outright or in a spouse trust, the income earned on the capital will all go to him or to her and everything over approximately $120,000 will be taxed at the highest marginal rate of tax (approximately 46% in Ontario). However, if half of the estate consisted of assets that would not give rise to taxable capital gains, those assets could be left in a trust under which the spouse and the children were all potential beneficiaries (sometimes referred to as a "tainted spouse trust"). The income could then be split among the three children and taxed in their hands, with a fourth share taxed in the hands of the trust itself. Assuming that this half of the estate earned interest income annually at a rate of 6%, there would be $150,000 to split four ways. Taking advantage of the personal deduction for each child and the lowest tax bracket for the children and the trust (the trust does not qualify for a personal deduction), the total tax paid on that $150,000 would be approximately $28,000 (ignoring other income and deductions the children might have). On the other hand, if that income had been earned by the surviving spouse or by the spouse trust, on top of the income from the other half of the estate the additional tax at 46% would be approximately $69,000, a difference of $41,000 each year. Payments to or for the children could be paid to their parent as reimbursement of amounts paid on their behalf for such things as schools, camps, sports equipment, and travel. Those who are familiar with the taxation of trusts will be concerned about the "21 year rule." A tainted spouse trust will be deemed for tax purposes to dispose of all its capital property every 21 years. The first deemed disposition will occur 21 years after the death of the parent whose Will established the trust. However, this deemed disposition and the resulting taxation of accrued gains can be avoided by distributing the assets out of the trust prior to the expiry of the 21 years. In the example set out above, the assets could be transferred free of tax to the surviving spouse or the children, or any combination of them, in whatever proportions are considered advisable. If they are transferred to the surviving spouse, he or she will then be in the same position as if the entire estate had been left to him or to her outright, except that he or she will have enjoyed many years of tax savings. Of course a Will is often prepared a number of years before death when the exact nature of the assets one will have at death may be unknown. This uncertainty can be dealt with by having the Will create two trusts, one of which is a traditional "spouse trust" and the other of which is a "tainted spouse trust". The executors of the estate can be authorized to assign individual assets to whichever trust they feel is appropriate. They would then have an opportunity to consult with the surviving spouse, examine the tax implications, calculate the potential savings, and allocate the assets in the most advantageous manner. When planning Wills, estate planners and their clients should not immediately gravitate towards an outright gift to the spouse or to a spouse trust, but should take a little more time to review the advantages of incorporating a tainted spouse trust into the plan. The purpose of this document is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Ogilvy Renault LLP or any member of the firm on the points of law discussed. For further information, please contact: Peter E. Lockie (416) 216-4813 PDF Version
plockie@ogilvyrenault.com
