The testamentary trust is, potentially, an effective estate planning tool that you ought to consider when you retain a professional to draft or revise your will. A trust describes a relationship under which a person, called a trustee, holds property for the benefit of the beneficiaries. The term testamentary indicates that the trust is set up in a will.
This arrangement has a number of benefits: the testator will have greater control over the distribution of the assets, and it can be used as an effective tax planning tool. The most significant tax benefit is the opportunity for income splitting with the beneficiaries and the trust itself.
Income splitting refers to shifting income from a taxpayer paying a high rate of tax to another taxpayer paying tax at a lower rate. Accordingly, the income will be taxed at a lower rate. With a testamentary trust there are two significant ways to split income: with lower income family members and with the trust itself (which files its own tax return).
The only requirement to split income with lower income family members is that they be beneficiaries under the trust. Thus, if someone dies and leaves his assets to be held in trust for the benefit of his descendants, any income generated by the deceased’s estate can be accrued for the benefit of any surviving descendants, such as minor grandchildren or children, who may have little or no taxable income.
In Canada, every person is entitled to earn a certain amount of income tax-free (“the basic personal amount”); beyond that, income is taxed at graduated rates. Thus, the estate’s income can be neatly “split” among such family members to minimize the overall tax burden. Note that with a direct gift under a will there is no way to have the assets’ income split with low-income family members.
For example, if you were to leave an income producing asset as an outright gift under a will to one of your children, who is taxed at the highest marginal tax rate, he or she would not be able to split that asset’s income with your grandchildren. If, however, you leave that asset in trust for the benefit of your child and family, they would be able to split the asset’s income amongst all family members.
The other income splitting opportunity made possible by the testamentary trust is by accruing some of the estate’s income to the trust itself. A trust is taxed on its income in the same manner as other individual taxpayers. The trust files its own tax return, called a T3 Trust Income Tax and Information Return, and receives its own tax bill. Regular trusts are different than other taxpayers in that they do not pay taxes at graduated rates; instead, they are taxed on their income at the highest marginal tax rate. Testamentary trusts, however, enjoy graduated tax rates and this permits income splitting, as income can be retained and taxed within the trust at the same graduated rate structure as is available for a living individual (except for the basic personal amount).
It is important to note that the current graduated tax-rate for testamentary trusts may be eliminated in the future, most likely by 2016. In the 2013 Federal Budget, the Department of Finance announced that it will review how testamentary trusts are taxed and it released a consultation paper on June 3, 2013 which calls for testamentary trusts to have graduated tax-rates limited to the first 36 months. After that time, the testamentary trust would be subject to the highest-rate of tax on all of its income.
If you require assistance with estate and will planning and drafting including setting up a testamentary trust or you need advice on the current structure of your will or trust please contact one of our experienced tax and estate lawyers.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."