There has always been an aura of mystery and, sometimes, confusion with respect to trusts. Once reserved exclusively for the wealthy, trusts have become an increasingly popular estate planning tool for all walks of life. Even Canada Customs and Revenue Agency (CCRA) has made more trusts available with its recent introduction of alter ego trusts and appoint partner trusts in the Income Tax Act (Canada) (ITA). Much of the confusion lies in the multitude of names given to trusts. There are spousal trusts, inter vivos trusts, testamentary trusts, family trusts, business trusts, spendthrift trusts, insurance trusts, and offshore trusts, to name a few. But what is the difference? In essence, not much. In a way, trusts and bags are analogous. There are shopping bags, garbage bags, handbags, and gym bags, each with a different name, but all similar in that they share a common purpose: to hold objects for you to transport. Likewise, the variety of available trusts also has a basic purpose in common.

Trusts originated in the Middle Ages when estate planning was very different from what it is today. Back then, property owners could freely bequeath personal items upon death, but not land, unless the King's consent was granted, as land vested in the Crown. Some things never change however, as the Crown levied a death tax to be paid before consent was given. A great concern of the day was the passing of large estates to heirs, as many owners went on distant travels to the Crusades, never to return. Lawyers of that period discovered a way to handle these issues by setting up a trust to hold the property indefinitely in the care of a trustee and pass it on to the next generation. Since a trust never died, this system also avoided death duties. Needless to say, the King was not amused.

The next few hundred years involved a struggle between Iawyers and the King over whether or not to do away with the trust. Finally, Henry VIII passed legislation abolishing trusts. Landowners, unhappy that they were back to square one, complained loud and hard and eventually Henry gave way.

The Wills Act introduced in 1535 allowed, for the first time ever, the disposition of land by Will However, trusts returned and their use grew as people recognized how flexible an estate-planning tool they could be. And so for every new application of a trust, a new name was invented. Needed a trust for your spouse? Enter the spousal trust. Children in the picture? A family trust was born. Got a financially irresponsible offspring who may spend the family fortune? A spendthrift trust was the way to go. In the end, regardless of the name, all of these trusts did the same thing: give property to a trustee to care for on behalf of a beneficiary. The instructions may have differed, but the purpose was the same. What has changed is how trusts are taxed.

We still use trusts today to take care of property on behalf of others. Regarding the taxation of trusts, generally all trusts pay tax on earned income remaining in the trust. Every trust must file a T3 tax return with CCRA every year. Money distributed to beneficiaries is taxed in their hands at their applicable marginal tax rates.

If you invest in segregated funds, you are using trusts without even realizing it. Segregated Funds are actually business trusts, and investors receive a T3 trust tax receipt to include in their tax return and not a T5 for interest earned as would be received from a bank. With segregated funds, you are giving your money to a trustee to manage on your behalf and at the end of the year, all income earned is distributed so that the trust (segregated fund) does not have to pay tax.

In addition to taking care of property for others, we still use trusts today to avoid paying some taxes. There are some tax differences between testamentary (those in a Will) and Inter vivos (those created while you are alive) trusts. Inter vivos trusts were used for family situations and once enjoyed many tax advantages. However, CCRA has tightened or closed most of these tax advantages, and today, you have to plan carefully before setting up an inter vivos trust strictly for tax purposes. The major advantages affected by the changes made by the CCRA involve the tax rate, the preferred beneficiary election, and the 21-year deemed disposition rule.

The main difference between an inter vivos trust and a testamentary trust is the tax rates used on each. This difference has a major impact on the trust as all trusts pay tax on the income earned inside the trust. The inter vivos trust pays tax at the top marginal tax rate on every dollar earned, while the testamentary trust pays progressively with whatever marginal tax rate is applicable, and therefore may not pay as much tax on the same amount of income earned.

At one time, trusts could hypothetically deem the trust income distributed to preferred beneficiaries without actually giving it to them and in this way they could income split and reduce tax as the beneficiaries would pay tax at their applicable marginal rate. This advantage has been eliminated except for financially dependent beneficiaries. Another change to trusts involves capital assets. These assets were once able to grow indefinitely inside a trust and ended up with large unrealized capital gains that were never taxed. This was tightened up so that there is a deemed disposition of the assets at fair market value every 21 years after either the death of the spouse or the creation of the trust, and tax is paid accordingly.

Although tax changes have made the trust, especially the inter vivos trust, less appealing strictly for tax purposes, there is still room for some income splitting. The use of trusts has grown because of the other benefits they possess, namely the professional care and management of assets that they afford a beneficiary.