Article Source: Manulife Advisor Portal
This Tax Topic addresses basic questions involving personal trusts and life insurance. These questions will be addressed from both a trust law and tax perspective where applicable. Unless otherwise specified, it will not address Quebec law. Note however, that except for the section dealing with testamentary insurance trusts, the discussion of acquisition, ownership, funding and transfers of life insurance will generally apply to trusts created under Quebec law using equivalent legal concepts.
The main questions addressed in this Tax Topic relate to acquisition, ownership and funding of life insurance. Also, transfers of life insurance into or out of a trust will be discussed. As well, the receipt and distribution of life insurance proceeds by a trust and the creation of a trust with life insurance proceeds will be covered.
Acquisition, ownership and funding life insurance by a trust
Ownership of life insurance – General considerations in the context of trusts
In general, when determining if it would make sense for a trust to own a life insurance policy a good start is to answer three key questions:
- What is the purpose of the life insurance?
- When and where will the life insurance proceeds be needed?
- Where are the funds available to pay the life insurance premiums?
A trust allows control over the policy by the trustees, and when desirable, allows discretion over the distribution of the policy or insurance proceeds.
A trust can sometimes be used to simplify administration where multiple policies would otherwise be required. For example, in a life insured criss-cross buy sell arrangement, every shareholder must acquire a policy on every other shareholder to provide each shareholder with the funds to buy the shares of the deceased shareholder. Instead, a trust can be used to hold just one policy on every shareholder and also provide a mechanism to ensure that all the policies are kept in force (for more details, refer to the Tax Topics, “Buy/Sell Agreements – Criss-Cross Purchase Method” (with trustee & without trustee)).
Another situation where trust ownership makes sense is when the policy will be owned by someone other than the life insured, and the preferred successor owner of the policy is someone to whom a transfer would result in a policy gain or who is a minor. For example, consider the situation where Mom (a single parent) purchases a life insurance policy on the 1 life of her minor child, with the intent of over-funding it and passing it on to the child when they reach age of majority. If Mom names her sister or brother to be successor owner of the policy (in case she passes away before the child reaches the age of majority), a transfer at the time of her death would create a policy gain to the extent the cash surrender value exceeds the adjusted cost basis of the policy at that time. It would also be undesirable to name the child as successor owner (even though there would be a tax-free rollover to the child under subsection 148(8) of the Income Tax Act, the (“Act”). Unless otherwise noted, all references in this article are to the Act) because a minor child cannot legally deal with the policy and may not be old enough for the responsibility. A solution is for Mom to settle a trust, make contributions to the trust to fund the policy owned by the trust with the child as beneficiary of the trust. In this way, there is no disposition of the policy on the death of Mom; the policy, policy withdrawals or death benefit can be distributed to the child as seen fit by the trustee(s).
Trust ownership also makes sense when there is a life insurance need in the trust. For example, a trust may hold life insurance to fund the capital gains tax liability arising on the deemed disposition of capital property held by a life interest trust on the death of the life interest beneficiary. (See the discussion below regarding a tax issue relating to life interest trust ownership of life insurance.)
Another example may be to fund the tax liability arising to the beneficiaries of a family trust on growth shares that the trust acquired as a result of an estate freeze. A trust may acquire life insurance on the beneficiaries of a trust who will be distributed the shares and at the time of distribution, distribute the policy that funds the liability at the same time. However, in the context of family trusts that hold the shares of an operating business, one must be conscious of whether or not the trust has sufficient funds to pay the premiums under a life insurance policy. If there are no excess funds at the trust level to pay the premiums it may not make sense to hold the policy in the trust since a dividend would have to be distributed to the trust which would pay tax at the top marginal tax rate. If instead the policy were personally held by a beneficiary and the dividend were distributed via the trust to fund the policy, the beneficiary would be subject to graduated rates.
On the other hand, where a family trust has significant investible assets, life insurance may be considered as an alternative asset class. The main question in respect of this use is more of an underwriting question – who is the life insured under the policy, what is their connection to the trust and whether the amount of insurance makes sense in respect of this ownership? Insurance on someone unconnected to the trust or family cannot merely be used as an investment of the trust.
Finally, another context in which trust ownership of insurance may be commonly considered is for U.S. estate tax planning reasons. It is common to hold a personal life insurance policy through a special trust called an Irrevocable Life Insurance Trust (“ILIT”) that can be structured to avoid inclusion of the death benefit in the estate of the life insured. For more details, refer to the Tax Topic, “U.S. Estate Taxes”.
Trustee investment powers and duties
The purchase, ownership and funding of life insurance by a trust may be the subject of an explicit duty or obligation imposed on the trustee to purchase and pay premiums under a life insurance policy set out in the trust document or a specific reference to life insurance as a permitted investment in trust provisions dealing with trustee investments. Prior to the introduction of the prudent investor standard discussed below, life insurance was not on the “legal list” of trustee investments permitted under trustee legislation so it was common to see either expansive investment powers including the ability to invest in life insurance specifically or a specific investment instruction regarding life insurance.
Where the trust document is silent regarding the acquisition, ownership and funding of a life insurance policy, a trustee’s power to invest trust property, whether on account of income or capital, would generally be governed by a “prudent investor” standard. This standard generally allows a trustee to invest in any form of property, requiring that the trustee act with the care, skill, diligence and judgment that a prudent investor would. In general, the trustee must consider relevant criteria in planning investment decisions, including: economic conditions; inflation/deflation; tax consequences; the role that each investment plays in the total portfolio; expected total return from income and 2 appreciation of capital; needs for liquidity, regular income, preservation or appreciation of capital; an asset’s special value or relationship to the purpose of the trust or a beneficiary. Also, in general, diversification is a requirement to an extent that is appropriate to the requirements of the trust and general economic conditions.
In weighing these considerations, relevant attributes of life insurance would include: tax exempt growth of cash values; tax-free death benefit; cost of life insurance vs. alternative investments to satisfy a need for capital preservation and appreciation on or after the death of a life interest beneficiary; guaranteed costs, values or investment returns in respect of a life insurance policy, if any; cash values and consequences of access thereto vis a vis the income and/or capital beneficiaries; life expectancy of life/lives insured and timing of distributions to income and/or capital beneficiaries of the trust; coverage amount required to fund tax liabilities of the trust on death of a life interest beneficiary, if any.
Life insurance funding – Capital vs. income under trust law
Because life insurance has protection and investment elements, a question arises, whether an expenditure in respect of life insurance or an income inclusion for tax consequences arising from a life insurance policy is in relation to income or capital for trust law purposes in the absence of the trust document being prescriptive regarding this. The allocation to income or capital under trust law is relevant to the trustee in satisfying its duties to the beneficiaries of the trust. In general, unless the trust instrument provides otherwise, a trustee must act impartially or maintain an even hand as between classes of beneficiaries with varying interests. Particularly where life insurance is purchased by a trust to fund a tax liability arising on the death of a life interest beneficiary, it is intuitive to conclude that the expenditure by the trust on a life insurance premium would be considered on account of capital of the trust. However, life insurance can have cash values and those values may be accessed to provide liquidity to the trust or be paid to an income beneficiary. Or, cash values may not be accessed fully, or at all, and ultimately may be paid to the trust as beneficiary under the policy upon death as a death benefit. Income for tax purposes may arise when a policy’s cash value is accessed. For tax purposes, access may give rise to a disposition (for example, a policy loan or a full or partial surrender of the cash value is considered a disposition of a life insurance policy pursuant to subsection 148(9) definition of “disposition” of the Act) and may result in ordinary income being reported to the policyholder. The proceeds of the disposition in excess of the policy’s adjusted cost basis (ACB) is reported on a T5 by the insurer in respect of a disposition. Taxable income on a policy gain to the trust, is not necessarily the same thing as an allocation to trust income (as opposed to trust capital) for trust law purposes. It is for this reason that trust terms may prescribe the treatment of the payment of life insurance premiums, receipt of proceeds and taxable policy gains to specifically address this.
Tax issues – “Tainting” life interest trusts
Life interest trusts (spousal, alter ego or joint partner trusts) have a deemed disposition of the trust’s capital property upon the death of the relevant life interest beneficiary (paragraph 104(4)(a) of the Act). Life insurance is an obvious solution to fund the often-significant tax liability arising in the trust upon death.
The CRA has taken the position that the ownership and funding of life insurance within a life interest trust would taint the life interest trust. This would result in the trust not qualifying for a rollover of capital property into the trust (pursuant to paragraph 70(6)(b) or subsection 73(1) of the Act). This would result in a realization of capital gains in respect of the transfer of any capital property to the trust at fair market value. It also would result in subjecting the trust to the 21-year deemed disposition rule, which could trigger the realization of capital gains in respect of capital property held by the trust in advance of the death of the life interest beneficiary. The CRA’s position is seen to apply whether the trustee has the duty or merely the ability to pay premiums under a life insurance policy held by the trust.
The CRA’s position was stated most recently (#2014-052936) in relation to a spousal trust as follows:
… our position remains as previously stated. In particular while we agree … that the relevant legislation does not contain a requirement that the spouse “benefit” from the trust while alive, the concern remains that no one other than the spouse obtains the use of trust capital or income. The distinction must be made from … situations where a trustee in his/her fiduciary capacity takes action to preserve or increase the capital of a trust or invests in an asset providing income to a trust. In this regard, we are still of the view that a trustee’s duty to maintain certain income producing or capital appreciating properties which may potentially benefit a spouse during their lifetime, is not, in our view, analogous to the payment of insurance premiums by the trustee to maintain rights to receive the insurance proceeds by the policy beneficiary after the death of the spouse. … we consider the payment of premiums by the trust to be property used to establish the residual beneficiaries’ rights to funds from the policy that will be realized after the death of the spouse.
At the 2018 CALU CRA and Finance Roundtable, Finance expressed the view that paying a premium to maintain life insurance, even if the policy has a cash surrender value, is not the same thing as maintaining income-producing or capital property of a trust. However, Finance also indicated they were willing to listen to further submissions on why the payment of premiums on a life insurance policy should be considered analogous to maintaining trust property. It is expected that CALU will provide a further submission.
It is fair to say that these positions are questionable. Where a life interest trust is the owner and the beneficiary of a life insurance policy it is arguable that the requirement that “no person other than the life interest beneficiary can receive or otherwise obtain, before that person’s death, use of the trust capital or income” is satisfied. It is arguable that the payment of insurance premiums under a life insurance policy that will deliver proceeds payable to the trust as beneficiary to fund a tax liability on the death of the life interest beneficiary should be considered like any other action to preserve or increase the capital of the trust. Mitigation of the risk of loss of an asset (or assets) due to a need for liquidity to satisfy a known liability (capital gain in respect of property held by the trust on the death of a life interest beneficiary) which is certain to arise is congruent with preservation of capital and in particular, preservation of particular capital assets (assets that are illiquid or which the purpose of the trust seeks to protect from liquidation). The payment of an expenditure on account of capital should not be confused with an encroachment on capital which is dispositive. The CRA appears to be suggesting the latter.
These positions should be reviewed when considering the ownership of life insurance by a life interest trust. What ownership alternatives exist?
At the 2012 APFF Conference (Q1 #2012-0453121C6) the CRA confirmed that it would not view a life interest trust to be tainted if paid-up life insurance is transferred to the trust. The context of the question involved a joint last to die policy with premiums payable to the first death. The CRA (unofficial translation) stated:
Assuming that the ownership of the insurance policy, following the death of the policyholder-testator, was legally transferred to this trust, and that this trust (or its trustees) does not have to pay any premiums using the trust income or capital to maintain the policy in force, and that no other person, other than the surviving spouse or common-law partner, can before the death of the spouse or common-law partner, receive or obtain all, if applicable, of the income or surrender value of the policy, it appears to us that the condition set out in subparagraph 70(6)(b)(ii) of the Act would be honoured.
The transfer of a paid-up policy to a trust may result in a taxable policy gain on the policy’s disposition. See the discussion in the below section dealing with transfers into a trust.
Where the life interest trust holds shares of a private corporation, another alternative would be to purchase life insurance in the corporation to fund liabilities arising on the death of the life interest beneficiary. The 2012 CALU CRA Roundtable asked the CRA to consider the situation where corporate owned insurance is purchased by Opco B and the 4 directors of Opco B have signed a resolution requiring Opco B to maintain an insurance policy until the death of the life interest beneficiary and to pay out the insurance proceeds to the testamentary trust as a capital and/or taxable dividend. The CRA was “unable to confirm that such a structure would not taint the status of a testamentary trust and also impact on the rollover of property under subparagraph 70(6)(b)(ii) of the Act.” This position is dubious. The underlying assets and expenses of a corporation, whose shares are held by a life interest trust should have no bearing on whether a life interest trust is tainted.
The purchase of personal insurance by the life interest beneficiary funded by distributions out of the trust may also be possible. The trust may be named as a beneficiary of the policy. However, this approach will only be practicable where the interests of the life interest beneficiary and the residual beneficiaries of the trust are aligned.
Finally, it may be possible to argue that where the life interest trust is not empowered to own life insurance a subsequent purchase of life insurance by it should not result in the trust being tainted. The CRA confirmed paragraph 8 of Archived Interpretation Bulletin IT-305R4 “Testamentary Spousal Trusts” that “once a trust qualifies as a spouse trust under the terms of subsection 70(6), it remains a spouse trust… even if its terms are varied by agreement, legal action or breach of trust.” (See 2016 CALU Q4 and STEP Q11 Roundtables #2016-0632631C6 and #2016- 0645821C6.)
Tax issues – No trust benefit where the trust is owner and beneficiary of a life insurance policy
Where a life insurance policy is owned by a trust, the trust would normally be the beneficiary of the policy. Notwithstanding prior conflicting commentary (#2006-0174041C6) the CRA has confirmed (#2008-030188) that no benefit under subsection 105(1) of the Act arises for beneficiaries of a trust when the trust owns and is the beneficiary of a life insurance policy.
Tax issues – Life insurance is not subject to a deemed disposition under the 21-year rule
By the combined operation of the definitions in subsection 248(1) and section 39 relating to capital property and capital gains, together with the special rules in the Act dealing with the taxation of life insurance policy gains, it is clear that an interest in a life insurance policy is not “capital property” for tax purposes, nor property of any other type listed in subsections 104(4) and (5) of the Act. As such the 21-year deemed disposition rule does not apply to life insurance policies held by a trust.
Transferring a life insurance policy into or out of a trust
Life insurance as the subject property of a trust when the trust is created – Certainty of property
Under trust law in common law provinces, a trust is only legally constituted when three certainties co-exist. The three certainties are:
- Certainty of intention – the settlor displays a clear intention to create the trust, such as recording the intention to create a trust in the trust instrument;
- Certainty of property – the property that is the subject of the trust is clearly ascertainable. When a life insurance policy is part of the subject property of a trust, the trust instrument should clearly identify the insurance policy by describing the issuer of the policy, the life insured and the policy number;
- Certainty of beneficiaries – the beneficiaries of the trust are clearly identifiable either by name or by class. When the three certainties come into existence, the trust is formally constituted and comes into existence.
When the three elements do not co-exist, the trust fails. If a trust does not exist, some other relationship or consequence may be present such as an agency relationship, a transfer, a gift of property or co-ownership of property.
Tax consequences on transfer of life insurance to a trust
In general, when property is transferred to a trust there is a disposition and where the settlor does not deal at arm’s length with the trust, the proceeds of disposition of capital property is deemed to be at fair market value. Certain trusts (i.e. alter ego, joint partner, self-benefit, spousal or common-law partner trusts) receive rollover treatment in respect of transfers of capital property to the trust. As noted above in discussing the 21-year rule, life insurance is not capital property under the Act. Therefore, if a life insurance policy is transferred to any of these trusts, there will be a disposition of the life insurance policy.
Where this is so, subsection 148(7) of the Act will apply to the disposition. The transferor is not dealing at arm’s length with the trust since the transferor is beneficially interested or related to someone beneficially interested in the trust (definition of “arm’s length” in subsection 251(1) of the Act). Under subsection 148(7) the deemed proceeds of the disposition and the adjusted cost basis (ACB) of the policy to the trust is deemed to be the greatest of the policy’s ACB, cash surrender value (CSV), or, the fair market value of consideration given in respect of the transfer of the policy. Assuming that there is no consideration given, if the CSV of a policy at the time of transfer is greater than the ACB of the policy, a policy gain will result on a non-arm’s length transfer into such a trust.
The transfer of a life insurance policy into a trust would not qualify for a rollover pursuant to subsection 107.4(1) definition of “qualifying disposition” due to paragraph (b). This paragraph requires that the disposition is not subject to some other deeming provision that would deem the proceeds of disposition on the transfer if the Act were read without 107.4(1). Since subsection 148(7) would deem the proceeds of the disposition of a life insurance policy on a non-arm’s length transfer to a trust, 107.4(1) would be rendered inoperative.
In the specific context of a paid-up joint-last-to-die policy transferred on the death of one of the joint insured persons to a testamentary spouse trust (#2012-0453121C6 discussed above), although this may not taint the spouse trust, the transfer to the trust would not occur on a rollover basis. Rather, subsection 148(7) would apply to determine the proceeds of the disposition of the policy. However, if the transfer of such a policy were made to the spouse and not a spouse trust (either under a right of survivorship if the policy were jointly owned or via the deceased spouse’s will as a distribution from the estate) the rollover provision in 148(.8.2) would apply.
Tax consequences on transfer of life insurance out of a trust
It should be noted that although a life insurance policy is not capital property as defined under the Act, it nevertheless can constitute trust capital and is eligible to be rolled out to a capital beneficiary in satisfaction of a capital interest in the trust at the trust’s “cost amount” (i.e. the ACB of the policy) where subsection 107(2) of the Act applies. This has been confirmed by the CRA in 1999 CALU #9908430 and subsequently in #2011-0391781E5.
Trusts receiving proceeds of a life insurance policy on death and distributing those proceeds to a beneficiary(ies) of the trust
The tax treatment of life insurance proceeds received by a trust is substantially the same as if the proceeds are received by an individual. Death benefit proceeds of a life insurance policy paid to a trust are received tax-free (receipt of proceeds in consequence of death is generally not a “disposition” of a life insurance policy under s. 148(9) of the Act and therefore is not subject to tax).
A payment from a trust may be made tax-free to a capital or income beneficiary in satisfaction of a capital or income interest of a trust (pursuant to subsection 107(2) or 106(2) and (3) of the Act). The trust document would identify capital and income beneficiaries. Notwithstanding that the beneficiary may receive death benefit proceeds from a life insurance policy via the trust, insurance proceeds do not retain their character when flowed through the trust (subsection 108(5) of the Act). As a result, if death benefits from a life insurance policy are distributed by a trust to a private corporation that is a beneficiary of the trust, the company will not receive a credit to the capital dividend account.
Creating a trust with life insurance proceeds – Insurance trusts
An insurance trust is created on and in consequence of an individual’s death by virtue of a declaration (eg. section 171 Ontario Insurance Act) in favour of a beneficiary for which a trustee is appointed (eg. subsection 193(1) Insurance Act). Such a declaration may be made in a will or any other written instrument (including in the policy contract – the application for insurance forms part of the policy contract – or on the insurer’s beneficiary designation form). The instrument must be signed by the policy owner and identify the contract or describe the insurance or insurance fund or part thereof to which the declaration relates. On death, the life insurance proceeds paid pursuant to such a declaration pass outside of and do not form part of the estate creating a separate insurance trust notwithstanding that the trustee of this trust may be the same person as the estate trustee. Insurance trusts cannot be used in Quebec due to the manner in which trusts must be established under the Civil Code.
Creating an insurance trust in respect of a joint-last-to-die life insurance policy involves some additional practical considerations. Often a joint-last-to-die policy on spouses is jointly owned. Two signatures are required in dealing with the policy including, naming a beneficiary and appointing a trustee. Because a will can only be signed by its maker, a testamentary insurance trust in respect of a jointly owned joint-last-to-die life insurance policy cannot be signed by both owners within a will. In this situation, options would include: using a separate trust instrument containing a declaration signed by both; or, using a letter of direction executed by both referencing the insurance trust declaration in each of their wills to be referenced should they be the last to die.
The CRA has confirmed that a trust funded from the proceeds of life insurance owned by an individual on that individual’s death whose terms were established while the individual is alive, within or separate from a will, is viewed as a testamentary trust. (See #9625975, #9605575 and #2009-0350811E5.) The policy owner is the person legally entitled to name a beneficiary and to direct the payment of the proceeds into the trust, thereby, creating the trust. An insurance trust arises upon the death of the settlor but does not arise from the estate even if the declaration is contained in the will and the trust terms are captured in the same instrument. As a testamentary trust, an insurance trust for a disabled beneficiary may qualify as a “qualified disability trust” (QDTs) and be taxed at graduated rates provided the other requirements for this status are met.
This tax topic deals with the basics of what are the tax and legal consequences of a trust acquiring, owning, funding, being transferred or transferring, receiving proceeds or distributing proceeds or being settled with proceeds of a life insurance policy.
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