A testamentary trust is a common vehicle used in will and estate planning. Like grandfathered inter vivostrusts, testamentary trusts enjoy preferential tax treatment that is not available to ordinary inter vivostrusts. This may soon change, however, as the 2014 federal budget proposes to eliminate many of these tax advantages and create a level playing field for all trusts.
This article summarizes the proposed changes to the tax rules for the affected trusts, and considers the usefulness of testamentary trusts post-budget.
What is a testamentary trust?
A testamentary trust is a trust or estate that arises on, or as a consequence of, the death of an individual. By contrast, an inter vivos trust is a trust created during the lifetime of the settlor.
Proposed changes to the tax rules
The proposed changes to the tax rules in the 2014 federal budget would apply to grandfathered inter vivos trusts and testamentary trusts. The two exceptions to the proposed new rules are as follows:
- The first 36-month period of an estate that: a) arises on and as a consequence of an individual’s death, and b) is a testamentary trust. This type of estate is defined as a “graduated rate estate.” The 36-month period was seen as a reasonable period of time for the estate’s executor to administer and wrap up the estate, and to distribute the estate assets to the beneficiaries.
- A testamentary trust with an individual beneficiary who is eligible for the federal disability tax credit.
Flat top-rate taxation
Perhaps one of the most significant proposed changes is the elimination of the graduated tax rates (applicable to individuals) for testamentary trusts and grandfathered inter vivostrusts. Under the proposed rules, such trusts would be subject to flat top-rate taxation, similar to the taxation of ordinary inter vivos trusts. This would eliminate the benefit of creating multiple testamentary trusts under a will to take advantage of multiple sets of graduated tax rates for income retained and taxed in the trusts. In addition, it would remove the benefit of splitting income between the trust and its beneficiaries.
Exemption from income tax instalments
Testamentary trusts would have to pay quarterly tax instalments (if required), like individuals and inter vivos trusts.
Calendar year as taxation year
Existing testamentary trusts that have an off-calendar taxation year-end would have a deemed taxation year-end on December 31, 2015. An estate that exists at the end of its 36-month period would have a deemed year-end on the day on which the 36-month period ends, and would have a year-end of December 31 for the following taxation year.
Basic exemption for AMT
The basic exemption of $40,000 for alternative minimum tax (AMT) would no longer apply to testamentary trusts or grandfathered inter vivostrusts. However, even though the basic exemption would be removed, such trusts may be less likely to be caught by AMT post-budget, since they are subject to the highest personal tax rate.
Part XII.2 tax
Testamentary trusts would be subject to Part XII.2 tax.
Investment tax credits
Investment tax credits would have to be recognized in testamentary trusts, and it would no longer be possible to allocate them to trust beneficiaries.
“Personal trust” status
A testamentary trust would be subject to the same conditions as an ordinary inter vivos trust in determining its classification as a “personal trust.”
Tax administration rules that otherwise apply only to ordinary individuals
Ordinary individuals using testamentary trusts would lose the benefit of being able to extend the time period for filing a notice of objection or for filing an agreement to transfer forgiven amounts under the debt-forgiveness rules. In addition, it would no longer be possible to extend the time period during which the CRA may refund an overpayment of tax, or during which, at the trust’s request, the CRA may reassess the trust after the normal reassessment period for a tax refund or reduction in taxes payable.
Timing of proposed changes
The changes with respect to the deemed taxation year-ends would come into force on December 31, 2015. Other changes would apply to 2016 and subsequent taxation years.
Benefits and uses of testamentary trusts
In spite of the loss of preferential tax treatment for testamentary trusts if the proposed changes are approved, there could still be potential benefits to setting up such trusts, some of which are non-tax related. Here are a few examples:
Spousal testamentary trust
A spousal testamentary trust established under a will offers both tax and non-tax benefits. From a tax perspective, an individual can defer the tax on the deemed disposition of their assets at the date of death by transferring these assets to a testamentary spousal trust on a rollover basis. One tax disadvantage under the proposed rules is that the testamentary trust would be taxed at the top personal tax rate on the income earned on the trust assets, as well as the eventual deemed capital gain on the trust assets at the date of the spouse beneficiary’s death. Contrast this with a direct rollover to a spouse who will receive the graduated tax rates on income earned on the assets and on the disposition of the assets on the spouse’s death.
From a non-tax perspective, a spousal testamentary trust is often established by individuals involved in a second or subsequent marriage for the benefit of their surviving spouse during the spouse’s lifetime, with the testator’s children receiving the trust assets following the death of the spouse beneficiary. If, by contrast, the assets are gifted outright to the surviving spouse, he or she then has the power to decide who should receive the assets after their death, which means they could leave the testator’s intended beneficiaries high and dry.
Trusts with disabled beneficiaries
Under the proposed changes, preferential tax treatment would still be available to a testamentary trust with a disabled beneficiary who is eligible for the federal disability tax credit, just as the preferred beneficiary election is now only available to a disabled beneficiary.
“Kiddie tax” does not apply to income from a property or taxable capital gains on the disposition of a property inherited from a minor’s parent as a consequence of the parent’s death, or of a property inherited from any person as a consequence of their death if the beneficiary is disabled and eligible for the federal disability tax credit. Therefore, a testamentary trust could allocate income from such property to a minor beneficiary without being caught by the kiddie tax rules.
Income splitting opportunities
A discretionary testamentary trust would have the same benefits as an inter vivos trust in that it would allow for income splitting among the trust’s beneficiaries.
Other non-tax reasons
A testamentary trust enables testators to:
- Prevent beneficiaries from gaining control of assets;
- Protect assets and possessions from beneficiaries’ creditors;
- Manage and protect assets for beneficiaries who are minors, beneficiaries with disabilities, and beneficiaries who are spendthrifts; and
- Eliminate probate fees on assets held in a trust in the event of a beneficiary’s death.
Planning for testamentary trusts
If the proposed changes are passed, changes in planning for testamentary trusts will be required. These changes may include the following:
- Existing multiple testamentary trusts may be consolidated into one trust to reduce administrative costs, unless there are other reasons for keeping the trusts separate.
- Trust income may be allocated to beneficiaries who are in a lower personal tax bracket instead of being retained in the trust to be taxed at the highest personal tax rate.
- If control and/or asset protection are not issues, it may be preferable to distribute estate assets directly to the individual beneficiaries instead of distributing estate assets to testamentary trusts created by the will.
- Individuals who are taxed at the highest tax rate on death and who are concerned about probate tax may avoid probate tax on death by transferring assets to alter-ego or joint-partner trusts on a tax-deferred basis. The capital gains tax on the assets on death will be at the highest tax rate whether they are held personally or in the trusts. Prior to the proposed changes, the advantage of graduated tax rates for one or multiple testamentary trusts was often compared to the savings on probate tax—all other things being equal.
Readers are cautioned that client planning will depend on each client’s unique situation and that all tax and non-tax considerations should be taken into account.
Jackie Wong is a tax manager with Grant Thornton LLP in Vancouver, where she specializes in tax planning for privately held businesses.
- Refers to inter vivos trusts created prior to June 18, 1971.
- At the time of this writing in late April 2014, the proposed legislation had not been enacted.
- As defined in subsection 108(1) of the Income Tax Act (the Act). There are some conditions that can disqualify a trust from being a testamentary trust, but they are beyond the scope of this article.
- Proposed definition in subsection 248(1) of the Act.
- Part XII.2 tax is imposed on “designated income,” which includes taxable capital gains from the disposition of taxable Canadian property and income from a business carried on in Canada (generally, income a non-resident earns in Canada that is subject to Part I tax in Canada).
- A “personal trust” status provides certain benefits under the Act.
- Subsection 164(1.5) of the Act.
- Subsection 152(4.2) of the Act.
- Kiddie tax is tax applied on split income allocated to beneficiaries under the age of 18 (“minor beneficiaries”) at the end of the tax year.
- Refers to inter vivos trusts that are taxed at the highest tax rate.