A testator will often transfer assets into a trust for his or her surviving spouse after death. The reasons for transferring these assets may be tax-based because a rollover of property is allowed to a spousal trust. Sometimes the testator wants to set aside assets to provide for the ongoing financial security of the surviving spouse. In other cases the transfer is part of a larger estate plan where the next level of beneficiaries will receive additional assets upon the passing of the second spouse.
If one of the assets transferred to a spousal trust is a life insurance policy on the life of the surviving spouse (or a joint last-to-die life insurance policy on the lives of the testator and the surviving spouse), great care must be exercised; otherwise, the spousal trust could be tainted, the tax-free rollover(s) denied, and an income tax liability triggered in the testator’s estate. The unexpected result is the premature recognition of the income tax liability embedded in the testator’s assets, which would become due at the “wrong time”, i.e., at the death of the first spouse rather than the second.
The crux of the issue is that if a spousal trust owns and funds a life insurance policy on the life of the spouse, the Canada Revenue Agency (CRA) is of the view that there is a possibility of someone other than the surviving spouse benefiting from the assets of the spousal trust. This has led the CRA to give several technical interpretations over the years, stating that the spousal trust would be tainted and would therefore be denied the tax-free rollover from the testator.
Some of the strategies that have been suggested as a way to avoid the situation of a spousal trust funding a life insurance policy are outlined here.
- Ensure the trust is not “obligated” to fund the life insurance policy. This would involve ensuring no further premiums or deposits are due on the policy, and the policy is completely paid up by the time of the first spouse’s death. It is important to note that anyone paying the life insurance premiums on behalf of the trust would be considered to contribute to the trust — which would also taint the trust’s ability to qualify as a spousal trust. Great caution needs to be exercised to ensure simple and well-intended actions do not frustrate the intention to maintain spousal trust status.
- If a life insurance policy is found to have been inadvertently transferred into a newly created spousal trust, consideration should be given to immediately transferring title of the life insurance out of the spousal trust to another party before any premiums are paid. Such transfer would have to take place for consideration equal to the fair market value of the policy to ensure the spousal trust is not benefiting another party. The other party could be another trust that is already a tainted spousal trust, which is part of the testator’s larger estate plan.
- Consideration could be given to holding the life insurance policies inside a corporation that in turn is owned by the spousal trust. The spousal trust could be the 100% shareholder of all shares, or perhaps the 100% owner of the fixed-value preferred shares. In this strategy the corporation would be the beneficiary of the life insurance policy, and if the trust owns all of the common shares, the trust would directly benefit from the payment of the insurance proceeds. Alternatively, if the trust owns only the fixed-value preferred shares, payment of the insurance premiums and receipt of the proceeds would not change the financial position of the trust, which is one of the conditions required to maintain qualifying spousal trust status. However, it should be noted that this strategy was presented to the CRA, who declined to comment on its effectiveness. In this strategy the trust property is not directly used to fund the life insurance policy.
It should be noted that there may be a risk of a negative assessment by the CRA with any strategy involving life insurance in a spousal trust, so this should be taken into account when devising strategies to meet the qualifying conditions.
Tax planning is a constantly changing arena, and the planner must be aware of the issues, opinions and alternative strategies. To the extent the testator’s estate plan contains life insurance on the life of the surviving spouse (or any other life) and a spousal trust, it takes careful planning to ensure the policies do not end up in the spousal trust.
This commentary is published by the Institute in consultation with an editorial board comprised of recognized authorities in the fields of law, life insurance and estate administration.
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Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.