Testamentary trusts still useful

For many Canadian families a straightforward transfer of assets will meet their primary estate planning needs. But increasing complexity around issues of asset control, protection and tax-efficiency can make the use of trusts a better option.

Read: Trusts are essential to estate planning

A common vehicle is the testamentary trust, which becomes effective upon death. It’s useful for protecting assets going to minors or beneficiaries with disabilities; passing assets to the next generation after the surviving spouse dies; or saving heirs tax by arranging for them to income-split with a trust of which they’re beneficiaries.

The federal government’s proposal to eliminate graduated tax rates that apply to testamentary trusts, some estates and some intervivos trusts will have a major impact on the planning process. The measure would apply flat top-rate taxation, effective 2016, to an individual’s estate—which, under the Income Tax Act is considered a testamentary trust—if it exists more than 3 years.

This means complicated estates will be taxed at the graduated rates for the first 3 years and at flat top-rates thereafter. The top-rate (29% federally) would also apply to all existing and new testamentary trusts beginning 2016, and to grandfathered intervivostrusts as of 2016.

Clients may now be wondering if trusts should be eliminated from their estate plans. Include the following considerations in your discussions:

1. Heirs with a disability. Inherited funds may cause the clawback of federal or provincial disability support. A trust can protect these funds. The “Preferred Beneficiary Election” (an income tax provision allowing income to be recognized for tax purposes in the beneficiary’s hands even if it isn’t paid out) isn’t affected by the federal proposals. But taxing the income in this fashion may cause unintended clawback. It may be useful in these circumstances to consider investments in tax-deferred corporate class mutual funds. The flexibility of tax-deferred switching and minimized taxable distributions can save money for both the beneficiary and the trust.

2. Minors or beneficiaries who aren’t financially responsible. Inherited funds may be diverted for management by the Public Guardian and Trustee in the case of a minor, or be spent quickly by an heir who doesn’t handle money well. The security of a formal trust, with its direction to the trustee for use of and access to the funds, may be the best option. Income can be allocated to the beneficiary to lessen the tax payable at the top tax rate, or trust assets can be paid out over time to guard against irresponsible spending.

Read: Demystifying trusts

3. Spouse or common-law partner. Although the proposed tax rates would remove the benefit of income splitting between the spouse or common-law partner and the trust, there’s no change to the tax-deferred transfer of non-registered assets when the first spouse passes away. Transferring assets at cost base to the spouse or a spousal trust can defer significant tax to the estate, so a discussion relating to spousal trusts is worthwhile.

4. Client wants to include more than one generation in the estate plan. A testamentary trust can still protect assets across generations. The will can stipulate who is part of the trust and what kind of income can be paid out to each beneficiary. Again, although the proposals could increase the amount of tax the trust would pay on investment income, tax-efficient investments in the trust, or the election to pay out income to designated beneficiaries can reduce negative tax effects and fulfill the estate plan’s intent.

5. Planning for more than one marital relationship. A testamentary trust can manage and distribute assets to desired beneficiaries who are part of a blended family.

The budget includes a number of related proposals:

• Quarterly income tax installment filings for testamentary trusts established in a will and for top-rate estates (those in existence after the 3-year exemption period).
• Changing the taxation year for testamentary trusts and top-rate estates from the fiscal year to calendar year. Presently, a testamentary trust is permitted to file a tax return by no later than 90 days after the anniversary of the trust, so taxation may be any time in a calendar year.

The federal government is currently seeking input from interested parties before enacting any legislation. In the meantime, it’s worthwhile discussing with clients the impact of the potential changes on their estate planning objectives.

Also read:

5 tax benefits of testamentary trusts

How to use testamentary trusts

Inter vivos trusts help minimize tax

5 reasons trusts work for incapacity planning