Control, Protect, Preserve: Leveraging Trusts in Life Insurance Planning

A trust is a special arrangement for owning property, designed to ensure it is managed carefully for beneficiaries, especially if they are young, have special needs, or are not adept at managing large sums of money. It involves three key parties: the settlor, who establishes the trust and provides the property; the trustee, who legally owns and manages the property for others; and the beneficiary, who ultimately benefits from the trust property. This arrangement is typically detailed in a trust agreement and can be set up during the settlor's lifetime as an inter vivos trust or after their death via a will as a testamentary trust.

Life insurance is a contract where premiums are paid in exchange for a death benefit upon the insured's passing. Combining a trust with life insurance offers significant advantages. It provides control and flexibility, allowing trustees to manage the policy and distribute funds to beneficiaries over time, which is particularly useful for minors or those who might not handle a large sum wisely. Furthermore, a trust can simplify complex arrangements, such as in a business where a single policy on each shareholder, held by a trust, can streamline a life insured criss-cross buy-sell agreement.

Trusts also help avoid problems with future policy ownership. Directly transferring a policy to a new owner whereby the transfer would result in a policy gain, which in turn can trigger taxes, or, to a minor child who can’t legally manage the policy, can be problematic. A trust can circumvent these issues.

For individuals with connections to the U.S., a specialized trust known as an Irrevocable Life Insurance Trust (ILIT) can be employed to prevent the life insurance death benefit from being included in the insured person's taxable estate. Beyond tax and distribution benefits, for trusts with substantial assets, life insurance can also be considered as an investment option, contributing to the overall financial strategy of the trust.

Trustees managing life insurance policies must adhere to specific guidelines. Sometimes, the trust document explicitly instructs the trustee to acquire and pay premiums for life insurance. If not, trustees are generally required to act as a "prudent investor." This standard mandates careful investment decisions, considering factors such as economic conditions, taxes, the investment's role within the trust, expected returns, liquidity needs, and the asset's special value to the trust's purpose. When evaluating life insurance, a prudent trustee would consider its specific features, including tax-exempt growth of cash value, a tax-free death benefit, potential guaranteed values, and the liquidity provided by its cash value.

A significant advantage of holding life insurance within a trust, particularly in Canada, relates to the "21-Year Rule." Under this rule, capital property held in a trust is typically deemed to be sold every 21 years, potentially triggering a tax bill even if no actual sale occurred. However, life insurance policies are not considered "capital property" under Canadian tax laws. Consequently, a life insurance policy held by a trust is not subject to this 21-year deemed disposition rule, allowing it to remain in the trust for extended periods without triggering a tax event solely due to its age.

Despite these benefits, several important considerations exist. The Canada Revenue Agency (CRA) has a concern regarding "tainting" life interest trusts, such as spousal or alter ego trusts, if they own and pay premiums for a life insurance policy on the life interest beneficiary. The CRA views this as benefiting future beneficiaries rather than solely the current life interest beneficiary, which could cause the trust to lose its tax benefits and become subject to immediate taxation, or the 21-year deemed disposition rule for other assets. Experts often dispute this view, arguing that such policies preserve trust capital. Alternatives include transferring a paid-up policy or having a related corporation own the insurance.

Transferring life insurance policies into a trust can be considered a "disposition," potentially resulting in a taxable policy gain if the cash surrender value exceeds the cost. Special trusts may not receive a tax-free "rollover" for life insurance as they might for other capital property. Conversely, transferring a policy out of a trust to a capital beneficiary can be tax-efficient, usually at its cost. When a trust receives a death benefit, it is generally tax-free, and subsequent distributions to beneficiaries can also be tax-free. However, the money does not retain its "life insurance proceeds" character once in the trust, which can affect corporate beneficiaries' tax credits. Therefore, it does not create a credit to the corporation’s capital dividend account (CDA).

Sometimes, a trust is created after death using the life insurance death benefit, known as a Life Insurance Trust. In the case of a LIT, its terms may be set up inside or outside of a Will. In each case, the policy owner directs the insurance company to pay the benefit directly to a trustee, bypassing the deceased's estate. A key benefit is that this money avoids probate fees. It is crucial to use the correct wording and procedures when designating a trust as a beneficiary to ensure the intended trust structure is maintained. Note that in Quebec, specific "insurance trusts" created solely by declaration are not permitted due to different legal requirements for trust establishment.

While trusts offer comprehensive control, simpler settlement options provided by insurance companies might suffice if the primary goal is merely to control how a beneficiary receives the death benefit (e.g., as regular payments like a term or life annuity). These options are less costly and complex than a full trust but offer less flexibility and specific control. Ultimately, combining a trust with life insurance is a powerful strategy for managing one's legacy, offering control over distribution, asset protection, and tax advantages such as avoiding probate fees and the 21-year deemed disposition rule for the policy itself. However, given their complexity, professional advice from a lawyer or financial expert is always essential to ensure a proper setup for individual situations.