Testamentary Trusts

FORUM Magazine

2013-05-07


It’s been nearly two months since the 2013 federal budget and while you’ve likely focused most of your attention on the government’s plans to shut down leverage insured annuities (or “triple back-to-backs”) and “10/8 arrangements” you may have missed that the government also intends to launch a consultation on the future of the taxation of testamentary trusts. This potential change could have a significant impact on the wills and estate planning of many of your clients.

What is a testamentary trust?

A testamentary trust is an estate planning tool and describes a relationship that allows property to be managed by one person, typically called your estate trustee, for the benefit of another, called your beneficiary. So, instead of leaving an asset directly to a beneficiary under your will, you could create a testamentary trust and name a trustee who would manage the assets on behalf of the beneficiary under terms you specify. The term testamentary means that the trust arises as a consequence of your death.

Leaving assets in a testamentary trust can offer a number of benefits over direct gifts including control over the timing and amount of distributions to beneficiaries, flexibility in structuring payments to beneficiaries, reduced probate fees (where applicable) and maintaining privacy for your estate.

But trusts can also be used to lower tax bills for the surviving beneficiaries, who are often family members, through “post-mortem income splitting.”

Post-mortem income splitting

For tax purposes, a trust is considered to be a separate individual for tax purposes such that any income earned on the funds invested inside the trust is taxed as if the income was earned by a person who is separate from the individual setting up the trust, the trustee or its beneficiaries. One significant difference between an “inter vivos” or family trust, which is established during your lifetime, and a testamentary trust is the tax rates that are applied to trust income.

An inter-vivos trust pays tax on all its income at the top personal marginal tax rate, which can be as high as 50%, depending on the trust’s province of residence. In a testamentary trust, however, the progressive graduated personal tax rates apply, resulting in lower tax rates on the first $135,000 of trust income. This can result in tax savings as high as $20,000 annually, which will vary by province, when income is taxed in a testamentary trust instead of perhaps in the hands of a high income beneficiary had they inherited the funds directly and subsequently invested them.

Example – Jack & Diane

To illustrate, here’s an example using a couple whom we’ll call Jack and Diane. Let’s suppose Jack names his wife, Diane, as the beneficiary of his $2 million life insurance policy and that Diane invests the insurance proceeds to earn $100,000 of taxable investment income annually after Jack’s death. If Diane already has other income that puts her in the highest tax bracket, she would pay combined federal and provincial income tax on the investment income ranging from $39,000 to $50,000 annually, depending on her province of residence.

If Jack, instead, leaves the insurance proceeds in a trust for Diane, either under a beneficiary designation or in his will, the $100,000 of annual income could be taxed inside the trust. The testamentary trust isn’t taxed at the top marginal tax rate like Anne is on the additional income, but rather is taxed at progressive, graduated rates. The result is that only $25,000 to $32,000 of tax would be payable on trust income annually, depending on the province, which could yield tax savings of $14,000 to $18,000 each year after Jack’s death. After the income is taxed inside the trust, it could then be paid out to Diane as a non-taxable distribution. While this example illustrates savings from life insurance policy proceeds, tax savings can be realized when any income-generating asset is placed into testamentary trust. And the savings could be multiplied by establishing multiple testamentary trusts for other beneficiaries, such as Jack and Diane’s adult children.

Consultation process

As the government pointed out in its federal budget document, “the taxation of testamentary trusts…at graduated rates allows the beneficiaries of those trusts to effectively access more than one set of graduated rates. This tax treatment raises questions of both tax fairness and neutrality in comparison to the treatment of beneficiaries of ordinary inter vivos trusts and taxpayers receiving equivalent income directly.”

The budget also indicated that the government was concerned with the growth in what it called the “tax-motivated use of testamentary trusts and the associated impact on the tax base.” As a result, the government is planning to issue a consultation paper to the public on whether the tax benefits that arise from taxing income inside testamentary trusts at graduated rates should be eliminated.

Whether the benefits of testamentary trusts will continue indefinitely is an important matter to discuss with your clients, especially when considering the use of such a trust as the beneficiary of a life insurance policy.