Chapter 9: Probate, Trusts, and Estate Tax Minimizing Strategies

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“This is great coffee, Sandra,” said Uncle Wayne. “I wish you could talk your Aunt Jen into buying the good stuff. She always gets coffee on sale, and it’s so weak that I end up needing a whole pot just to get my heart started most mornings. Oh well, let’s get back to work.

“I believe we were about to go over information about trusts and some methods you could use to minimize probate fees. So, Alice, has your research taken you down either of these paths yet?”

“Actually, it has,” she said with pride. “And from what I can see, there are four major categories of asset transfers, including:

1. gifts, like the lump sum Aunt Lorraine is giving to Mark;
2. non-probatable assets, which pass directly upon a person’s death to a beneficiary without having been designated in a will;
3. probatable assets, which are transferred through a will and are, therefore, subject to probate and executor fees; and
4. trusts.

 

“There are a few different types of trusts, and Uncle Wayne’s going to have to help me explain them, because I don’t completely understand them. However, what I do understand is that whenever possible, we’ll want to transfer assets outside of our wills so that our estates will pay the minimum amount in probate and executor fees.”

“I’ll second that,” I nodded. “Probate fees, or estate administration tax, starting January 2020 in Ontario, is 1.5% of the value of the estate over $50,000. 

“Let’s not get too far ahead of ourselves,” Uncle Wayne said. “I want to go back and look at the pros and cons of each of these methods of transferring assets, starting with gifts.

But first, there can be some advantages to probate, such as:

• It can protect the executor from claims by the beneficiaries and/or third parties. 
• It can offer some protection from claims against the estate, as there is a specific time frame for claims when a will is probated.
• It may be easier for estate administration by the executor.
• In some cases, it may make it easier to allocate the estate on an after-tax basis to the beneficiaries as intended in the overall estate plan. 

 

“So with any of the strategies, they must be reviewed carefully with your lawyer, accountant, and financial advisor to make sure it makes sense and accomplishes what you intended. You must be concerned about unintended results, which means attempting to save on probate fees that cause other problems.”

“What’s an example of unintended results?” Alice asked. 

“I thank I can answer that,” Sally said as she took a sip of her drink. “My lawyer friend mentioned that while you want to minimize probate and estate fees, you have to be careful of unintended circumstances, as Uncle Wayne said. For example, he has seen that some people put their homes in joint ownership with their adult children to avoid probate fees, but this can cause problems. Since the child then owns part of the home, the child’s creditors could have access to the property, and the child may also end up with two homes, and only one can be a principal residence, which could cause tax problems.”

“Very good point, Sally. This is why you have to include your lawyer and accountant when making and implementing an estate plan,” Uncle Wayne said with a smile.

“The transfer of Aunt Lorraine’s gift to Mark is tax-free to him and to Aunt Lorraine because Mark is over the age of eighteen. The only real tax concern is that Aunt Lorraine could have some capital gains on her hands if she had to sell assets that had appreciated in value in order to get the cash to give to Mark. Of course, Mark is ultimately responsible for taxes on income he earns by investing the gift.

“We had also talked about the family cottage with Aunt Lorraine, and if she was to gift the cottage to Mark today, it would avoid the probate fees; however, she would have to pay tax today on the gain between the fair market value of the cottage and the tax cost base. This could be very expensive since she has had the cottage for over fifty years. To help reduce taxation in the future, she has kept the track of the capital improvements, like your new deck, as they increase the tax cost based, and she did bump up the cost base in 1994, as allowable by the CRA back then.

“What she could also do is transfer the cottage into a trust for Mark. The transfer would be tax-free today, but the tax would have to be paid on her death. However, since the property is in a trust, there would be no probate fees, as it passes directly to him. We will review this a bit later.

“Now, getting back to the gifts. The rules for gifts change when the person getting the gift is under the age of eighteen, a minor. In that case, any income earned by investing the gift money is attributed back to the person who gave the gift. For example, if Jack gives money to Connor and Paige, then any investment income from that gift, such as interest or dividends, is still counted as part of Jack’s income, and he pays the tax bill. If the investment income earned is capital gains, it’s then taxed in the children’s hands. However, and here’s where it gets really complicated, income earned on the income is not attributed back to Jack.

“The bottom line here is that gifts are more advantageous as a method of transferring assets if you give the money to someone over the age of eighteen or, if the person is under the age of eighteen, the gift is invested in an investment that generates capital gains, such as stocks or an equity mutual fund.”

“I think I followed that all right,” David commented. “Now, what about non-probatable assets? What are those?”

“I’m glad you asked,” said Alice, beating Uncle Wayne to the punch. “Non-probatable assets are assets that are transferred to a beneficiary outside of a will. For example, if spouses own a house together as joint tenants, then one’s share passes directly to the other if either die. That means the value of the share in the house doesn’t have to go through probate, so no probate or executor fees are paid. Now, with RRSPs …”

“Hold it a minute,” Uncle Wayne interrupted. “You should all know that the same thing applies to bank accounts and other investments that are held jointly. If you don’t have joint ownership for financial accounts, then a spouse can’t get his or her hands on the assets until they go through probate. Sorry, Alice. Carry on.”

“Thanks,” she said, smiling. “With RRSPs, you can name a beneficiary, and if it’s your spouse, the RRSPs can be passed tax-free and outside the will directly into the surviving spouse’s RRSP, without being subjected to probate fees.

“If the beneficiaries are the children or grandchildren, under the age of eighteen and financially dependent, the RRSP proceeds either have to be included in the income of the child or grandchildren, or the proceeds can be used to buy an annuity, payable to the age of eighteen only. If this is done, income taxes would be paid on the income as the kids get it.”

“Would my kids be classified as dependent?” asked Mark.

“Under your definition, they probably would,” laughed Uncle Wayne, “but not according to Revenue Canada. By their rules, a child over the age of eighteen must be either infirm or handicapped in order to be considered dependent. In a case such as this, the RRSP monies left to them could be rolled over into the dependent child’s RRSP or RRIF or used to buy an annuity.”

“There’s more,” Alice cautioned. “You should also name someone as direct beneficiary on all life insurance policies, including your group benefits at work. A lot of people name their estate as beneficiary, but then the proceeds must go through probate, and again, the estate pays a fee, and the heirs get less.”

Uncle Wayne added, “Some good points, Alice; however, you most likely will not want to name minor children as beneficiaries of life insurance. By naming your estate, the terms and conditions of your will apply, which is what you most likely desire.”  

“Well,” said Sandra, “if we want to reduce potential probate costs, we’ll have to make sure our house and bank accounts are held jointly. What’s the procedure, Uncle Wayne?”

“You should double-check, and while you’re at it, make sure you’ve named beneficiaries in all of your life insurance policies too. By the way, this stuff should all be in your binders.”

“I bet that Mark’s life insurance policy at work still lists his ex-wife as beneficiary!” Sally said with a devilish grin.

“You would lose that bet. I changed it last week.”

“Can we talk about trusts now?” asked Alice. “As I mentioned, I’m not all that clear on the ins and outs, Uncle Wayne.”

David thumped the side of his head as though he hadn’t heard her correctly. “I can’t believe I heard Alice admit twice in one day that she was unsure about something!”

“Ask me twice if I’m sure I married the right guy,” she said with a sideways glance, “and you just might witness this phenomenon again.”

“So much for marital trust,” Uncle Wayne said. “Now, getting back to the topic of monetary trusts. The advantage in setting up a living trust is that the transfer of assets takes place outside of your will and doesn’t have to go through probate, so there are no probate fees and no executor fees. In addition, there may be tax savings, depending on the terms of the trust.”

I asked Uncle Wayne what the other uses of trusts are, and he explained to us, “Well, in addition to reducing probate tax, trusts can be used for:

• control and protection of minor children and/or special needs dependents;
• protection for family members who are or could be a financial risk;
• allowing you to income split to lower the family tax rate;
• preserving an inheritance within a blended family, where the surviving spouse is provided for during their lifetime, and the remaining assets are passed to the children upon the surviving spouse’s death; 
• safeguarding and protection from family law or marital claims upon divorce;
• confidentiality;
• holding an important asset such as a cottage or family business; and
• charitable giving.

 

“This can be really complicated, and you will have to review with your own lawyer and accountant, but we can review the basics.”

“Before I learn the best way to structure a trust, I think I need to know exactly what it is and how it’s set up in the first place,” said David.

“There’s no way to put this without using the legal terms,” explained Uncle Wayne, “so here goes. A trust is an obligation that binds a person (the trustee) to deal with the property he controls (the trust property) for the benefit of another (the beneficiary) in accordance with the terms indicated by the person who established the trust (the settlor). What makes this confusing sometimes, is that the settlor and the trustee can be one and the same. Here, I wrote it down for you,” he said, handing each of us a piece of paper.

Trust – entity to which property is transferred

Settlor – individual who transfers the property to the trust

Trustee – person who makes the decision for the trust

Beneficiary – person who will benefit from the property

“I hope you’re still with me,” Uncle Wayne added, “because there’s more. A trust can either be an ‘inter vivos’ trust or a testamentary trust. An inter vivos trust is a transfer made while you are alive, and it can be either revocable, which means you can change it, or irrevocable, which means you can’t.

“The taxation of trusts can also be confusing, but you should remember that the income earned by a living trust is taxed at the highest marginal tax rates, with no deductions. However, if the income earned is paid out to the beneficiaries, it’s then taxed as the beneficiaries’ income, which allows for income splitting, assuming the beneficiary has a lower tax bracket than the person who gave the property.

“With my own estate planning since I am an old fogey, we’re reviewing a specific type of inter vivos trust called a joint partner trust. These types of trusts allow a settlor (me and my beautiful wife) to transfer capital assets to a trust on a tax deferred basis, provided we are both over the age of sixty-five at the time of the transfer. The conditions are that we as settlors must receive the income from the trust and pay tax on it each year. The capital gains tax is deferred until our deaths. Now there are some set up fees and tax returns to file, so we’re weighing the pros and cons of perhaps putting the family cottage and some of our investment portfolio into a joint partner trust for our kids. Aunt Lorraine is looking at the similar type of trust for Mark for the cottage as we discussed early, but since she’s single, it’s called an alter ego trust. 

“The other kind of trust, a testamentary trust, is something you set up under the terms of your will. That means the assets will have to go through probate, and the estate will have to pay fees, but at least you maintain some control over how the assets are handled after you’re dead.

“If it sounds complicated, believe me, it is. What’s important, though, is that you understand the concept of the trust, how it’s taxed, and who pays what. That’s what your lawyer or accountant is for. Let’s take a look at how you can all use these strategies in your individual circumstances.

“Sally, since you’re single with no kids, there’s really not much you can do to minimize probate and executor fees other than making sure you designate a beneficiary other than your estate on your group life insurance policy at the office. But there’s lots you married folks with kids can do, and here’s the course of action I’d recommend for David and Alice, and for Jack and Sandra:

1. Make sure the house and bank accounts are joint holdings.
2. Name one another as beneficiary for your RRSPs.
3. Set up a spousal trust for the investments that were made with capital taken directly from the inheritance.
4. Set up a testamentary trust for each child in your will for all remaining assets.
5. Since David and Jack are taking out permanent life insurance to ensure that the original value of their inheritance goes to their kids, name the estate as beneficiary so the terms of the will apply. You could also look at an insurance trust instead of naming the estate, but that can get complicated.”

 

“I think I’m going to need a little help making sense out of those instructions,” I confessed.

“No problem,” responded Uncle Wayne. “Joint ownership on the house and bank accounts ensures that the holdings pass directly to your spouse, with no probate fees. Same thing for the RRSPs if you name your spouse as beneficiary; however, please review your overall estate plan to make sure that by making your accounts joint, and naming beneficiaries, you don’t defeat the purpose of your estate plan to begin with. Mark, you will have to pay attention to this, as this can happen when someone has had a prior marriage or relationship that included children and support payments, and perhaps has made some charitable gifts in their estate plan or has other financial obligations. You have to be very careful and think about the overall estate plan and intentions before changing anything.”  

“Thanks, Uncle Wayne, I’ll remember that.” Mark added. 

Uncle Wayne continued, “If you set up spousal trusts for the investments you made outside your RRSPs with capital taken directly from your inheritances, then Alice and Sandra can live on the income from the investments, but the capital stays secure and will go to the kids when their mothers eventually die. The other advantage to this arrangement is that the investments transfer into the spousal trusts without requiring your estate to pay capital gains taxes currently. This concept is often referred to as a ‘rollover.’”

“Oh,” I commented, “so by doing this, we defer capital gains taxes, and we make sure that our inheritance from Dad eventually goes to his grandchildren, but our wives are taken care of for as long they live. Good plan.”

David added, “It seems fair.”

“I agree,” said Alice, looking at Sandra. “After all, it’s not our money.”

Uncle Wayne continued. “Both of your families have term insurance to provide income for living expenses and childcare if anything should happen to you. To split income, you could name your spouse as the beneficiary for the major portion of the term insurance, but you should also the name each of the children directly, with your spouse named as a discretionary trustee. This way, some of the money would go to the children directly in trust, and as discretionary trustee, your spouse will be able to use it for the cost of care and education as necessary. It’s tax effective because the income on the funds earned in the trust, if paid out, will be taxed at the children’s lower income tax rate. So the same income may be earned, but it’s divided among two or three people. This is an effective income splitting strategy. Also, you can designate the age at which the money is to be given to the children. The trust document has to clearly set this out.

“Now, we hate to even think about this, but setting up a testamentary trust in your wills for each of your children covers the bases to protect and help them. As I mentioned earlier, the assets in a testamentary trust do have to go through probate, but this setup allows tax splitting of the income from the assets in the trusts, and it also lets you determine when the children will gain control of the assets.

“For example, as we discussed a few weeks ago, you may want the trustee to withdraw funds for normal expenses, such as the cost of university, but you probably don’t want your kids to get their hands on their entire inheritance at a young age.”

“We’ve already made provisions in our wills for paying the cost of university for our kids,” Sandra remarked. “What I’d like to know is whether there’s any way to set aside money for their education now that could also give us a tax break?”

“I’ve got some information on that,” David responded.

I guess we all looked pretty stunned.

“Knock it off. Alice doesn’t have a monopoly on research. Anyway, here’s the scoop. There’s a federal program out there called a Registered Education Savings Plan (RESP), and there are two basic types.

“The first type is where you have your own self-directed education trust plan. You would make the investment decisions (such as a mutual fund) and name a beneficiary, which can be changed if it is a blood relative. You can contribute up to $2,500 per year, or a lifetime total of $50,000, for each child. There’s no immediate tax benefit or deduction like an RRSP when you make the contribution, but the money in the plan can grow tax-free, and you get a 20 % grant on the contributions, to a maximum of $7,200 lifetime. There are also some other benefits, depending on your family income. 

“So within the plan, you’ll have your contributions, the grant, and growth. When the grant and growth is taken out, it’s taxed in the hands of the child, which is normally in a lower tax bracket. Contributions are removed with no tax. If one child doesn’t use the RESP, another child can use it. In the worst case scenario, if no one can use the RESP for post-secondary school, you would get your contributions back tax-free. You have to pay back the grants, and you have to pay tax on the growth when redeemed, or rollover tax-free to your RRSP if you have room.

“The other type of plan is a single plan with a multitude of subscribers, often called a scholarship trust. In this plan, those who don’t go to university lose their contributions and pay for those who do, so I would not recommend using these types of plans.”

Uncle Wayne added, “With an RESP, if you and your wonderful spouses are joint subscribers and anything happens to one of you, the other can take over. If there’s only one subscriber, you may want to name a successor subscriber in your will so that the RESP can continue and won’t be collapsed in the estate.”

Mark said, “My head’s starting to spin, and you haven’t got around to me yet! What do you think I should be doing?”

“Since your kids are past eighteen, I’d recommend that you set up a testamentary trust in your will that would specify the ages at which your kids gain control of their inheritance, and instruct the trustee when and how to dole out money for their school and living expenses in the meantime. Your sons are quite responsible, but I still recommend that you not leave them their entire inheritance all at once, in case they blow it.

“Now, since you’re no longer married, you may want to consider a permanent life insurance policy, with your sons as beneficiaries, that will cover any capital gains taxes on your investments and on your business when you die, plus about half the value of your RRSPs. Remember, your RRSPs will be taxed near the 50% level when you die. The permanent life policy will ensure that the true value of your estate will go to your kids, assuming that’s what you want.”

“I just thought of something” Sally said, jumping back into the discussion with vigour. “If you use investment products offered by life insurance companies, you can name a beneficiary directly, so the investments remain separate from your estate and can pass to beneficiaries without going through probate. You can save a bundle, and this applies to both RRSPs and other investments as well.

“Plus, if you’ve got your money in segregated funds instead of mutual funds, then the insurance companies will guarantee that your beneficiaries receive either the market value of your investments or up to 100% of the original principal you invested, depending on which company you’re with.”

“Another date with your friend from the insurance business?” Mark asked.

“Actually, I’m dating his roommate, a jazz trombonist. Shall we talk about your love life now?”

“Okay, you two, I’ve heard all I want to hear about dating,” warned Uncle Wayne. “Good heavens, my last date was fifty years ago, but that’s another story. Anyhow, Sally’s right about insurance company products. Just remember, do your homework to make sure the company’s on solid ground.

“And although we’ve been over this before, it bears repeating. As a business owner, Mark may find segregated funds to be particularly attractive because they’re creditor-proof, so if he’s sued, a third party can’t get at his investments. Also, Mark, with your business assets, you can have a secondary will for those specifically, and it will bypass probate.” 

“That’s a good point,” Mark agreed. 

“Well,” said Uncle Wayne, “I haven’t got much to add on the subject of trusts and probate fees, unless you’ve got some more questions.”

“I remember you gave us criteria for selecting an executor,” Sandra mentioned, “and I would imagine you want us to use the same guidelines in choosing a trustee. What’s it going to cost us to set up a trust?”

“I am glad you brought this up,” he answered, “because there’s no point in trying to cut corners. You need a lawyer familiar with trusts; it will probably cost you a few thousand dollars, and you might as well have the work done in conjunction with your wills and powers of attorney. And yes, Sandra, you must choose your trustees very carefully. After all, they could wind up with your children’s futures in their hands.”

Uncle Wayne let out a happy sigh and then continued. “I won’t be available next weekend, so let’s get together on Labour Day weekend for a final session. Our discussions have set out a framework for all of you, but we need to talk about selecting a team of advisors who can guide you when I’m down south playing golf this winter!”

Sandra and Alice said they would prepare a special meal for our last breakfast, and that Uncle Wayne was to bring Aunt Jen along.

Later that night after we put Connor and Paige to bed, Sandra and I each had a glass of wine, hers expensive and white, mine cheap and red. We started to review the main points from the day’s dual session, and Sandra opened her lap-top and started to make some notes:

Inheritances, life insurance proceeds, and gifts belong to the individual and are excluded from the legal definition of family property if received after marriage.The income and growth produced by investments made with the capital from an inheritance, insurance proceeds, or gifts are considered family property unless the will or document specifically states that the income and growth are for the sole use of the individual.

Once you start to comingle the assets by paying off a mortgage or topping up RRSPs, the assets are generally considered to be part of family property.

David and Jack could protect the full value of their inheritance for their children by adding up the capital spent on joint assets and then buying a permanent life insurance policy for that amount, with the children named as beneficiaries.

Single or divorced people like Sally and Mark should consider insisting on a domestic contact (commonly called a marriage contract) that excludes all prior assets from being part of family property.

Probate and estate costs can be minimized by:

• designating specific beneficiaries on life insurance policies and, in some cases, for RRSPs;
• making sure spouses have joint ownership of such assets as houses, bank accounts, and investments so that the assets are transferred outside the will with no probate fees;
• using gifts while alive;
• establishing trusts that can minimize estate costs, since property in an inter vivos trust does not form part of the estate for probate purposes;
• establishing spousal trusts for Sandra and Alice to provide enough income for their living expenses if Jack or David died, while ensuring that the capital is eventually passed on to the children (Spousal trusts also can be used to defer capital gains taxes.);
• if you are over the age of sixty-five, reviewing the potential use of alter ego and joint partner trusts to avoid probate fees.

 

Trusts can be used for:

• control and protection of minor children and/or special needs dependents;
• protection for family members who are or could be a financial risk;
• potentially income splitting to lower the family tax rate;
• preserving an inheritance within a blended family, where the surviving spouse is provided for during their lifetime and the remaining assets are passed to the children upon the surviving spouse’s death; 
• safeguarding and protection from family law or marital claims upon divorce;
• confidentially;
• holding an important asset such as a cottage or family business;
• charitable giving; and
• reducing probate tax. 

 

The funds earmarked for a testamentary trust will be subjected to probate fees but are a useful way to split income by naming the children as beneficiaries, with your spouse as trustee, and usually one or two other trusted individuals, so the income earned will be split among two or three people.

An inter vivos trust may not offer immediate tax advantages in relation to current income if the beneficiaries are under the age of eighteen, or if it is your spouse, since any income earned will be taxed in your hands, unless it is capital gains income for the children. But the assets in an inter vivos trust will not go through probate or have any estate costs, so it is a tax-effective estate planning tool. It also allows you to maintain control over the assets in the trust.

If you use insurance company investment products, such as segregated funds, you can name a beneficiary, and the assets will pass outside the will without any probate or executor fees.

Insurance company investment products are also considered to be creditor-proof.

If you have an RESP as a sole subscriber, you may want to consider naming a successor subscriber in your will so the RESP will continue. 

For business owners, the use of a secondary will can avoid probate fees on those assets.

Some probate and estate tax minimizing strategies can have unintended consequences, so you will have to review all strategies with your insurance expert, accountant, lawyer, and financial advisor in conjunction with your entire estate plan.

For more information, refer to Preserving Wealth: The Next Generation – The definitive guide to protecting, investing, and transferring wealth by Jack Lumsden, MBA, CFP®.

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