A testamentary trust can be a very powerful estate-planning tool. It offers tax-planning opportunities as well as the flexibility and control over the use and distribution of the deceased's assets.
A trust is unlike a corporation in that a trust is not a legal entity but is simply a type of relationship that separates the legal ownership of property from the beneficial use and enjoyment of that property. There are a number of parties in a trust arrangement: the settlor entrusts the legal ownership of assets to someone else, the trustee. It is then the trustee's responsibility to manage the property of the trust according to a legal document (either the trust deed or the will) for the benefit of another, the beneficiary.
What is a testamentary trust?
A testamentary trust is a trust (or estate) that arises on the death of an individual. It's generally created via an individualÕs will. The deceased's will sets out the terms and conditions of the trust, naming the capital and income beneficiaries, whether they have discretionary or fixed interests in the trust, and whether or not income must be paid annually or can be retained in the trust, among other conditions.
Often the trustee of the testamentary trust is also the executor of the will but need not be. The powers of the trustee under the will should be drafted in such a way that the trustees have the appropriate degree of flexibility to make appropriate investment decisions with regards to the assets in the trust.
Types of testamentary trusts
From a tax perspective, testamentary trusts can be divided into spousal trusts (both "qualifying" and "tainted") and non-spousal trusts. Under current tax parlance, the term "spousal" trust is still commonly used, although the tax rules treat both legally married and common-law partner (CLP) relationships (both opposite and same-sex) as equal. Spousal trusts offer unique tax consequences not available to non-spousal trusts.
Qualifying spousal trusts
A "qualifying" spousal trust is a trust that is resident in Canada under which the deceased's spouse or CLP is entitled to receive all of the trust's income while he or she is alive, and prevents anyone – other than the surviving spouse or CLP – from accessing any of the income or capital until after the death of the surviving spouse or CLP. If a spousal trust does not meet the above criteria, it's known as a "tainted" spousal trust. There are tax benefits of maintaining a testamentary spousal trust as a qualifying trust, which will be discussed, so it's important that the trust is not tainted.
Advisors need to be careful to ensure the wording in the trust does not provide for accidental tainting. For example, a common clause that could create a problem is if the trust states that should the surviving spouse remarry, the assets in the trust may be distributed to the children. Regardless of whether the spouse remarries, this clause alone can cause the spousal trust to be tainted since the possibility of someone other than the spouse receiving the assets while the spouse is still alive exists.
The main advantage of having a qualifying (as opposed to a tainted) spousal trust is in the beneficial tax treatment available to the deceased's estate for assets left to a qualifying trust. Upon death, the deceased is deemed to dispose of all of his or her capital property for proceeds equal to their fair market value (FMV). The primary exception to this deemed disposition is where property is left to a spouse, CLP, or the qualifying spousal trust. If so, the deemed disposition upon death is deferred and the property is transferred to the spouse, CLP, or the qualifying spousal trust at the adjusted cost base (ACB). As a result, there is essentially a rollover and the tax on any accrued gains is deferred until the property is either sold or until the surviving spouse or CLP dies.
It is possible to elect out of this automatic rollover and to have the property deemed to be disposed of at FMV at death. This may be beneficial if there were substantial capital losses in the estate that would otherwise go unutilized if not applied to these deemed capital gains.
The other major benefit of a qualifying spousal trust is that the "21-year rule," which states that the property of a trust is deemed to be disposed of on each 21st anniversary of the trust, will not apply. Instead, the deemed realization of capital gains will occur on the death of the spouse or CLP.
Tainted spousal trusts
A tainted spousal trust is similar to a qualifying spousal trust, with the primary difference being that the trustees have the ability to pay either income and/or capital not only to the surviving spouse or CLP but also to other beneficiaries, such as the children or grandchildren, while the spouse or CLP is still alive. From a tax point of view, the disadvantage of a tainted spousal trust is that any assets transferred to such a trust are transferred at FMV, resulting in a potential capital gains tax liability to the estate upon the transfer of assets to the tainted spousal trust. With proper planning, however, it still may be beneficial to establish a tainted spousal trust by selecting assets without accrued gains – such as cash and cash equivalents – to be transferred to the tainted spousal trust, leaving other appreciated assets to the qualifying spousal trust on a rollover basis.
MINI-CASE STUDY
Choosing a testamentary trust year-end
Miles Rich passed away on July 12, 2002, and established a testamentary trust in his will. The trustee chose a January 31st year-end for the trust and thus the trust filed its first tax return for the period from July 13, 2002, to January 31, 2003. Any income earned in the trust from July 13, 2002, to January 31, 2003, and payable to the beneficiaries of the trust, would be taxable to the beneficiaries in their 2003 tax return, which is due April 30, 2004. Thus a substantial tax deferral was possible by selecting an early year-end for the testamentary trust.
Taxation of testamentary trusts
Unlike intervivos trusts, which must have a calendar tax year (i.e., a December 31st year-end), testamentary trusts can choose their year-end. Since the tax year cannot exceed 12 months, a trustee of a testamentary trust has the ability to choose any year-end he or she chooses up to the first anniversary of the deceasedÕs death. This creates a tax-planning opportunity for the trustee of a testamentary trust in that he or she can provide for an ongoing one-year deferral by selecting an early tax year-end (see sidebar).
MINI-CASE STUDY
Tax savings with post-mortem income splitting
Jack and Jill are husband and wife. Currently, Jack’s will provides that if he should predecease Jill, all of his assets will be transferred immediately upon his death to Jill. Jill, who is already in the top tax bracket as a result of substantial other income and RRIF withdrawals, would pay tax on any additional income earned from Jack’s portfolio at the highest marginal rate.
To avoid this and to achieve post-mortem income splitting, Jack executes a new will wherein Jack’s assets are transferred upon his death directly to a testamentary trust for the benefit of Jill. Since the testamentary trust is considered to be a separate individual, it does not pay tax at the highest rate (as an intervivos trust would) but will pay tax at the various graduated rates.
The tax savings from this strategy can be substantial. For example, suppose Jack’s portfolio generated $105,000 (the lower income threshold of the highest tax bracket) of taxable income per annum. If the portfolio was left to Jill directly, who is in the highest marginal bracket of 45 per cent, the annual tax liability to Jill would be approximately $47,250. By establishing a testamentary trust and having the $105,000 taxed annually in the trust at the graduated tax rates, the testamentary trust will only pay tax of approximately $35,000, resulting in a net annual tax savings of $12,250.
Avoiding the "kiddie tax"
Another potential tax benefit to establishing a testamentary trust is to avoid the application of the tax on split income (the "kiddie tax"), which may be applicable to dividends paid on private company shares to minor children. The kiddie tax was introduced in 2000 and effectively eliminated one the most common tax-planning strategies for owner/managers. The owner/manager would have his or her children own shares of the private company through a family trust. Each year, the corporation would earn active business income, pay the small business rate of tax on income inside of the corporation, and have the after-tax amounts paid out as dividends to the children. Each child, generally with no other source of income, could receive approximately $24,000 of Canadian dividends completely tax-free because of the basic personal tax credit as well as the dividend tax credit. In 2000, this planning strategy was eliminated through the imposition of the kiddie tax.
The kiddie tax imposes a tax at the highest marginal rate on any Canadian dividends received by someone under the age of 18 from a related private corporation. In fact, not only does it tax these dividends at the highest rate regardless of the amount of other income that the child may have, but also it does not allow the basic personal tax credit to be used to shelter this dividend income. As a result, the possibility for splitting dividend income from a private corporation amongst children has been effectively eliminated.
An exception to this rule, however, is through the use of a testamentary trust established for minor children of the deceased. If private company shares are left to a testamentary trust, private company dividends could be paid to that trust and allocated out to the children beneficiaries to be reported in their hands. These dividends would not be classified as "split income" and the kiddie tax rules would therefore not apply since the income is considered to be from property acquired by the child as a result of a parent's death, an exception to the kiddie tax rules.
Non-tax advantages
Notwithstanding the tax advantages available through the use of testamentary trusts, there may also be substantial non-tax advantages of establishing such trusts. Trusts allow control over estate assets that would not be otherwise available where assets are left directly to beneficiaries. For example, insurance trusts can be used to leave proceeds of a life insurance policy to minor – or even non-minor – beneficiaries to ensure that the money is not spent prematurely and is invested wisely on the beneficiaries' behalf. In addition, testamentary trusts can be used to protect an inheritance in the case of a spouse or CLP who subsequently remarries and risks having the deceased's inheritance passed to the new spouse or CLP.
These are just two examples of the non-tax uses of testamentary trusts. More information and additional strategies can be obtained through discussions with other professionals and centres of influence, including lawyers, accountants, and tax specialists. And finally, as always, be sure that your client also receives his or her own independent legal advice before proceeding with any of the above strategies.