The changing landscape of testamentary trusts

Clients want to know how Budget 2014’s testamentary trust changes will affect estate plans. Here’s what you should know.

Breaking it down

The change that has received the most attention is the elimination of graduated rates for testamentary trusts, beginning in 2016. There are two exceptions to this rule:

• Graduated rates will continue to apply to a trust if the beneficiaries are eligible for the federal Disability Tax Credit (DTC).
• An estate that arises as a consequence of death and is a testamentary trust will be able to use the graduated rates for 36 months from the date of death.

Unfortunately, Budget 2014 provides no details about the requirements to meet the first exception, and no details have since been released.

However, the reference to the DTC is important. In Ontario, a testamentary trust known as a Henson trust is commonly used when a testator wants to leave a gift for someone who receives benefits under the Ontario Disability Support Program (ODSP). The Henson trust permits unlimited capital to be held in the trust without disqualifying the beneficiary from receiving ODSP benefits (although there are restrictions on distributions).

The key is that approval for the DTC is not a prerequisite for receiving ODSP benefits. In practice, many ODSP recipients have already been approved for the DTC. But the new testamentary trust rules provide another reason to get approval.

Read: Alternatives to testamentary trusts

Graduated rates

The loss of graduated rates after 36 months means you’ll have to carefully review each case if you’re using testamentary trusts only to minimize tax.

Let’s use the example of Paula Rodrigues and her family. Paula is recently widowed and has assets of approximately $2.5 million. They consist of a principal residence valued at $750,000 and investments of $1.75 million. Her son, Dominic, is a single father and earns $50,000 a year. Dominic has three children, between ages 19 and 23, who are either attending post-secondary institutions or have just started earning $30,000 to $35,000 per year. Paula does not want to hand over a significant sum to her son outright.

The Rodrigues family could continue to benefit from a testamentary trust, even under the new rules. There are several potential beneficiaries, who all earn income at less than the highest marginal rate. During the first 36 months after Paula dies, the trust can use the graduated tax rates. After the 36-month period, all income can be made payable to any one or more of Dominic and his children.

The beneficiaries will pay the tax on the income below the highest marginal rate.

Seven years later

Now, let’s see how the situation changes seven years later. Paula died one year after making her will, so it’s six years from her date of death. Dominic opened his own business with the insurance proceeds he received when his mother died, and now earns $150,000 per year. Dominic’s children have all graduated or progressed in their careers, and earn between $135,000 and $195,000 annually. Since all of the income beneficiaries of the trust are now earning income at the highest marginal rate before any distributions from the trust, there aren’t tax savings.

Read: Avoid the (new) Kiddie Tax

Has the Rodrigues family trust now outlived its use? That depends on the motivation for setting it up.

If tax planning was the only reason, then there’s no longer any benefit. In that case, if the trust was drafted with sufficient flexibility to allow the trustee to declare a distribution date and wind up the trust, then it would be appropriate to do so to avoid the costs of administration. Since you can’t predict the income-earning potential of beneficiaries, giving the trustees discretion to wind up the trust is a good idea. That way, the trust can be brought to an end if tax benefits are lost.

You’ll also recall that Paula was worried about handing over a large amount of money to her son outright. This highlights an important point—tax planning is only one consideration when determining whether a testamentary trust makes sense in a particular case.

Indeed, non-tax reasons are often the most important reason for using a trust. But a testator may be worried a beneficiary is not responsible enough to manage a large amount of money, or may have creditors looming on the horizon, so the testator may never want to hand over a large sum of money to that beneficiary. In such cases, the loss of graduated rates will be unfortunate, but unlikely to change the testator’s objectives.

If the testamentary trust holds only capital property, such as the family cottage, the loss of graduated rates will not affect the trust from a tax perspective.

More changes

Budget 2014 introduced a number of additional changes that affect the administration of testamentary trusts, two of which are very important logistically. Beginning in 2016, testamentary trusts will no longer be exempt from:

• the requirement to file quarterly tax installments;
• the requirement that trusts have a calendar year-end.

The first means that executors must focus on the estimated tax liability early on in the administration of an estate to avoid interest charges. This may be challenging in the first year of an estate.

Read: Be prudent about trusts

While the second point may make administration easier, executors and trustees will need to understand when two year-ends in the same calendar year will occur. On December 31, 2015, testamentary trusts that have existed for more than 36 months will have a deemed year-end and thereafter use a calendar year-end, resulting in two year-ends in 2015. If the trust has not existed for more than 36 months on December 31, 2015, it will have a deemed year-end at the end of its first 36 months and thereafter use a calendar year-end, resulting in two year-ends in the year the 36-month period ends.

Budget 2014 has altered the landscape of testamentary trust planning in Canada, but there remain circumstances in which the use of these trusts will continue to be an attractive option.

Darren G. Lund is an associate in the Toronto office of Borden Ladner Gervais LLP. His practice is focused on estate planning and administration. Reach him at (416) 367-6358 or dlund@blg.com.