An Inter Vivos Trust and a Testamentary Trust must have a settlor, a trustee, and beneficiaries.
Key Roles & Parties in Inter Vivos vs. Testamentary Trusts
Inter Vivos Trust (Living Trust)
Settlor - The person who creates the trust and transfers assets into it while they are alive.
Trustee - The person or entity appointed to manage the assets according to the trust agreement, both during and after the settlor's life.
Beneficiaries - The individual(s) who are entitled to receive the income and/or capital from the trust. This can include the settlor themselves (e.g., in an Alter Ego Trust).
Testamentary Trust (Will Trust)
Settlor - The Testator/Testatrix (the deceased person) who establishes the trust through the instructions in their Will.
Trustee - The person or entity appointed in the Will to manage the assets for the beneficiaries. This is often the same person appointed as the Executor of the Will.
Beneficiaries - The individual(s) named in the Will to receive the benefits of the trust after the Testator's death (e.g., minor children, a surviving spouse).
The Three Certainties of a Trust
For any trust to be legally valid and enforceable, it must satisfy three strict legal prerequisites known as the 'Three Certainties': Certainty of Intention, Certainty of Subject Matter, and Certainty of Objects:
Certainty of Intention (The intent to create the trust).
This requires that the settlor (the creator of the trust) clearly and unambiguously intends to impose a mandatory, legally binding obligation on the trustee to hold the property for the benefit of the beneficiaries.
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The language used must be imperative (a command), not merely "precatory" (a wish or hope). For example, saying, "I give my house to John, hoping he will use it to support my children," is generally not enough. Saying, "I transfer my house to John, to hold in trust for my children," is clear intention.
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To distinguish a legally enforceable trust from a mere moral obligation or an outright gift.
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Certainty of Subject Matter (The assets being put into the trust).
This requires that the property (assets) being placed in the trust is clearly identifiable and segregated from all other property.
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The trustee must know exactly what assets they are responsible for managing, and the beneficiary's interest in that property must also be clear. You can't say, "I put the bulk of my estate in trust" or "I leave my best vintage in trust." You must specify the exact account number, property address, or number of shares.
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Certainty of Object (The beneficiaries who will benefit).
This requires that the beneficiaries (the objects) are clearly defined or ascertainable so that the trustee and the court know exactly who is entitled to the benefits of the trust.
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The identity of the individuals, or the class of people, must be conceptually clear. You must be able to say with certainty whether any given person is or is not a beneficiary. For example, "my children" is certain; "my best friends" is usually considered uncertain.
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The trust fundamentally exists to be enforced for the benefit of the beneficiaries; if they cannot be identified, the trust fails because the court has no one to order performance for. (A key exception exists for Charitable Trusts, which are enforced by the Attorney General for the benefit of the public, and therefore do not require certainty of objects.)
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Key Distinction between Inter Vivos & Testamentary Trusts
The main difference is the timing of the trust's creation and who the settlor is:
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Inter Vivos Trust: The settlor is the living person who signs the trust agreement.
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Testamentary Trust: The settlor is the deceased person whose Will instructs the Executor to form the trust. The trust only legally comes into existence after the death.
Overview of Common Inter Vivos Trusts & Testamentary Trusts
Inter Vivos Trusts (Living Trusts)
An Inter Vivos Trust (Living Trust) is a trust created and takes effect during the settlor's lifetime. Assets transferred into this trust are no longer considered part of your personal estate and therefore avoid probate upon your death.
Family Trust (Discretionary)
Wealth Management & Protection: To hold and manage family assets, ensuring control over distribution to future generations.
Tax Planning (Income Splitting): To shift income to beneficiaries in lower tax brackets, subject to strict attribution rules. Asset Protection: To shield assets from creditors or matrimonial claims of beneficiaries.
General Rule: The trust itself is generally taxed at the highest personal marginal tax rate on any income retained within the trust and not paid or made payable to beneficiaries.
Alter Ego Trust
Probate Planning & Privacy: To transfer assets outside of the estate to avoid probate fees and keep the transfer details private.
Incapacity Planning: The trustee can manage the assets seamlessly if the settlor becomes incapacitated.
Tax Deferral: Assets can be transferred to the trust on a tax-deferred basis (no immediate capital gains).
Tax on Death: A deemed disposition of all capital assets occurs on the settlor's death, and capital gains are taxed at the trust level.
Exemption: Exempt from the 21-year deemed disposition rule during the settlor's lifetime.
Joint Partner (or Spousal) Trust
Probate Planning & Privacy for a couple: To transfer assets outside of the estate to avoid probate fees on the death of the first spouse/partner.
Estate Administration Simplified: Allows for quick and private transfer of assets to heirs upon the second death.
Tax Deferral: Assets can be transferred on a tax-deferred basis.
Tax on Death: A deemed disposition is triggered only on the death of the last surviving partner/spouse, and capital gains are taxed at the trust level.
Exemption: Exempt from the 21-year deemed disposition rule during both partners' lifetimes.
Henson Trust (Qualified Disability Trust - QDT)
Support for a Disabled Beneficiary: To provide financial support without negatively impacting the beneficiary's eligibility for government disability benefits.
Asset Management: Ensures assets are managed by a responsible trustee.
Graduated Rate Estate (GRE) Rules (with conditions): If structured as a Qualified Disability Trust (QDT), it is taxed at graduated personal tax rates on retained income, which is a significant exception to the general Inter Vivos rule. The trust and beneficiary must jointly elect to be a QDT.
Bare Trust
Administrative Convenience and Privacy: To hold legal title to an asset (e.g., real estate) on behalf of the beneficial owner (the beneficiary).
Ease of Property Transfer: Simplifies transfers as only the beneficial ownership changes, not the registered title.
Taxation to Beneficiary: All income, capital gains, and losses are attributed directly to the beneficiary as if they owned the property. The trust itself is generally not taxed.
Inter Vivos Trusts (REVOCABLE vs. IRREVOCABLE Trusts)
A revocable inter vivos trust, also known as a living trust, is one you can change, amend, or cancel during your lifetime. When you die, it undergoes a fundamental change.
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Becomes Irrevocable: Upon your death, the trust automatically becomes irrevocable. This means its terms are now set in stone and cannot be altered by the trustee or beneficiaries (with very limited exceptions).
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Successor Trustee Takes Over: The successor trustee, named in the trust document, assumes full responsibility for managing and distributing the assets according to your instructions.
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Avoids Probate: Because the assets were already owned by the trust (not you) at the time of your death, they bypass the probate process. This saves time, probate fees, and keeps the details of the estate private.
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Assets are Taxable: While the trust avoids probate, the assets held within a revocable trust are still considered part of your taxable estate for income tax purposes. This triggers a "deemed disposition," meaning any capital gains that have accumulated on the assets are now taxable.
An irrevocable inter vivos trust cannot be changed or revoked once it's created, even during your lifetime. When you die, it continues to operate largely as it did before.
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Remains Irrevocable: The trust's terms and its legal status do not change.
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Successor Trustee Takes Over: The successor trustee continues to manage the trust's assets as outlined in the document, distributing them to beneficiaries according to the established rules and timelines.
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Assets are Not Part of Your Estate: Assets held in a properly structured irrevocable trust are not considered part of your personal estate. This means they are generally not subject to probate fees and, in some cases, may offer a way to reduce estate taxes or protect assets from creditors.
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The Trust is the Taxpayer: Since the assets were transferred to the trust while you were alive, the trust itself is responsible for paying taxes on any income it generates, not your estate.
Testamentary Trusts (Done Through the Will)
A Testamentary Trust is a trust created and takes effect as a consequence of the settlor's death, typically through the provisions of their Will. This is often used to manage assets for minor children or beneficiaries with special needs.
Since January 1, 2016, most new testamentary trusts are generally treated as Inter Vivos Trusts for tax purposes, except for two key types, which are given special tax treatment:
These two trusts are given special tax treatment, primarily the right to be taxed at graduated personal tax rates on income retained within the trust, which is a significant tax benefit compared to most other trusts.
Graduated Rate Estate (GRE)
Estate Administration: To hold the deceased's property during the first 36 months of estate administration.
Tax Efficiency (Graduated Rates): To utilize the most favourable tax treatment during the estate settlement period.
Graduated Rates: For the first 36 months after the death, the GRE is taxed at the graduated personal tax rates (the same rates as an individual), allowing for tax savings on retained income. Post-36 Months: After 36 months, it loses GRE status and is taxed like an Inter Vivos Trust at the highest personal marginal tax rate.
Qualified Disability Trust (QDT)
Support for a Disabled Beneficiary: To provide financial support from the estate without jeopardizing the beneficiary's eligibility for government benefits.
Tax Efficiency (Graduated Rates): To allow for tax savings on retained income intended for the beneficiary.
Graduated Rates: It is taxed at the graduated personal tax rates on income retained in the trust, which is highly favourable. The trust and the beneficiary must jointly elect to be a QDT.
Spousal Trust (Testamentary)
Support for Surviving Spouse/Partner: To provide income for the surviving spouse/partner during their lifetime while securing the capital for ultimate beneficiaries (e.g., children from a previous marriage).
Tax Deferral: Allows for the assets to pass to the trust on a tax-deferred (rollover) basis at death.
Taxed as an Inter Vivos Trust: Unless it qualifies as a QDT, it is taxed at the highest personal marginal tax rate on retained income. Capital gains are deferred until the surviving spouse's death, at which point a deemed disposition occurs.
General Testamentary Trust
Control Over Distribution: To hold assets for minor children or beneficiaries who are not yet financially mature, dictating the timing and terms of distribution.
Asset Protection: Protecting the inherited assets from creditors or matrimonial claims of the beneficiaries.
Taxed as an Inter Vivos Trust: Unless it qualifies as a GRE or QDT, it is taxed at the highest personal marginal tax rate on any income retained within the trust.
Key Tax Rules for Most Canadian Trusts
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Deductible Distributions:
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If the trust income is paid or made payable to a beneficiary in the year it is earned, the trust can generally deduct that income, and it becomes taxable in the beneficiary's hands at their personal tax rate. This is the primary mechanism for tax planning and reducing the trust's tax burden.
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21-Year Deemed Disposition Rule:
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To prevent indefinite tax deferral, most trusts are deemed to have sold all of their capital property every 21 years at fair market value and immediately reacquired it. This triggers capital gains tax on any accrued, unrealized appreciation.
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(Exceptions: Alter Ego and Joint Partner Trusts are exempt until the death of the settlor(s).
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Attribution Rules:
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These anti-avoidance rules are designed to prevent tax avoidance through gifting or transferring property. In an Inter Vivos Trust context, if a settlor transfers or loans property to a trust for the benefit of their spouse or a minor child, any income or capital gains realized from that property may be attributed back to the settlor and taxed in their hands at their higher tax rate. Attribution rules generally do not apply to capital gains in Testamentary Trusts.
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******* Trust law and taxation in Canada are highly complex. You must consult with a qualified Canadian lawyer, financial professional, and a tax advisor (tax accountant) for specific legal advice regarding the creation, operation, and taxation of any trust.
Henson Trust combined with an RDSP
While both an RDSP (Registered Disability Savings Plan) and a Henson trust are powerful tools, they serve different, complementary purposes. The ideal strategy for many families is to set up both a Henson trust and an RDSP.
Here's a breakdown of why you would set up a Henson trust even if a person has an RDSP:
1. The RDSP Has a Lifetime Contribution Limit
The RDSP has a lifetime contribution limit of $200,000. While this is a significant amount, a family might want to leave a larger inheritance to a disabled family member.
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Complementary Use: If a family's estate is large and they wish to leave more than $200,000 for their disabled loved one, the excess amount can be left to a Henson trust. This ensures that the entire inheritance is managed for the beneficiary's benefit without affecting their eligibility for government assistance programs.
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Larger Inheritance: An inheritance from an RRSP, RRIF, or other assets that exceeds the $200,000 RDSP limit can be transferred to the trust, allowing the assets to be fully invested without disqualifying the beneficiary from provincial disability benefits.
2. The Henson Trust Protects Government Benefits from the Beneficiary's Other Assets
The core purpose of a Henson trust is to protect the beneficiary's eligibility for provincial disability benefits, such as the Ontario Disability Support Program (ODSP) or its equivalent in other provinces. These programs have strict asset limits.
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How it Works: In a Henson trust, the beneficiary has no legal claim to the assets. The trustee has "absolute discretion" to distribute funds for the beneficiary's benefit. Because the assets are not considered to be "owned" by the beneficiary, they do not count against the asset limits of provincial assistance programs.
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The RDSP is also exempt, but the Henson Trust provides flexibility: While the assets in an RDSP are generally exempt from provincial asset tests, a Henson trust provides an additional layer of protection and control for assets that would not otherwise qualify for the RDSP's tax-advantaged status.
3. A Henson Trust Offers Flexibility and Control
The RDSP is a highly regulated plan with specific rules regarding withdrawals, especially concerning the government grants and bonds.
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Withdrawal Rules: If a withdrawal is made from an RDSP within 10 years of receiving government grants or bonds, a portion of those funds must be repaid. This "assistance holdback amount" can make the RDSP unsuitable for short-term or emergency financial needs.
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Short-Term Needs: A Henson trust can be used to provide for a disabled person's short-term needs without triggering the clawback rules of the RDSP. The trustee can make payments for things like vacations, medical expenses not covered by government programs, or other quality-of-life improvements. While these distributions may be considered income and impact income-tested benefits, the trustee has the discretion to manage the distributions strategically.
4. Estate Planning and Post-Mortem Control
A Henson trust provides greater flexibility in estate planning after the beneficiary's death.
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Residual Beneficiaries: In a will, a Henson trust can specify who receives any remaining assets after the disabled beneficiary has passed away. This is crucial for beneficiaries who are not mentally capable of writing a will.
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RDSP Assets: In contrast, assets remaining in an RDSP after the beneficiary's death become part of their estate and will be distributed according to their will or, if they have no will, by provincial intestacy laws. This may not align with the family's wishes for where the remaining funds should go.
In conclusion, an RDSP is an excellent vehicle for taking advantage of powerful government grants to build a retirement nest egg. A Henson trust is an essential estate planning tool for protecting larger inheritances and assets to ensure that a person with a disability continues to be eligible for crucial provincial assistance programs. For comprehensive financial security, using both is often the best strategy.
The Ideal Scenario: A Testamentary Henson Trust
The most straightforward and effective way to use a Henson trust is for the person leaving the inheritance (the testator) to include a provision in their will that directs the assets to a Henson trust upon their death.
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Beneficiary has no claim: In this scenario, the disabled person never legally receives the assets. The inheritance goes directly into the trust, and the trustee has absolute discretion over its use. Since the beneficiary has no "entitlement" or legal claim to the assets, they do not count against the asset limits of provincial disability programs like ODSP. This is the "pure" form of a Henson trust.
The Problem with Post-Inheritance Trusts
If a person receives an inheritance directly into their bank account or name, the funds become their personal asset. At that point, the provincial government may count those funds against the asset limits for disability benefits.
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The "Self-Settled" Trust Problem: A trust set up by the beneficiary with their own money is called a "self-settled trust." In most jurisdictions and for most government programs, assets in a self-settled trust are still considered to be owned by the beneficiary. Therefore, this type of trust would not protect the funds from the asset test.
The "After-the-Fact" Solution: The Special-Purpose Trust
Fortunately, some provinces have specific provisions that allow for a limited amount of an inheritance to be placed into a special-purpose trust after it has been received, to protect a person's eligibility.
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Ontario Example (ODSP): In Ontario, a recipient of the Ontario Disability Support Program (ODSP) can place up to $100,000 from a direct inheritance or life insurance payout into a trust that they themselves establish.
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Time Limit: There is a specific time limit to do this, usually within six months of receiving the inheritance.
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Limit: The $100,000 limit is a total limit and also includes the cash surrender value of any life insurance policies they own.
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Conditions: The beneficiary must be mentally capable of setting up the trust, or have a legal substitute decision-maker (e.g., a power of attorney) who can do so on their behalf.
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Important Caveats
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Limited Amount: This after-the-fact trust is capped at a specific amount ($100,000 in Ontario), which may be insufficient if the inheritance is larger. Any amount over this limit would count against the asset test and could cause the beneficiary to lose their benefits.
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Provincial Specificity: The rules for these types of trusts vary by province. What is allowed in Ontario may not be allowed in another province.
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The "Pure" Henson Trust is Better: An after-the-fact trust is a band-aid solution. It is far better to have a well-drafted Henson trust in a will to begin with. This ensures that the entire inheritance, no matter how large, is protected and there is no risk of the beneficiary's benefits being interrupted.
Summary
While it is possible to set up a trust after an inheritance has been received, it is a much more complex process with significant limitations. It is always recommended that an individual with a disability who is receiving or may receive provincial benefits should have a testamentary Henson trust set up in a loved one's will to ensure the full inheritance is protected and their benefits remain secure.
Henson Trust when not registered for the Disability Tax Credit (DTC)
A person with a disability does not need to be registered with the Disability Tax Credit (DTC) for a family member to set up a Henson Trust.
Here is a breakdown of the key points:
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Purpose of a Henson Trust:
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The primary purpose of a Henson Trust is to hold assets for a person with a disability without jeopardizing their eligibility for provincial government disability benefits, such as the Ontario Disability Support Program (ODSP). These benefits are typically "asset-tested," and a direct inheritance or gift could make the person ineligible. A properly structured Henson Trust ensures that the trust assets are not considered the beneficiary's personal assets.
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DTC and Henson Trusts:
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The Disability Tax Credit (DTC) is a separate federal tax credit. While being eligible for the DTC is not a requirement to set up a Henson Trust, it can offer significant tax advantages to the trust.
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Qualified Disability Trust (QDT):
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A Henson Trust can be structured to qualify as a "Qualified Disability Trust" (QDT), which allows the trust's income to be taxed at lower, graduated tax rates instead of the highest marginal rate. To be a QDT, a Henson Trust must meet certain criteria, and one of the key requirements is that the beneficiary must be eligible for the DTC.
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In summary, a family member can set up a Henson Trust for a disabled person regardless of their DTC status. However, if the beneficiary is eligible for the DTC, the family can choose to have the trust also be a Qualified Disability Trust to benefit from tax savings.
Henson Trust when the disabled person is registered for the Disability Tax Credit (DTC)
When a disabled person is registered for the Disability Tax Credit (DTC), a Henson Trust can be structured to qualify as a Qualified Disability Trust (QDT). This provides significant tax advantages that would not be available otherwise.
Here are the key tax advantages:
1. Graduated Tax Rates
This is the most important advantage. While most trusts in Canada are taxed at the highest marginal tax rate (regardless of the amount of income), a QDT is an exception. It is taxed at the same graduated personal income tax rates as an individual.
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A typical trust pays a flat tax at the highest federal and provincial rate, which can be over 50%.
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A QDT benefits from the lower tax brackets, just like a person with a low to moderate income. This means a much smaller portion of the trust's income is paid in taxes, allowing the assets to grow more quickly and providing more financial support for the disabled beneficiary.
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This is particularly beneficial for income that the trustee chooses to retain within the trust rather than distributing to the beneficiary.
2. Income Splitting Opportunities
The QDT status allows for a degree of income splitting. The trustee can strategically decide whether to pay out income to the beneficiary or retain it within the trust.
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If the beneficiary has a low income:
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The trustee can pay out income from the trust to the beneficiary. This income will be taxed in the beneficiary's hands, likely at a very low or zero tax rate, as they can use their own personal tax credits and exemptions.
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If the beneficiary has other sources of income:
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The trustee can retain the income within the trust. Because the QDT is taxed at graduated rates, this income will be taxed at a lower rate than if the trust were subject to the highest marginal rate. This provides the trustee with the flexibility to manage the trust's income in the most tax-efficient way possible.
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Important Conditions to Qualify as a QDT
For a Henson Trust to be a QDT and receive these tax benefits, it must meet specific criteria:
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It must be a testamentary trust, meaning it was created through a will and arose as a result of a person's death. Trusts created during the person's lifetime (inter vivos trusts) do not qualify.
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The beneficiary must be eligible for the Disability Tax Credit.
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The trust and the beneficiary must make a joint election with the Canada Revenue Agency (CRA) on the trust's annual tax return (Form T3QDT) to designate it as a QDT.
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A person with a disability can only be the beneficiary of one QDT at a time. If multiple family members set up trusts for the same person in their wills, only one of them can be elected as the QDT.
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The "Recovery Tax"
It is important to note that a "recovery tax" may be applied to a QDT if certain conditions are no longer met. This is essentially a claw-back of the tax savings.
The recovery tax can be triggered if:
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A capital distribution is made to a beneficiary who is not an electing beneficiary of the QDT.
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The trust ceases to be a resident of Canada.
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The beneficiary is no longer DTC-eligible.
For these reasons, proper legal and financial advice is crucial when setting up and administering a Henson Trust that is also a QDT.
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