In-trust accounts can help avoid probate

The settlement of a trust is a simple step that opens the door to sophisticated wealth planning opportunities.

In last month’s story we touched on the requirements for a trust to come into existence, and canvassed some of the most common ways trusts may be characterized for tax purposes. Ultimately though, reducing trust taxes is but an intermediate step toward the ultimate purpose of providing optimal benefit to beneficiaries.

Income splitting

As a starting point, if settled through a person’s will, a trust will obtain testamentary treatment, meaning access to graduated tax rates for income reporting. This obviously compares favourably with the top marginal tax rates that apply to inter vivos trusts (those settled during lifetime). In effect, the deceased person continues to be somewhat present from a tax perspective.

It is actually possible to multiply this benefit by establishing multiple trusts, though within limits dictated by the Income Tax Act. Essentially, only one such trust may be created for each beneficiary designated under a will. Still, that’s a side-by-side graduated tax rate vehicle for each person a testator wishes to benefit out of an estate. In addition and as discussed in last month’s article, the CRA has acknowledged separate testamentary trusts may be established out of life insurance proceeds and RRSP/RRIF receipts.

Selecting the year-end

The year-end of a testamentary trust may be elected as any day in the full year following the relevant death. A trustee may use this election to strategically delay income recognition, as beneficiaries must report an income distribution from a trust in the beneficiary’s tax year in which the trust’s year-end falls.

If a beneficiary receives an income distribution in February (Year 1) from a testamentary trust with a January 31 year-end, that income is deemed to be received on January 31 (Year 2), with the tax due with the filing of the beneficiary’s Year-2 T1 return in April (Year 3).

Income sprinkling

Beyond initial creation of the trust, there’s an art and science to year-to-year trust tax management. For example, a trustee could selectively distribute annual trust income among beneficiaries to reduce the long-term total tax bill for all beneficiaries. This could be particularly effective when beneficiaries have little or no income from other sources, so that their basic personal amount credit and low bracket rates might be accessed when otherwise left unused.

This practice, called ‘income sprinkling’, could be effective in the short-term, but the trustee would have to remain vigilant to carry out the even-hand duty among beneficiaries over the long-term.

A very useful tool for a trustee to tax-manage a trust, whether inter vivos or testamentary, is to employ elections for allocating tax liability on income. Subject to the trust terms and the Income Tax Act, income may be retained in the trust or paid out to a beneficiary, with associated taxes either paid by the trust, the beneficiary or both.

While not a serious cost issue in provinces like Quebec and Alberta, probate taxes or fees can be as much as 1.5% of incremental estate value, with no cap on the upper end. Probate avoidance is thus a common goal in estate planning, but it should not be pursued at all costs as it may in fact be a net negative benefit.

The simplified example in the following chart shows how an incremental $1,000 inheritance fares if it flows directly to a high tax rate spouse or incurs probate tax to flow to that spouse as beneficiary of a testamentary trust. The difference in values at the end of the first year is small, but by the end of the second year the trust option begins to show the benefit of graduated tax bracket treatment (as the probate tax only applies once), and that gap will widen in following years.