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Alter Ego & Henson Trusts – Trusts Series 5/6

 

In a previous article, we identified the key differences between testamentary trusts and inter vivos trusts. In this blog, we will focus on three types of inter vivos trusts: Alter Ego Trusts, Joint Partner Trusts, and Henson Trusts, each serving unique purposes. From avoiding probate to preserving government disability benefits, these trusts offer flexible solutions for asset management and beneficiary protection. Understanding how these trusts work can help you make informed decisions about estate planning, privacy, and the financial well-being of your loved ones.

An Alter Ego Trust in Canada is a specialized inter vivos trust established for individuals aged 65 or older, allowing them to transfer assets into the trust without triggering immediate tax on accrued gains (through a tax rollover under the Income Tax Act), while retaining all trust income and exclusive access to capital during their lifetime; this trust also provides seamless management for the settlor if they become incapacitated, avoids probate at death (keeping asset distribution private), yet requires ongoing tax filings as a separate taxpayer, with potential capital gains tax implications upon the settlor’s death due to a deemed disposition of assets.

  • Setup and Qualification: 
    • The trust is created by an individual (the settlor) who transfers their assets into the trust. According to ITA ss. 73(1.01)–(1.02), this transfer of assets qualifies for a tax rollover, meaning that the transfer does not trigger any immediate tax on the accrued gains of those assets.

  • Income and Control: 
    • The settlor must be entitled to receive all the income generated by the trust during their lifetime. Additionally, they must be the only person who can receive any income or access the capital of the trust until their death.

  • Tax Implications: 
    • While the trust does file its own tax returns and is treated as a separate taxpayer, the rollover treatment under the ITA allows the settlor to defer taxes on any capital gains until the trust assets are eventually sold or the settlor passes away. 
    • At the settlor’s death, the trust assets are deemed to have been disposed of at their fair market value, which may result in capital gains tax.

  • Benefits:
    • Better assets and income management:
      • As the beneficiary (who is also acting as one of the trustees) gets older, he might find it difficult to manage his assets. With an alter ego trust, if he no longer wishes to manage the assets or become incapacitated during his lifetime, the assets will continue to be managed by his co-trustee or named alternate trustee, in a seamless fashion.
    • Avoids Probate:
      • When the settlor of an Alter Ego Trust dies, the distribution of assets to the beneficiaries is governed by the trust document itself, not by the settlor’s will or intestacy rules. An Alter Ego Trust typically includes specific clauses naming the beneficiaries who will inherit the trust assets upon the settlor’s death, along with detailed instructions on how the assets should be distributed. This arrangement allows the assets to bypass the probate process entirely, as the terms of distribution are already established within the trust.

    • Privacy: 
      • Since the assets are transferred outside of the will, this process remains private, unlike the probate process, which is a matter of public record.

  • Disadvantages:
    • More expensive upfront legal fee to set up the Alter Ego Trust and more ongoing accounting fee, as the trustees will need to file T3 for the Alter Ego Trust.
    • Income retained in the Trust will be taxed at the highest marginal rate
      • So basically the trustee needs to make sure all its income has been paid out to the beneficiary each year to minimize the harm.
    • Loss of spousal rollover → Inescapable high capital gain tax
      • Any capital gains that have accrued on trust assets will be subject to the deemed disposition on beneficiary’s death.
    • LCGE no longer applicable

A Joint Partner Trust functions similarly to an Alter Ego Trust but allows both partners to transfer their assets into the trust and receive income from it during their lifetimes, with the surviving partner retaining sole access to income and capital until their death. This trust bypasses probate upon the death of the second partner, ensuring privacy and efficient asset distribution, while also requiring separate tax filings as a distinct taxpayer, with potential capital gains tax on asset disposition when the last surviving partner passes away.

  • For couples over 65 years old
    • While an alter ego trust is for an individual, a joint partner trust is for both members of a couple, allowing them to manage and control their assets together.
  • Set up by spouses/partners: 
    • Both spouses (or common-law partners) transfer their assets into the trust, so it is same creation procedure as alter ego, BUT for entitlement of both spouses to receive income until death of surviving spouse
  • Benefit during lifetime: 
    • Both can receive income from the trust and use its assets while they are alive.
  • Avoids probate:
    • After both partners pass away, the assets in the trust go directly to the named beneficiaries, skipping the probate process.
  • Tax implications:
    • Like the alter ego trust, the joint partner trust is considered a separate taxpayer and has to file its own tax returns. Upon the death of the surviving partner, the trust is deemed to have sold its assets at fair market value, which might lead to capital gains tax.
  • Main advantages:
    • Same as above Alter Ego Trust
  • Main disadvantages:
    • Same as above Alter Ego Trust

A Henson Trust is a specialized trust designed to protect the eligibility of disabled individuals for means-tested government benefits, like the Ontario Disability Support Program (ODSP), by granting trustees absolute discretion over how and when trust assets and income are distributed to the beneficiary; this discretionary setup ensures that assets within the trust are not legally “vested” in the disabled individual, meaning they do not count as personal assets or income that could disqualify them from benefits, thus allowing the beneficiary to receive both trust funds and public assistance.

  • The key is that the trust’s trustees have total control (absolute discretion) over the trust and how money and assets are given to the beneficiary, so these don’t count as personal assets for the disabled individual, meaning the settlor has zero control.
  • The important aspect of a Henson trust is that the trustees must have absolute discretion with respect to the allocation of income and capital to the disabled beneficiary (there may be several discretionary beneficiaries that include the disabled individual) so that the assets in the trust and income generated from the trust investments cannot be said to have vested in the disabled beneficiary. This means this setup allows the disabled person to receive both trust benefits and government assistance like ODSP simultaneously, as the trust income does not affect their eligibility for these programs.
  • When drafting a Henson trust for a disabled individual, it is highly recommended to engage an experienced estate planning lawyer to ensure the trust complies with relevant regulations and avoids future legal issues. Mistakes have occurred in the past; for instance, a parent, trying to save costs, hired a more affordable lawyer to establish a trust for his child. Unfortunately, this lawyer failed to create a proper Henson Trust, resulting in the disabled child losing their ODSP government benefits. In the end, the parent had to spend even more money hiring an experienced litigation lawyer to sue the initial lawyer, making the whole process far more costly and counterproductive.

Henson Trust vs QDT (Qualified Disability Trust)

  1. Purpose:

    • QDT: Designed to provide tax benefits by allowing a testamentary trust to use graduated tax rates for a disabled beneficiary eligible for the Disability Tax Credit (DTC).
    • Henson Trust: Aimed at protecting a disabled beneficiary’s means-tested government benefits (like ODSP) by giving trustees absolute discretion, so assets aren’t legally vested in the beneficiary.
  2. Tax Treatment:

    • QDT: Beneficial tax rates, as it’s taxed on graduated rates rather than the top marginal rate.
    • Henson Trust: Typically taxed at the highest rate, with the main benefit being the preservation of government assistance eligibility, rather than tax efficiency.
  3. Eligibility and Structure:

    • QDT: Must be a testamentary trust, resident in Canada, with only one QDT allowed per DTC-eligible beneficiary per tax year.
    • Henson Trust: Can be either a testamentary or inter vivos trust and does not require DTC eligibility; it instead focuses on safeguarding means-tested benefits through discretionary asset management.

Important Notice:

This blog series offers readers a basic understanding of the concept of “Trust.” It does not constitute legal advice from our firm. If you encounter any trust-related matters, it is essential to consult your lawyer. As always, it is best to leave professional matters to the professionals.