Testamentary Trusts


Testamentary trusts are used in tax planning to allow income to be taxed at another set of lower marginal tax brackets.  They are used in wealth planning to preserve wealth.

There are a lot of misconceptions about testamentary trusts and how they are used.  The purpose of this article is to clarify, on a general basis, some of the more common practical uses of these trusts in estate planning.

Trust definition

A “trust” is an obligation or an agreement that legally binds a trustee to take care and control of specific property for specific people.  The specific property is normally defined in the trust agreement.  The specific people are the beneficiaries of the trust (i.e. the people that will benefit from the capital of the trust and / or the income earned on the trust property.

Creation of a trust

All trusts require that there be a settlor.  The settlor, transfers legal ownership of property to the trustee(s), and provides guidance to the trustee with respect to the handling of this trust property.  The guidance on the handling of this trust is documented in a legal document referred to as a trust indenture or agreement, will or codicil.

Types of trusts

  1. An intervivos trust is a trust created while the settlor is alive.  An Intervivos trust does not benefit from the lower tax brackets.
  2. A testamentary trust is created by inserting specific wording in a will or codicil to a will.  In order to preserve its testamentary trust tax status, the testamentary trust can only become effective on the death of the individual (deceased / testator).

Trusts can be broad trusts for all of a family, child trusts for certain children as a group or independently or for spouse(s).

Benefits of a Testamentary Trust:
  • Tax minimization – income tax can be minimized on future income realized by the trust on the inherited property.
  • Testator’s objectives – The trust can be used to ensure that spendthrift beneficiaries do not exhaust or spend the trust assets too quickly.
  • Family law and creditor protection.  The trust can reduce the exposure to claims on the trust assets held for beneficiaries from creditors and family law claims on property.  This protection is based on the legal wording printed in the trust.  Your legal counsel can confirm what level of protection is available in your scenario given the wording in the trust in question.
Tax Minimization
  1. Returns – trusts must file their own tax returns each year (referred to as a T3 return)
  2. Allocation of income – income can be taxed in the trust at the trust’s income tax rates or allocated to beneficiaries by way of a T3 slip and T3 summary.
  3. Marginal tax rates – testamentary trusts receive their own set of graduated marginal personal income tax rates in the same manner as an individual person.  This savings is realized where an individual receives an inheritance via a trust, the income is taxed in the trust at a trust tax rate of say 20% or 31%.  If that individual is a top tax bracket taxpayer in Ontario, they would be taxed on this same income at 46.4%.  Therefore a savings of 15% to 26% can be realized on the same income earned through a trust vs. in the individual’s hands.
  4. Tax elections – If the trustee makes appropriate elections in the tax return for the trust, the income can be taxed in the trust, yet the wealth can be paid to and used for lifestyle or other expenditures on behalf of the individual (subject to the trust permitting this payment and or expenditure).  The value of this tax bracket savings can be up to $17,500 in Ontario for a top bracket taxpayer.
  5. Annual savings – This savings can occur every year the trust is in place (some trusts end on say the 40th birthday of a trust or the 20th anniversary of the death etc.
  6. Multiple beneficiaries – this savings can be multiplied if there is more than one beneficiary and the estate’s income is significant.  For example if an individual were to put in their will that the trust would benefit 3 grandchildren, the income earned could be allocated to the grandchildren for their lifestyle expenses and no income tax would be paid on the first $10,000 earned per grandchild (assuming the grand child had no other sources of income).
Testators Objectives & Wishes
  1. Testator can control how property owned at date of death is utilized.  This can include control over which beneficiaries receive access to certain trust property along with when they obtain access.
  2. In practice this control may allow control over determining use of a family cottage or house.
  3. The trust can set schedules for usage and clarify which entity / user pays for taxes, utilities and repairs.
  4. In the case of a family with a disabled family member, the trust can ensure the property benefits the disabled child this can affect any provincial disability support payments.

Separate trusts for each child can allow trust property be managed separately with different maturity dates, risk levels.  Different trustees and alternate trustees can be named to reduce conflict between family members.

The selection of trustees is a significant decision.  Factors that should be considered in deciding on who a trustee is:

  1. Age
  2. Skill set
  3. Financial experience
  4. Ability and willingness to perform the duties
  5. Independence, exposure to current and future conflicts of interest
  6. Flexibility – consider making child the trustee of their own trust
  7. Concern re spendthrift – consider not making child as trustee of their own trust
  8. Tax residency of trustee
Income & Capital Discretion

Trustees can be given power to encroach on capital for and allocate income to beneficiaries.  This power can be restricted in terms of dates and ages.  This power can be discretionary i.e. all income can be allocated on a fully discretionary basis while no capital encroachment until say the 35th birthday.  Income allocated to adult beneficiaries becomes payable at the trust tax year end, and therefore the beneficiary can enforce payment immediately thereafter.  Capital encroachments can be restricted to only specific expenses – medical, educational, sporting, religious, cultural and / or general household maintenance purposes.

Costs of Setup and Operation
  1. Legal fees – setup – the last will and testament of the individual will need to be revised before they die, the individual must have capacity and understanding to be able to communicate their desires to their legal counsel.
  2. Accounting fees – for the preparation of the annual tax returns for the trust, and trust resolutions.
  3. Trustee fees – the trustee may charge the trust a trustee fee for their services.  This is dependent on the terms of the trust

The use of testamentary trust planning is case specific and you should consult your tax advisor before implementing any of the suggestions above.   This article is written based on income tax rules in Canada for Ontario resident individuals. There are complexities on trusts that last more than 21 years or trusts that have non-resident beneficiaries or non-resident trustees.

Effective early June 2013, The Department of Finance Canada has invited the public to provide comments on proposed measures affecting trusts.  These proposed trust rules indicate Finance's desire to change the tax rules that apply to testamentary trusts.  If these consultation papers become law, the tax benefits of testamentary trusts will be virtually eliminated.  We will update this web page after proposed legislation is announced.  Readers should take this into account with their advisor before they finalize their estate plan.

 

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