It can be challenging managing finances between spouses in second marriages.
Add two sets of children to the mix — and often some mutual children — and things can get very complicated. And it doesn’t necessarily get any easier as those children become adults, or even if they are already adults when the new relationship develops. It’s a delicate balance.
Beyond the day-to-day issues, attention will eventually turn to what happens when one of the spouses dies. While there are common interests between them as spouses, their parental desire to provide for their respective children adds a layer of complexity to the estate planning exercise.
How spousal trusts work
The spousal trust has been used for decades as a tool to address these concerns. Let’s assume the spouses are Jay and Pat.
Jay’s Will may make some immediate bequests, then a trust is set forth with Pat as lifetime income beneficiary. Pat may or may not be allowed to encroach on the capital to some extent, with Jay’s children being the ultimate capital beneficiaries on Pat’s death.
As an alternative, Jay could settle a joint-partner trust created during lifetime. In that case such an inter vivos trust would be a top bracket taxpayer, though income distributions would be taxed to Pat.
Either route would result in a spousal trust into which capital assets could be transferred at their cost base. This defers tax recognition of gains to that point, and allows for continuing deferral on future gains. Some gains could be triggered and taxed to Pat if there is an encroachment, but otherwise the gains will be deferred until Pat’s death.
Tax changes after 2015
A couple of wrenches were thrown into the machinery of this planning with changes to the rules for trust taxation passing into law in 2014. Let’s assume Jay dies, with the trust provisions having been established in Jay’s Will.
First, Jay would have contemplated that Pat’s income could be optimized by coordinating with the testamentary trust’s graduated tax brackets. But after 2015 (unless Pat is disabled at Jay’s death), such a testamentary trust will be subject top bracket taxation. Thus there will be less spendable income than the plan intended, possibly insufficient to sustain Pat based on Jay’s expectations when the Will was executed.
The second key change relates to the capital gains related tax on the deemed disposition of trust assets on Pat’s death. Under prevailing rules the trust is responsible for that tax, following which it distributes the net remainder to Jay’s children as capital beneficiaries.
Under the new rules for deaths occurring after 2015, the capital gain is deemed to be Pat’s. Pat’s estate is responsible to pay the tax, though if it is insolvent then the trust has the contingent liability. Subject to that proviso, Jay’s children will likely receive the trust capital, while Pat’s children bear the brunt of the taxes in the form of a depleted estate.
Even if an agreement is struck to have the trust pay the taxes, this will likely be considered a contribution to Pat’s estate that immediately disqualifies it from use of graduated tax rates (which otherwise would be available for three years under the new rules).
Any reprieve ahead?
These issues were acknowledged by the Canada Revenue Agency at this year’s annual conference of the Society of Trusts and Estates Practitioners. Not surprisingly, the loss of graduated brackets for testamentary spousal trusts did not seem to be a concern.
On the other hand, the mismatch problem on death of the spouse-beneficiary appears to have been unintended. It remains to be seen whether the government takes any action to address this.
Regardless, spouses in the planning stages may wish to reconsider, redraft or possibly completely unwind their plans — hopefully both spouses still have testamentary capacity. It’s likely not so easy for trusts that have already come into existence, potentially requiring a court application to vary trust terms.
[NOTE: Late in 2015, the federal Department of Finance issued a comfort letter acknowledging the issues discussed in this article, opening a dialogue with tax professionals intended to address the concerns.