What Is A Spousal Testamentary Trust And When Is It Appropriate To Use?
What Is A Testamentary Trust?
A spousal testamentary trust is used to benefit the creator’s surviving spouse. Established through a will, this offers tax benefits and flexibility when dealing with a blended family, or other complex family situations. This type of trust allows the trustee to manage and invest the assets, distribute income to the surviving spouse, and execute the wishes of the willmaker.
Testamentary Spousal Trusts Qualifications
There are 5 criteria that must be met for the trust to qualify under the Income Tax Act.
The trust must be established in the will, with the transfer of property occurring due to the willmaker’s death.
During the surviving spouse’s lifetime, they must be entitled to receive all income generated by the spousal testamentary trust.
No other person may receive or access income or capital from the trust during the surviving spouse's lifetime. In other words, income and capital exclusively belongs to the surviving spouse.
The transferred property must “vest indefeasibly” in the trust within 36 months of the settlor’s death. In this case, property will vest indefeasibly when the surviving spouse acquires unconditional legal or beneficial ownership in the property.
Vesting means that the beneficiary has a right to an asset and no future event can deny them of that right.
The settlor must be a Canadian resident upon death, and the spousal testamentary trust must be a resident in Canada immediately after the property vests.
When Is A Spousal Testamentary Trust Useful?
There are plenty of benefits to a spousal testamentary trust ranging from financial to non-financial, that can help individuals in different situations.
Taxation Benefits
Upon the settlor’s death, their assets can transfer to the spousal testamentary trust at the adjusted cost base, not the fair market value. This will defer the capital gains tax liability until the assets are sold, or until the surviving spouse’s death.
Income paid to the surviving spouse will be taxed in their hands at their marginal tax rate. This is advantageous as trusts are taxed at the highest marginal rate, and distributions of income and capital made to the surviving spouse are generally tax free.
Asset Protection
Trusts offer asset and creditor protection and a spousal testamentary trust is no different. When an individual transfers their property to a trust, they are no longer the legal owner of the property. If they were to be sued or be involved in a litigation battle, they can’t use assets they don’t own to pay creditors.
Spousal testamentary trusts can protect the assets from the surviving spouse’s creditors by precluding the distribution of assets to your spouse. To maximize creditor protection, the surviving spouse should not be the trustee and should not have control over the trustee’s actions.
Business Succession
If you own shares of a family business, which you would like to ensure your family retains ownership of, you can establish a testamentary trust to hold the shares instead of leaving it outright to your children, who could end up selling the shares if they own them outright with full control.
Subsequent Marriages
Spousal testamentary trusts are a useful tool in blended families. This type of trust allows the settlor to take care of their surviving spouse during the spouse’s lifetime, with assets going to the settlor’s children from a previous marriage after the death of the surviving spouse. The surviving spouse is not able to change this after the settlor has died.
Example Use Case
Let’s look at a situation where a spousal testamentary trust will benefit you.
You decide to establish a testamentary spousal trust through your will to protect the financial interests of your spouse after you pass away, while making sure your children from a previous marriage ultimately benefit upon your passing.
You appoint a professional trust company as the trustee of the spousal trust and transfer shares of your holding company, personal investments, real estate and other assets into the trust. The trust agreement stipulates that only your spouse will receive income distributions from the trust during their lifetime, ensuring their financial security.
After you pass away, assets are transferred to the testamentary spousal trust as outlined in your will, with your spouse becoming the primary beneficiary. A corporate trustee will have already been appointed as per your instructions to manage the trust assets, investing for growth while making sure regular income distributions meet your spouse’s financial needs.
Here are the tax implications of this scenario:
First, your assets are rolled into the spousal trust at their adjusted cost base, not the fair market values. This defers capital gains tax until the assets are sold or until your spouse passes away, whichever occurs first.
During your spouse’s lifetime, income generated within the spousal trust is distributed to them and taxed in their hands at their marginal tax rate.
When your spouse eventually passes away, there will be a deemed disposition of the remaining assets in the spousal trust. Any realized capital gains must be taxed in the trust’s tax rate, which is the highest marginal tax rate. The trust can continue for the benefit of your children (or other beneficiaries), with income and capital distributions subject to applicable tax rules.
Alternative Uses For A Testamentary Trust
Beneficiaries With A Disability
Aside from blended families or protecting the financial interests of a spouse, a testamentary trust is a great tool to protect vulnerable beneficiaries. If you have a disabled child, you can ensure that they are taken care of physically and financially after you are gone. With a testamentary trust, you can set aside funds as well as name an individual to take care of your disabled child’s needs.
Minor Children
Another benefit of testamentary trusts is taking care of minor children. Funds that you leave outright to a minor child cannot be paid directly to them because they do not have legal capacity to manage those funds.
A great workaround is to create a testamentary trust in your will for the benefit of your minor children and designate a trustee to manage the funds. You can specify in your will what the trust funds can be used for and when they can be used, as well as any other specific instructions or wishes that you have.
Frequently Asked Questions
Is a Testamentary Trust Revocable or Irrevocable in BC?
As testamentary trusts do not come into effect until after the settlor passes away, they are irrevocable by nature, they cannot be altered after the deceased's death.
Does a Testamentary Trust Avoid Probate in BC?
Generally, only assets passing through your estate can be transferred to testamentary trust. Therefore, probate fees will have to be paid. The exception is insurance proceeds, which may be paid directly to the trust, rather than through the estate. In BC, probate fees are 1.4% of the value of your estate.
If avoiding probate is your main goal, consider an inter vivos trust (e.g. a family trust). Although you may not achieve the same benefits, the assets within an inter vivos trust will avoid the 1.4% fee.
How Do You Set Up a Testamentary Trust?
A Testamentary Trust is set up within a Last Will and Testament. The individual will need to leave instructions on which assets will be transferred to the trust and when and how they will be distributed to the beneficiary. The individual also must designate a trustee.
