Qualifying Spouse Trusts – How do They Actually Work? -Part 2

Today, in the conclusion of her two part guest post on Qualifying Spousal Trusts, Katy Basi discuses how these trusts actually work. I thank Katy for her excellent posts.

Qualifying Spouse Trusts - How do They Actually Work? 

By Katy Basi

In Part 1 of this blog, BBC aficionados were introduced to the idea of leaving their estate to their spouse using a “qualifying spouse trust” or QST ("QST"). This week we look at the degree of protection that a QST can provide to non-spouse beneficiaries, and at methods of ensuring that a QST functions effectively.

In Monday's post, Fred’s will left the residue of his estate to his wife Wilma by way of a QST. The QST provides that any property remaining in the QST upon Wilma’s death is equally divided among Fred and Wilma’s children. How confident are we that the children will actually receive anything from Fred’s will? How protective is this QST?

The degree of protection afforded by the QST to the children (and any other non-spouse beneficiaries) will depend on two main factors:

1) The trustee’s ability to encroach on the capital of the trust for the benefit of Wilma.

2) The identity of the trustee.

The QST must provide that all income be paid or payable to Wilma. Of course, the trustee can invest the QST in assets producing high amounts of income, or no income at all. (In the latter case, the trustee should be cautious about a potential claim by Wilma.)

As to capital, the QST can provide that:

(i) no one is entitled to the capital of the QST during Wilma’s lifetime (very protective but also very inflexible),
(ii) the trustee can encroach on the capital for Wilma’s benefit under limited circumstances (eg for medical reasons), or
(iii) the trustee has full discretion to encroach on the capital for Wilma’s benefit, even if the encroachments exhaust the trust prior to Wilma’s death.

Clearly, the broader the encroachment power, the greater the likelihood that there will be minimal property remaining in the trust upon Wilma’s death.

A broad encroachment power can still be protective, depending on the identity of the trustee. If Wilma is the sole trustee of a QST with a broad encroachment power, we are back in “just trust me” territory. We are relying on inertia/laziness for protection – Wilma can pull all of the funds out of the QST, but we’re hoping that she doesn’t get around to it!

It would be more protective to name an independent trustee, or Wilma and an independent trustee, jointly, to manage the QST and make encroachment decisions. In my view, some flexibility is necessary re capital encroachment – Wilma could have major medical needs and require some (or even all) of the capital of the QST for very legitimate reasons.

At this point in my explanation of QSTs, many of my clients revert back to the “just trust me” option (no doubt thanking their heavenly stars that they didn’t go to law school), while others go ahead with the QST structure.

For the latter group, it is imperative to note that only assets falling under the will are grabbed by the QST. Therefore, joint assets (which are inherited by right of survivorship, and not under the will) and assets with completed beneficiary designations (eg RRSPs, RRIFs, TFSAs, life insurance, pensions) do not fall into the QST.

It is often necessary to split joint investment accounts (ie create two investment accounts, one in Fred’s name, and one in Wilma’s name) in order to make the QST structure viable. There is often no point in having a spouse trust containing only $20,000, as a trust tax return must be filed every year, and the QST funds must be held in a separate, segregated account which may also incur fees.

Splitting joint accounts is viewed with horror by the probate tax-avoidance crowd, as Wilma may have to then probate Fred’s estate and pay probate tax on his investment account. I am not terrified by this concept, as I view it more as a prepayment of half of the probate tax bill when Fred dies. If the account were maintained as a joint account, probate tax would be payable on the entire account upon Wilma’s death in any event – so we’re just paying half of the probate tax early (this is a very simplified analysis, of course!)

Finally, let’s get to the income splitting benefits of a QST. QSTs are often recommended not for any of the protective reasons mentioned above, but because the QST is a separate taxpayer that has access to the marginal rates of tax. In other words, Wilma can elect to have some or all of the income of the QST taxed in the QST, and essentially income split with her QST (which seems only fair, since she can no longer income split with dead Fred).

However, the federal budget in March of this year indicated that marginal rates for testamentary trusts (which would include QSTs) may soon be a relic of the past. We are waiting for draft legislation to be released, but the idea of inserting a QST purely to income split may be dying a slow, tortured death – we will have to wait and see. [Mark comment: As per this government consultation paper, it is proposed that testamentary trusts will only be allowed a low rate of tax for 36 months].

Income splitting aside, if you or your clients like the idea of their cold, dead hands controlling their assets long after their death, and can live with some complexity in their estate planning, a QST may be just the ticket.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Katy Basi is a Barrister and Solicitor with her own practice, focusing on wills, trusts, estate planning, estate administration and income tax law. Katy practiced income tax law for many years with a large Toronto law firm, and therefore considers the income tax and probate tax implications of her clients' decisions. Please feel free to contact her directly at (905) 237-9299, or by email at katy@katybasi.com. More articles by Katy can be found at her website, katybasi.com.

Qualifying Spousal Trusts – What are They and Why do we Care?

Last week I noted the concept of a qualifying spousal trust in my post on "When Spouses Don’t Leave All Their Assets to Each Other - The Income Tax Implications". The creation and use of spousal trusts can be very complicated, so I thought this week, I would have Katy Basi, an estate expert break down the topic. I just had no idea 88 Fingers Louie and brontosaurus burgers would be that integral to the explanation.

Qualifying Spousal Trusts- What are They and Why do we Care?

By Katy Basi

Whenever I am drafting wills for spouses, I’m usually on the receiving end of both a quizzical look, and a moment of silence, near the beginning of the first meeting.

My clients level a quizzical look at me when I tell them that their plan of leaving everything to each other, and then to their children, means that they are creating “just trust me” wills.

To illustrate this point, we run the scenario of Fred dying and leaving everything to Wilma. After a suitable period of grieving, Wilma marries Barney (I’ve assumed that Betty divorced Barney years ago and has been living it up in Cuba). In Ontario, marriage revokes a will, so Wilma is intestate. Understandably alarmed, she runs to her nearest estates lawyer and draws up a new will, leaving everything to Barney. Wilma is concerned about Barney, as he not skilled at saving for retirement and will need funds in his old age if Wilma predeceases him.

Hmmm. That’s when the moment of concerned silence arrives. Back when Fred and Wilma made their original wills, they were trusting each other to “do the right thing” in the future. Sometimes that works out! Sometimes, not so much.

How can we address this issue? There are three main options:

1) Call up a family lawyer. The family lawyer can draft a marriage contract requiring Fred and Wilma to keep their current estate plan regardless of future circumstances. This is a relatively expensive and time-consuming option, especially if the only goal is to manage estate issues.

2) Create “mutual wills”. Mutual wills are essentially wills where Fred and Wilma promise not to change their wills in the future. I do not recommend mutual wills – they are fraught with legal uncertainty, and litigation abounds when mutual wills are in play.

3) Create “qualifying spouse trusts” (“QSTs”) in Fred and Wilma’s wills.

Let’s say that the residue of Fred’s estate was left to Wilma in a QST. If Fred dies first, a trustee (usually but not always the executor) will hold the residue in trust for Wilma. If there are funds left in the QST at Wilma’s death, it is Fred’s will that determines the distribution of the funds (not Wilma’s!) Upon Wilma’s death, Fred’s will instructs the trustee to divide the remaining funds among their children. This is starting to sound like a good idea!

A QST is a special kind of trust, with beneficial tax effects. When Fred dies, he is considered, for tax purposes, to have disposed of all of his assets at fair market value, and he will be taxable on any capital gains triggered by this disposition. There is an exception to this rule if Fred leaves his assets to Wilma, or to a QST. Fred is then considered to have disposed of his assets at his cost for tax purposes (so that no gain is triggered upon Fred’s death), and the QST is considered to have acquired the assets at that same cost. When Wilma dies, the QST will be considered to have sold its assets at fair market value, finally triggering any accrued capital gains. More or less, these are the same tax effects as if Fred had left the residue of his estate directly to Wilma.

So….we can use a QST in Fred’s will to provide for Wilma’s needs and take care of their children, without being disadvantaged from an income tax point of view. But how do we ensure that the QST functions effectively to protect Fred’s estate? On Wednesday, in Part 2 of this blog post I will address this issue and other practical questions such as how to ensure that the QST applies to the right assets.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

Katy Basi is a barrister and solicitor with her own practice, focusing on wills, trusts, estate planning, estate administration and income tax law. Katy practiced income tax law for many years with a large Toronto law firm, and therefore considers the income tax and probate tax implications of her clients' decisions. Please feel free to contact her directly at (905) 237-9299, or by email at katy@katybasi.com. More articles by Katy can be found at her website, katybasi.com.