Testamentary trusts can be better than joint ownership

For someone living in a jurisdiction with high probate taxes, it can be a near knee-jerk response to hold valuable property jointly with a spouse or with one or more children, with a right of survivorship. The expectation is if that person dies first, the property will not form part of his or her estate and will then be owned by the surviving spouse or child(ren). While this arrangement may be effective to achieve a one-time saving on probate taxes, it may come at a substantial cost – namely, the loss of income tax savings from the use of a testamentary trust (or trusts) that, when aggregated over time, can dwarf the probate tax saving.

Consider Jill who, at the time of her death on December 31, 2009, is married to Jack and has a five-year GIC with a face value of $2 million that pays simple interest at 5% per annum. Were probate of Jill’s will required, it would give rise to additional probate taxes of $30,000 on account of that GIC. Jill could have saved her estate that amount by changing the ownership on the GIC prior to her death so that it was held between her and her husband jointly, with a right of survivorship. On Jill’s death, Jack would have become the sole owner of the GIC.

Suppose that for his 2010 taxation year, Jack is in the top tax bracket as a result of his other sources of income. The federal tax rates for 2010 were:

For his 2010 taxation year, Jack would have paid additional federal tax of $29,000 on account of the GIC interest income.

Suppose instead that Jill had kept ownership of the GIC in her name and had made a will which called for the transfer of that GIC to a testamentary spouse trust for Jack, under the terms of which he would be entitled to all of the trust income during his lifetime. Under the current income tax rules:

• A testamentary trust is treated as a separate taxable entity that pays tax at the same graduated rates as does every individual taxpayer.
• Even though the will directs that all trust income is to be paid out to the beneficiaries of the trust, the trustee can elect to have all or any part of that trust income taxed to the trust.

If the trustee of the trust (who might be Jack himself) elects to have all of the trust income derived from the GIC taxed in the trust, the aggregate federal tax payable in 2010 would be $19,854. The saving of federal tax in one year alone through the use of a testamentary trust would have amounted to $9,146. There would be additional provincial tax savings, based on applicable provincial tax brackets for 2010.

By having Jill’s estate absorb the one-time probate taxes on the GIC, the aggregate income tax savings arising through the use of the testamentary trust would offset those probate taxes after only a few years. Income tax savings in each succeeding taxation year would continue to accumulate thereafter for the rest of Jack’s life. (A small additional benefit would also arise because the testamentary trust, unlike Jack, is not required to pay quarterly tax instalments.)

Suppose instead that Jill were a single parent with two adult children, each being in the top tax bracket. If her will called for the creation of two testamentary trusts, one for each child, one-half of the interest income would be taxed in each of the testamentary trusts, with an aggregate federal tax bill of $16,264 for 2010. If Jill had chosen to use joint ownership of the GIC to save probate taxes, the aggregate federal tax paid by her children in 2010 would have been $29,000. Thus the federal tax saving in 2010 through the use of two testamentary trusts would have been $12,736, so that the one-time probate tax cost would be eclipsed that much faster.

Barry S. Corbin, B.Sc., M.Sc., LL.B. is a lawyer with Corbin Estates Law.