THE ADVISOR December 16, 2008

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1 THE ADVISOR December 16, 2008 Testamentary Insurance Trusts for Estate Planning Tim Susel, BA, CGA, CFP, TEP Financial Advisory Support This article gives an overview of testamentary insurance trusts including what they are, how they can be created and what you should consider if you are interested in implementing this tax saving strategy. Are you aware that a strategy exists that enables you to attach terms and conditions to the distribution of life insurance proceeds? This strategy allows insurance proceeds to bypass your estate, enabling you to avoid provincial probate taxes and potential creditors. This strategy also offers a mechanism that facilitates the deferral of taxes and the splitting of income. This strategy is the use of a testamentary insurance trust. What is an insurance trust? An insurance trust is a trust that you fund with the proceeds of an insurance policy. The trust structure can be either an inter vivos (living) trust or a testamentary (created on death) trust. The benefits referred to above are all available when a testamentary insurance trust is created. How can a testamentary insurance trust be created? There are three ways you can create a testamentary insurance trust: The creation of a separate trust agreement The inclusion of an insurance trust clause within a Will The designation of a testamentary insurance trust within an insurance contract THE CREATION OF A SEPARATE TRUST AGREEMENT The formation of a separate trust agreement will identify you (the settlor), the trustee(s), the beneficiary(ies) and the terms under which the trust will be governed. This document can be as simple or as complex as you desire in order to meet your objectives and the needs of the beneficiary(ies).

2 The advantage of this method is that it provides you with the most flexibility as well as offers you a complete document that can stand on its own, uninfluenced by a Will or other outside factors. This method is most appropriate if you make frequent changes to your Will or wish to maintain your privacy. If the testamentary trust is part of your Will, a revocation of your existing Will will result in the revocation of your insurance declaration as well. If a separate trust agreement is created, the revocation of your insurance declaration will not occur. In addition, a probated Will is a public document, and by creating the insurance trust in this way, it will remain hidden from prying eyes. An example of an individual who could use this method is a single parent who wants to use an insurance trust for the benefit of their children, but in the future may consider remarrying. The remarriage would automatically nullify the preceding Will, unless the Will was created in contemplation of the marriage. THE INCLUSION OF AN INSURANCE TRUST CLAUSE WITHIN A WILL This is a separate clause incorporated in the body of the deceased s Will. One of the concerns with this method is that care must be taken in the drafting of the Will. The drafter must ensure that the insurance proceeds do not pass through the estate of the deceased. If the insurance proceeds pass through the estate, then probate taxes and/or executor fees could be levied. Your Will must contain a specific clause that states that the insurance proceeds should be dealt with as a separate insurance trust and not as part of the general scheme of distribution contained elsewhere in your Will. The key is that the paragraph setting up the insurance trust is not stipulated in the dispositive section (i.e. the section on the disposition of assets) of the Will. If the insurance trust clause is properly drafted, then your beneficiaries could also benefit from the creation of more than one testamentary trust (as in the separate trust agreement). For example, by using this method, two trusts could be created: the regular testamentary trust (#1) created within the Will from the residue of the estate and a second insurance testamentary trust (#2) created from the proceeds of an insurance policy.

3 In the diagram below, assume that you have already created a testamentary trust within your Will. The insurance trust will be a second testamentary trust. The insurance trust may mirror the provisions that are currently in the Will (residual testamentary trust) or may offer a different distribution scheme. Source of funds Destination of funds Minor Residue from estate (probatable asset) Insurance proceeds (non-probatable asset) Testamentary trust #1 Testamentary trust #2 If the insurance trust clause is properly drafted, then your beneficiaries could also benefit from the creation of more than one testamentary trust (as in the separate trust agreement). For example by using this method, two trusts could be created: the regular testamentary trust (#1) created within the Will from the residue of the estate and a second insurance testamentary trust (#2) created from the proceeds of an insurance policy. The creation of multiple testamentary trusts enables the beneficiaries to benefit from tax savings and income splitting. In essence, by having multiple testamentary trusts, you have numerous taxpayers, each benefitting from graduated tax rates. Some people may be concerned that an insurance trust may be treated by the Canada Revenue Agency (CRA) as the same trust as the residual trust created within the Will. The concern is that this could result in the insurance testamentary trust being merged with other trusts created in the Will and the loss of the tax benefits created by the separate testamentary trusts. For example, a court in Saskatchewan in one case held that in order to avoid probate fees utilizing an insurance trust, the trustee of the insurance trust must be someone other than the executor of the Will, and the distributive clauses in the trust should not be reflective of the clauses found in the Will. However it should be noted that this case is unique to Saskatchewan and may not be applicable in other jurisdictions. One way to ensure that the CRA does not take this position is to carefully draft the Will so that the testamentary insurance trust and the testamentary residual trust have different beneficiaries, or the provisions of the trust do not mirror those of the Will.

4 A disadvantage in creating an insurance trust through a clause in the Will is the possibility that if the Will is ever revoked, the insurance trust declaration will also be revoked. Individuals should be cognizant of this issue if their Will requires frequent updates due to major changes in their lives. THE DESIGNATION OF A TESTAMENTARY INSURANCE TRUST WITHIN AN INSURANCE CONTRACT The easiest method is to create the designation within an insurance contract. This method does not require a lawyer to draft anything saving you money. However, you may not get the flexibility to specify any terms particular to your situation. For example, if your intention is to setup a spendthrift trust, you may not be able to prevent a beneficiary from spending the capital. Benefits of creating a testamentary insurance trust PROBATE TAX The avoidance of probate taxes is ensured if your insurance proceeds are paid to a named beneficiary other than your estate. Insurance proceeds directed to an insurance trust will not form part of your estate and therefore will not be subject to probate taxes. CREDITOR PROTECTION Proceeds paid to a beneficiary from a life insurance benefit are protected against the creditors of the deceased whose life was insured. You should ensure that a contingent beneficiary is designated. This will prevent creditors from successfully claiming the funds in the event that the beneficiary you designated predeceases you. However, whether or not the insurance proceeds are protected against the creditors of the beneficiaries depends on how the insurance trust was created. Creditors of the beneficiaries generally have access to distributions from a trust that are paid or payable to the beneficiary. A regular trust does not protect a beneficiary from aggressive creditors. The solution is to create a fully discretionary trust for which the trustee has full discretion to distribute the assets to the beneficiaries.

5 Be aware that if you are in financial difficulty and you are considering a prepayment of the insurance policy to fund an insurance trust, the settlement of the property is void where the property is transferred within the year before the settlor declares bankruptcy. If you, as settlor, are already in financial difficulty, this strategy of prepaying insurance premiums is futile. WHAT ARE THE POTENTIAL TAX SAVINGS? As with all testamentary trusts, an insurance testamentary trust will benefit from graduated tax rates. These lower rates offer the beneficiaries incomesplitting opportunities that can help reduce their overall tax burden. There s flexibility in the taxation year-end of the trust. A testamentary trust can have a fiscal year-end other than December 31. This enables the trust to defer recognition of income passed through the beneficiaries to another taxation year, which offers the beneficiaries tax-deferral opportunities. Multiple testamentary trusts can be created. A testamentary trust is treated as a taxpayer under the income tax rules. The creation of multiple trusts means that you have multiple taxpayers that all benefit from graduated tax rates. Once again, income-splitting opportunities are available to the beneficiaries. Tainting the insurance trust To avoid tainting an insurance trust, you must take care to ensure that absolutely no property passes to the testamentary insurance trust prior to the receipt of the insurance proceeds upon your death. If the trust is funded in any way prior to your death, this trust will be an inter vivos trust and will be taxed at the highest marginal rates versus the graduated rates that usually apply to testamentary trusts. It is also possible to taint the trust after the death of the insured. This can occur if a living person contributes funds to or settles the trust. An example of such a situation is a beneficiary borrowing funds and transferring them to the trust. Also a trustee that fails to make a mandatory capital distribution to a beneficiary of the trust may taint a testamentary insurance trust.

6 Potential situations in which to consider an insurance trust BENEFICIARIES WITH SPECIAL NEEDS The creation of an insurance trust or a testamentary trust created within a Will works very well if you have beneficiaries that are receiving government benefits. To have this type of insurance trust work, the trust deed must state that the trust is a fully discretionary trust and the trustee has full discretion to decide on how much income or capital to pay to the beneficiary (e.g. the child with special needs). The beneficiary (child) has no outright entitlement to the funds, which may pass to other beneficiaries when the beneficiary (child with special needs) passes away, subject to the terms of the trust. This type of trust arrangement is designed to allow the trustee to disburse funds from the trust for disability-related support and services for the beneficiaries. In addition, a beneficiary could also receive small comforts such as spending money, recreational events or even vacations. The strategy is to ensure that the governmental funds received are not affected by any clawbacks or reductions. This insurance trust also works very well for beneficiaries that have substance abuse problems and/or financial management problems. In both cases the settlor has control (via the trust deed) over the disbursements of the trust. The settlor can even give the trustee discretion to pay additional amounts in the hope that the beneficiaries will one day rehabilitate themselves. TRUSTS FOR MINORS AND OTHER CHILDREN Certain provincial insurance acts provide that the insurance proceeds cannot be paid directly to a beneficiary that is a minor. Instead, the monies must be paid into court (i.e. paid in a trust account where the trustee is an officer of the court) or payment will be made to a person that has been appointed by the courts as the guardian of the child s property. The creation of a testamentary insurance trust will enable the monies to be managed as per your wishes via the trust deed. The insurance trust may mirror the provisions that are currently in the Will (testamentary trust) or may offer a different distribution scheme. Once again, the drafter of the insurance provision must be aware of the possibility of a merging of the testamentary trusts by the CRA, if the CRA is of the opinion that the testamentary insurance trust is not separate from the other testamentary trusts.

7 COTTAGE NEEDS A testamentary insurance trust can be used to finance maintenance, taxes and repairs on real estate, such as a cottage held by the estate for the benefit of your family members. This can remove the burden of deciding who will maintain and be responsible for the cost of the upkeep of the cottage. SUPPORT PAYMENT TRUSTS A testamentary insurance trust is also an excellent tool to fulfil any support payment obligations you may have. These support obligations could be either for a former spouse or for children. If support payment obligations are for minor children, then instead of naming your former spouse as the irrevocable beneficiary of the insurance policy, you can name the children as beneficiaries of the testamentary insurance trust. A trustee can then be appointed to administer the funds for them. This will prevent your former spouse from getting a lump sum directly in their name if you should die before the end of the payment period to your minor children. The concern may arise that if the former spouse receives lump-sum insurance proceeds that are intended to support minor children, the former spouse could spend this money frivolously. If this is the case, the children may make a claim against the deceased s estate for dependant relief. A claim for dependant relief gives individuals that have not benefited from the deceased s estate a further opportunity to do so. The rationale behind this kind of claim is that the deceased has a legal obligation to provide for those individuals after death, regardless of the provisions of the Will. Creating a testamentary insurance trust for support obligations to minor children may potentially prevent such a claim. Legal, accounting and trust administration fees It must be stressed that the creation of an insurance testamentary trust will require an initial expense and annual fees in order to maintain the trust structure. Hence, it is imperative that a cost benefit analysis be done by your tax and legal advisors to ensure that this structure meets your estate planning goals, as well as being a viable option for your situation. This publication is not intended as nor does it constitute tax or legal advice. Readers should consult their own lawyer, accountant or other professional advisor when planning to implement a strategy. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member CIPF. Registered trademark of Royal Bank of Canada. RBC Dominion Securities is a registered trademark of Royal Bank of Canada. Used under licence. Copyright All rights reserved.