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Why Use Testamentary Trusts in Estate Planning?

Why Use Testamentary Trusts in Estate Planning? 

Testamentary Trusts have been a popular and favored estate planning tool for a variety of reasons, one of which was tax benefits.  A testamentary trust is a trust established by a person as a result of his or her death for the benefit of another person.  If you are new to trusts, and would like to read information about the legal requirements to establish a trust and why you might consider using a trust, see our introductory article about trusts.

Changes to the Taxation of Trusts

Prior to January,1, 2016, a testamentary trust was treated by the Income Tax Act (Canada)  as a separate taxpayer from the deceased’s estate and from the trust’s beneficiaries.  Testamentary Trusts did have the benefit of graduated income tax rates applicable to individuals generally.  The federal government has recently made amendments to the Income Tax Act effective January 1, 2016 changing tax rules for certain trusts, including testamentary trusts, including:

  1. a process to eliminate the graduated income tax rates for the taxation of testamentary trusts;
  2. taxing accrued capital gains of in spousal, alter ego and joint partner trusts in a deceased beneficiary’s hands instead of in the trust itself (which puts the assets of the trust in the hands of the beneficiaries of the trust while leaving the tax liability in the hands of the deceased’s estate); and
  3. allowing a charitable donation in an estate plan to be allocated between the deceased and their estate.

The federal government’s explanation for these amendments is to perceived estate planning “abuses” through the creation of multiple testamentary trusts, and to combat tax-motivated delays completing estate administration. The new rules do allow an estate or trust to file an election with Canada Revenue Agency to claim “Graduated Rate Estate” status.  This will entitle the estate to the benefit of graduated income tax rates for three years from the terminal date of death tax return.  A person can only have one graduated rate estate and an election must be filed with CRA to claim that status.

In addition to losing graduated tax rate treatment, the new rules require affected trusts and a graduated rate estates (i.e. an existing testamentary trust) to select a December 31 year-end and to lose other benefits, such as:

  1. quarterly tax installments must now be made;
  2. the exemption from Canadian capital gain allocated to non-resident beneficiaries is eliminated;
  3. the trust cannot allocate investment tax credits to beneficiaries;
  4. shortening the time to file a notice of objection to an assessment to the regular 90 days applicable to other taxpayers; and
  5. Eliminating the ability for the trust and a beneficiary to split income earned by a trust.

Clients have asked if the first two changes have made their testamentary trust planning obsolete.   The answer to this question is for the most part “no”.   While these Income Tax Act amendments do eliminate the tax advantages previously enjoyed by using testamentary trusts, they do not eliminate the other legal and estate planning objectives accomplished using trusts and those objectives often are the main reason people use testamentary trusts in their estate planning.

The person making the trust should consider whether special authority should be put into the terms of the trust to address whether having the assets of the trust in the hands of the beneficiaries of the trust while having the tax liability in the hands of the deceased’s estate is a problem.  The Income Tax Act does provide that a trust or beneficiary and a person’s estate can be jointly and severally liable for this tax liability, to ensure Canada Revenue Agency can follow the money if the estate has no money to pay the tax owing by it.  This can be used to draft the documents to clearly impose responsibility to pay tax payable on the deemed disposition of assets in a trust to the trust or it’s beneficiaries.  This is done by providing in the documents that the estate not pay tax on assets in the trust and that the trust be charged with liability to pay that tax on the trustee of the trust, or even the beneficiaries of the trust.

Trusts for Disabled Beneficiaries Can Still Benefit from Graduated Income Tax Rates

Thankfully, testamentary trusts established for disabled beneficiaries (known as a “Qualified Disability Trust”) will continue to be eligible for graduated income tax rates.   A Qualified Disability Trust is a testamentary trust that is considered resident in Canada (i.e. it is managed by a trustee resident in Canada) with one or more beneficiaries who qualify under the Income Tax Act for a disability tax credit certificate.

Importantly,  a regular testamentary trust which will no longer has the benefit of graduated tax rates, can later become a Qualified Disability Trust if the capital beneficiary of the trust subsequently becomes disabled and become eligible for the disability tax credit.

Benefits of Charitable Giving are Preserved

Planned giving, or charitable giving in estate planning continues to be promoted under the Income Tax Act.  Beginning on January 1, 2016, a donation can be allocated between the deceased (on his or her terminal tax return) and his or her estate. The deceased’s tax filers may also apply the donation credit in the year of death or in the immediately preceding year. Alternatively, the graduated rate estate may use the donation in the year of the donation, or carry it back to any of its prior taxation years, or carry it forward for up to five years.

The avoidance of capital gains tax on the charitable donation of publicly traded securities remains in place; however timing and valuation variables remain.   Depending on your anticipated tax position at your death, a properly planned charitable gift included in your estate plan can effectively avoid the payment of tax and set aside that money for a desired charitable purpose.  That provides many clients with a good feeling of accomplishment.

Why Trusts Remain Useful

Regardless of the changes to the taxation of trusts, they remain useful and should still be considered for estate planning for other reasons which have not changed by these amendments.  The remaining purposes or advantages of using a trust include:

  1. If the beneficiary of the trust becomes disabled in the future, then the trust can become a Qualified Disability Trust and benefit annually from graduated income tax rates.
  2. Providing for or benefit and improve the quality of life of a beneficiary who is either too young to have access to such money.
  3. Providing effective financial management for the benefit of someone who cannot be trusted to manage the money wisely or responsibly for any other reason.
  4. Providing for more than one generation in the family in circumstances when you might want to preserve capital for the benefit of future generations.
  5. Establishing an endowment for a charity or for a charitable purpose dear to your heart, especially when you cannot count on your other beneficiaries to do so.
  6. Protecting capital you leave behind from your beneficiary’s creditors and even their own spousal claims.
  7. Providing for a subsequent spouse or partner while preserving capital remaining for children of a prior relationship.
  8. Preserving and distributing your wealth (using family trust, alter-ego trust or joint partner trust) outside your personal estate to avoid probate fees and the probate process.
  9. Avoiding wills variation claims which can potentially be made against your estate by a spouse or child who may be unhappy with your estate planning for them.
  10. Using Trusts as an incapacity planning tool that cannot be overridden by a Committee application under the Patients Property Act.

The loss of the previously described tax benefits for these trusts makes the process of assessing whether the benefits of doing so outweigh the ongoing costs to administer the trust more challenging; however, important benefits can still be achieved from the use of trusts in estate and incapacity planning, making their use worthwhile.

An executor cannot create a testamentary trust from a simple bequest in a Will or a simple beneficiary designation in a life insurance policy or registered account.  If however the Will or beneficiary designation includes a testamentary trust, it can be used to take advantage of the benefits of a trust and it can be overridden if there is any change in circumstances which make the trust not worthwhile to have or maintain.  If a testamentary trust is well drafted it will provide the trustee with the discretionary authority to end or wind up the trust if the trustee determines the administrative effort and cost of a testamentary is not worth the effort.  That way, there can be an ongoing assessment of the benefits and costs of the trust and the trust will be able to exist if the need justifies it and the trust can be brought to an end if the trustee determines the disadvantages of having or maintaining the trust outweigh the advantages of doing so.

If you have any further questions about the effect of these tax rule changes concerning trusts, or regarding the use of trusts generally in your estate planning or incapacity  planning, please contact us.