Testamentary trusts and taxes

Testamentary trusts can be an effective part of your estate plan. They can provide for family members with special needs, provide for a current spouse at the same time as children from a prior marriage, or even protect special assets from creditors.

But, whether you’re creating a trust for your own estate or dealing with a trust as an executor, it’s important to know how trust taxation works.

The trust is a considered a separate taxpayer. When considering taxation of trusts, examine both the rules for taxation of income and the treatment of capital property. Testamentary trusts are taxed at the same graduated rates as an individual taxpayer.

This rule affords potential for tax-planning opportunities. The treatment of capital property—in particular the application of the deemed disposition rules—depends on the type of testamentary trust established.

For income-tax purposes, a trust is a conduit for income paid or payable to a beneficiary. All income (including capital gains) generated by the trust’s investments will be taxed in either the trust or the hands of the beneficiary.

Depending on the trust’s terms, the trustee may be able to choose to allocate income to either. As a result, there’s opportunity for reducing tax when the beneficiary and the trust are in different tax brackets.

If there are multiple trusts, it’s possible to multiply the tax savings as each trust qualifies as a separate taxpayer.

The treatment of capital property varies depending on the type of trust. Where the trust is a qualifying spousal trust, capital property can be transferred to the trust on a rollover basis. The estate can defer the realization of capital gains until the capital property is sold; returns paid to the surviving spouse; and/or the death of the surviving spouse.

If the trust continues beyond the death of the surviving spouse, the 21-year rule will apply. That rule states any property held in trust is considered sold every 21 years, which means capital gains taxes. The 21-year rule clock starts on the testator’s death.

In the case of a non-qualifying spousal trust (a trust for minor children or grandchildren, for example), the usual deemed disposition at death will occur. The adjusted cost base of the trust property will be its fair market value; so capital distributions may be made to beneficiaries on a tax-free basis.

Elaine Blades and Scott Cummings