Wills and Testamentary Trusts:
What tax benefits might you be missing?
This newsletter focuses on an important part of the aspect of estate planning: the use of testamentary trusts in wills. Individuals who are beginning the estate planning process should consider whether a testamentary trust in a will should be used for tax benefits.
The use of trusts in wills.
Different types of trusts can be used in estate planning in order to achieve the wishes of the testators.
Trusts are often used in wills when minor children are the beneficiaries. Parents may set up trusts for children and appoint a trustee who is responsible for the assets of the trust until the children reach a particular age when they can manage the assets on their own.
“Spend thrift” trusts may be established when it is feared that an adult child is not responsible enough to receive all of his or her inheritance at once. With such a trust, a trustee may be directed to provide the child with an allocated amount out of the trust periodically, or discretion may be left with the trustee, or a hybrid approach may be taken where some funds are paid periodically with the trustee having discretion to pay and hold amounts.
While such trusts are important estate planning tools, the use of testamentary trusts in a will can also provide significant tax benefits to the beneficiaries and are often overlooked when drafting wills.
What is a testamentary trust?
Testamentary trusts and the tax benefits that arise from them result from the Income Tax Act (Canada) (the “ITA”). A testamentary trust is created upon an individual’s death pursuant to a will. The ITA defines a testamentary trust as a trust that arose on and as a consequence of the death of an individual.
Testamentary trusts differ from inter vivos trusts, which are created during the lifetime of the settlor, not only in how they are created but also in how they are taxed. Inter vivos trusts are taxed at a flat rate of tax equal to the highest individual marginal rate of tax, while testamentary trusts are taxed at marginal rates as described below.
Testamentary trusts also have the unique attribute of being able to elect for any year end, not exceeding 12 months for the first year end after the trust is established.
What is a spousal trust?
A spousal trust created in a will is one form of testamentary trust that can be used.
What makes a spousal trust distinct from other testamentary trusts is that section 70(6) of the ITA allows extra tax benefits for a qualifying spousal trust. In addition to the normal tax benefits of a testamentary trust, discussed below, all capital assets are transferred to the spousal trust on a tax deferred basis and no capital gains are payable at the date of death.
What are the tax benefits of using a testamentary trust?
As mentioned earlier, testamentary trusts allow for income splitting between the beneficiary and the trust. Without the trust, the assets will be direct assets of the beneficiary and the income generated from the assets will be added to the beneficiary’s income.
The trustee of a testamentary trust may elect in whose hands the income earned in the trust will be taxed – the trust, the beneficiary or a combination of the two. This provides the opportunity to realize the greatest amount of tax benefits.
By way of example, let’s look at a testator and his spouse. As is often the case, let’s assume that the testator gives all his assets to his spouse outright in the will with no other estate planning.
Any income that is generated from these assets will be taxed at the spouse’s marginal rate. If the spouse’s annual income is $100,000 and the other assets generated an income of $125,000, then her total income would be $225,000 and would be taxed at the top marginal rate, she would be paying approximately $90,000 in taxes.
Now, let’s look at the same income amounts but with the tax benefits of having the assets distributed to a testamentary trust.
The spouse’s annual income would be taxed as normal and she would pay about $30,000 on her personal income. The income earned on the assets in the trust would then be taxed at its own marginal tax rate and the tax payable would be about $40,000. By using the testamentary trust, the total tax payable by the beneficiary would be $70,000 – that’s $20,000 less tax in each year than without the use of the trust.
In fact, a trust need only generate $125,000 of income in a year in order to provide the maximum tax benefit of $25,000 based on the beneficiary’s income being in the top marginal tax rate.
Where the spouse does not earn any income personally, the tax benefits of the trust can still be used. Based on the same income-producing assets as above, the beneficiary would be able to save $10,000 per year in taxes by again splitting the income between her and the trust.
In both cases, significant tax savings can be realized with the simple interposition of a testamentary trust in the will.
What about trusts for children?
Testamentary trusts can similarly be set up for the children of a testator. As mentioned, trusts are often set up for minor children. However, testamentary trust can also be set up in a will for adult children so they can benefit from the same tax advantages outlined above. Depending on the value of the estate and the testator’s wishes, the testator may set up a trust for her spouse and, in the event her spouse predeceased her, testamentary trusts would be set up for her children.
Another option would be to set up testamentary trusts for both the spouse and the children, with assets being allocated to each trust in order to maximize the tax benefits. For example, assets that would have capital gains can be designated to the spousal trust in order to take advantage of the capital gain tax deferral and other assets can be designated to the children’s trust.
If a testator has three children, the marginal tax rates of the additional testamentary trusts for each of them could increase the total potential tax savings to $80,000 per year, depending on the personal income of each child and the income generated by the trust.
Testamentary trusts are an excellent estate planning tool that can allow for significant tax savings that continue for years.
Estate planning advice varies based on the circumstances, facts and wishes of the testator. Individuals should consult with their lawyer for specific planning strategies and preparation in order to determine how to best meet their needs.
This newsletter is produced by Wickwire Holm to keep our clients and friends informed of developments in the law and immerging issues. It is intended for general information purposes only. In preparing and circulating this newsletter, Wickwire Holm is not providing legal or other professional advice. Readers are urged to consult their professional advisers before taking any action on the bases of information contained in this newsletter.
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