Is it Time for a Testamentary Trust?
One thing that can go overlooked by many estate planners is the use of trusts. This is a pity, because trusts can provide significant tax and non-tax benefits to those that use them. The Canada Revenue Agency (CRA) recognizes two basic types of trusts that everyone should be aware of. They are the inter-vivos and testamentary trusts. The advantages of testamentary trusts is explored below.
Trusts are legal entities, like corporations. They must file their own income tax return, called a T3 and exist separately from the people that created it. In order to create a trust, three roles must be played. These are the roles of settlor, trustee and beneficiary. The settlor is the person whose assets are to be entrusted to the trustee, and the trustee is to manage those assets for the sole benefit of the beneficiary. The settlor and the beneficiary may actually be the same person in some cases. When a trust is created, legal title to the assets are transferred from the settlor to the trustee. For this reason, careful consideration must be given towards the selection of a trustee. They should possess the necessary skills in order to manage the assets entrusted to them, as well as be an individual (or organization) that the settlor is comfortable handing their assets over to.
A testamentary trust is a trust that arises on the death of an individual whose will calls for the creation of such a trust. The terms of the trust will be stipulated in the will and provide for such things as the payment of income or capital or both to the beneficiaries. The payment of benefits can be fixed in the will or be left to the discretion of the trustee. This can have several advantages if the trust is to be professionally managed and intended to provide a long-term stream of income to the beneficiaries.
Taxation of Testamentary Trusts
As previously stated, a testamentary trust is treated as a separate taxpayer under the Income Tax Act and must file a return reporting the income, gains and distributions to beneficiaries made in each year. Taxes are payable in the province of residence, or situs, of the trust. This is typically the same as the residence of the trustees. Trusts will generally have a calendar year-end, but that is not a requirement. Payments and distributions made to the beneficiaries are generally deducted against the income and capital gains made by the trust but any net income remaining in the trust is taxable at the appropriate marginal rate as if the trust were an individual. This contrasts with an inter-vivos trust, which is taxed at the highest marginal rate regardless of the net income earned by the trust. Distributions are then taxed in the hands of the beneficiaries as income.
Although trusts don’t receive the personal deductions available to individuals, the graduated rates on testamentary trusts make it much more beneficial to retain income and gains in the trust rather than be taxed in the hands of the beneficiaries if it means realizing a lower marginal rate. This is the main tax benefit to putting income producing assets in a testamentary trust. Being a separate taxpayer, the income produced by the trust will not be added on top of the income produced by the beneficiaries and taxed at higher rates.
Because testamentary trusts arise on the death of an individual, there will be a deemed disposition at fair market value of all property held by the settlor under the Income Tax Act. This forces the realization of capital gains even though the property has not yet been sold. This gain is taxed in the hands of the testator’s estate. Furthermore, since the assets pass through the estate before arriving in the trust, probate taxes will also be applied. The estate plan will need to address these gains and how to pay tax on them. Testamentary trusts are, however, able to avoid double probate tax. Even though assets initially placed in a trust are subject to probate taxes, the trust can dispose of the property at a later date thereby avoiding a second round of taxes.
All trusts in Canada are subject to the 21 year deemed disposition rule in the Income Tax Act. This provision deems that all property held by a trust is disposed of at fair market value every 21 years and any gains created by such accounting are taxed at that time.
Non-Tax Benefits of Testamentary Trusts
One of the main benefits of trusts is that they provide property owners with a powerful way to ensure that their assets are applied in the manner they describe. Since the trustee has legal title to the assets it is easier to set up and administer how family members and other beneficiaries can access the property. The trustee can take care of any repairs and maintenance as well, provided the trust produces enough income to offset the required expenditures.
Depending on the terms of the trust, beneficiaries and third parties typically have no right to demand that the assets of a trust be handed over to them. This is particularly useful in creating a protective barrier around your assets from the claims of beneficiaries’ creditors.
The use of trusts is a powerful estate planning tool that has significant tax and non-tax benefits. They are particularly useful for wealthy families and individuals seeking professional administration of their assets, tax efficiencies and legal protection.