Category: Advisor’s Edge / advisor.ca

Strategic use of trusts: Managing for tax advantage

The settlement of a trust is a simple step that opens the door to sophisticated wealth planning opportunities.  

In last month’s issue, we touched on the requirements for a trust to come into existence, and canvassed some of the most common ways trusts may be characterized for tax purposes.  

Ultimately though, reducing trust taxes is but an intermediate step toward the ultimate purpose of providing optimal benefit to beneficiaries.  Following are some further ways that a trustee’s careful decision-making can deliver that value to those beneficiaries. 

Income splitting

As a starting point, if settled through a person’s Will, a trust will obtain testamentary treatment, meaning access to graduated tax rates for income reporting.  This obviously compares favourably with the top marginal tax rates that apply to inter vivos trusts (those settled during lifetime).  In effect, the deceased person continues to be somewhat present from a tax perspective.  

It is actually possible to multiply this benefit by establishing multiple trusts, though within limits dictated by the Income Tax Act.  Essentially, only one such trust may be created for each beneficiary designated under a Will.  Still, that’s a side-by-side graduated tax rate vehicle for each person a testator wishes to benefit out of an estate.  

In addition and as discussed in last month’s article, CRA has acknowledged that separate testamentary trusts may be established out of life insurance proceeds and RRSP/RRIF receipts.

Selecting the year-end

The year-end of a testamentary trust may be elected as any day in the full year following the relevant death.  A trustee may use this election to strategically delay income recognition, as beneficiaries must report an income distribution from a trust in the beneficiary’s tax year in which the trust’s year-end falls. 

To illustrate, if a beneficiary receives an income distribution in February Yr 1 from a testamentary trust with a January 31 year-end, that income is deemed to be received on January 31, Yr 2, with the tax due with the filing of the beneficiary’s Yr 2 T1 return in April Yr 3.

Income sprinkling

Beyond initial creation of the trust, there is an art and science to year-to-year trust tax management.  For example, a trustee could selectively distribute annual trust income among beneficiaries to reduce the long-term total tax bill for all beneficiaries.  This could be particularly effective when beneficiaries have little or no income from other sources, so that their basic personal amount credit and low bracket rates might be accessed when otherwise left unused.  

This practice, called ‘income sprinkling’, could be effective in the short-term, but the trustee would have to remain vigilant to carry out the even-hand duty among beneficiaries over the long-term.  

Allocations and elections

A very useful tool for a trustee to tax-manage a trust, whether inter vivos or testamentary, is to employ elections for allocating tax liability on income.  Subject to the trust terms and the Income Tax Act, income may be retained in the trust or paid out to a beneficiary, with associated taxes either paid by the trust, the beneficiary or both.   The table below illustrates how this may operate:    

Taxed to Trust, Allocated to Trust

This is full retention of both income and tax liability in the trust.  One possible application would be a testamentary trust where the beneficiary is at top marginal tax rate and does not need immediate cash.  

From a non-tax motivated view, spendthrift and/or creditor protection trusts may be designed this way.

Taxed to Beneficiary, Allocated to Trust

In limited circumstances, tax liability may be elected to a beneficiary, while income remains in the trust, such as under the “preferred beneficiary election” for a disabled beneficiary.  

At a minimum, enough income would be allocated to use the beneficiary’s basic personal credit, effectively eliminating the tax on that income.

Taxed to Trust, Allocated to Beneficiary

Where the beneficiary needs or must be paid the income, it may be possible to elect to tax the income in the trust.  

For example, a qualifying spousal trust, inter vivos or testamentary, is required by the ITA to pay annual income to the spouse beneficiary.  The tax election decision would rest mainly on whether the spouse or trust has the lower tax rate.

Taxed to Beneficiary, Allocated to Beneficiary

The usual treatment of income is that it is distributed to income beneficiaries as it is earned annually, and the tax liability follows.  

As well, even if a trustee could act more strategically, he/she may decide that tax benefits of retaining income are nominal or outweighed by other considerations, and therefore a full distribution may be the best approach.

A final thought on probate

While not a serious cost issue in provinces like Quebec and Alberta, probate taxes or fees can be as much as 1.5% of incremental estate value, with no cap on the upper end.  Probate avoidance is thus a common goal in estate planning, but it should not be pursued at all costs as it may in fact be a net negative benefit.  

The simplified example in the following chart shows how an incremental $1,000 inheritance fares if it flows directly to a high tax rate spouse or incurs probate tax to flow to that spouse as beneficiary of a testamentary trust.  The difference in values at the end of the first year is small, but by the end of the second year the trust option begins to show the benefit of graduated tax bracket treatment (as the probate tax only applies once), and that gap will widen in following years.

TABLE

                                                                           Direct         Estate/trust

A) Value of benefit                                     $ 1,000.00           $1,000.00

B)  Incremental probate tax (using 1.5%)              n/a                  15.00   

C)  Net funds to invest                                   1,000.00               985.00

D) Annual income (using 5% interest)               50.00                 49.25

E) Tax (using spouse 40%, trust 20%)               20.00                   9.85

F) Net income                                                     30.00                 39.40

G) Value at year-end  [ C + F ]                   $ 1,030.00         $ 1,024.40

H) Value at 2nd year-end                            $ 1,060.90         $ 1,065.38

Strategic use of trusts: Legal Principles

The trust has been around for centuries as a device for the planning, protection and transition of property. Once perceived as the preserve of the affluent, trusts can now be woven into solutions — simple to sophisticated — across the spectrum of wealth holdings.

Investors have the potential to strategically manage who’s liable for income tax, and how and when such taxes are paid. And for financial advisors, a trust can be a tax-friendly platform to house clients’ current and estate investments, with minimal or no downside.

Settling a trust

A trust is the description of a property relationship, whereby an original property owner separates ownership interests into legal authority and beneficial entitlement. The original owner (person or corporation) is the settlor, the new legal owner is the trustee and the new beneficial owner is the beneficiary.  

Interestingly, a trust is not a legal entity but it is a taxable entity. The trustee is required to file tax returns for the trust, generally in that trustee’s resident jurisdiction. 

Inter vivos v. testamentary

There are little or no tax benefits available through the use of inter vivos trusts, those settled during lifetime. They are taxed at top marginal rates, cannot claim most personal tax credits (those intended for natural persons, such as the basic personal amount), and must report income on a calendar year basis.

On the other hand, a testamentary trust settled using a will could be used very effectively as a long-term tax management vehicle. While it similarly cannot claim those personal credits, it is entitled to apply graduated tax rates up through the combined federal-provincial marginal brackets. The year-end of a testamentary trust may be elected as any day in the full year following the relevant death (See “Comparing inter vivos and testamentary trusts,” this page). 

TABLE

Comparative            Inter vivos                                  Testamentary

Settlement               During lifetime or deemed so     At death, usually by Will

Tax benefit              Little or none                              Bracket management

Tax bracket             Highest bracket rate                    Marginal bracket rates

Year-end                 Calendar                                      Flexible

Tax-informed trusts

Apart from the graduated tax treatment of testamentary trusts, there are other trust tax attributes that may be accessed, depending on circumstances. In fact, a given trust may fall under more than one of these following characterizations (among other possibilities).

Qualifying spousal trust 

Property may be rolled at cost base into a QST, either while living or at death. The spouse is entitled to all income for life, and nobody else may receive any capital before that spouse’s death. This could be used to ensure that a spouse has reasonable access to a residence and/or investments for life, while preserving and protecting the ultimate distribution to the couple’s mutual children (as opposed to a later spouse and/or subsequent children).

Alter ego and joint partner trusts 

These trusts, available after 1999 for those aged 65 and above, allow an individual or couple to effectively retain indistinguishable use of selected property for life, with distribution on death to contingent beneficiaries. Mainly, it enables probate tax avoidance, but there can be unexpected income tax complications if it isn’t carefully managed. For example, capital losses in a trust cannot offset personal capital gains (or vice versa), which could be particularly costly on death, or last death of spouses. 

Life insurance proceeds 

CRA allows plan proceeds to be directed to a testamentary trust outside of an estate, possibly effected as simply as naming a trustee for a beneficiary on insurer forms. However, under such a bare designation, the trustee may merely be a conduit for delivery of those funds to the beneficiary at the age of majority. If ongoing management is intended, the trustee’s powers should be more explicitly defined in a formal trust indenture.

RRSP/RRIF receipts 

Again, CRA allows the direction of plan receipts to a testamentary trust outside of an estate. The additional hook here is that whereas life insurance proceeds are tax-free, RRSP/RRIF receipts give rise to a tax liability to the deceased. Accordingly, it is prudent to have trust terms that explicitly state whether and how the tax will be apportioned between the estate and the RRSP/RRIF trust.  

Charitable remainder trusts 

A charitable remainder trust allows a settlor to make a lifetime donation of the remainder interest of property, but retain a life interest personally. The donor can then claim the net present value of the capital interest for the associated charitable tax credit currently, rather than leaving the tax benefit of the donation to his or her estate. 

Non-resident trusts 

As a trust is taxed where the trustee is resident, in theory it may be possible to arbitrage tax rates where the trustee is in a lower bracket jurisdiction as compared to the beneficiary’s location. That said, non-resident trust tax rules generally cause trust income to be recorded in the hands of a Canadian resident beneficiary, whether that trust income is realized or not. On a province-to-province basis, provincial general anti-avoidance rules — or a specific rule for the province of Quebec — may be used to combat such inter-provincial tax avoidance.  

Immigration trust 

An exception to the general rules of non-resident trusts is made for trusts established by non-residents prior to immigrating to Canada. Originally enacted to allow for simplified tax rules applying to business people temporarily relocated to Canada, these trusts can be effectively used to transition an immigrant’s wealth into the domestic tax system, allowing up to a 60-month tax holiday until the trust is subject to tax in Canada.

Next issue we’ll look at how a trustee can strategically manage the operation of a trust for ongoing tax efficiencies.

Foolproofing education: Complement RESP savings with in-trust accounts

Sometimes learning how to fund an education is an education in itself. 

The foundation for this exercise is the Registered Education Savings Plan, but with the cost of post-secondary education continuously rising, make sure your clients aren’t fooling themselves into believing that blindly maxing out RESPs puts their children at the head of the class.

Quite to the contrary, well before reaching the maximum RESP limit, it may be prudent to allocate some dollars to an in-trust account. Humble though it may seem at first look, a trust for a minor child could provide significant tax benefits that can make the overall plan much more effective.

Deconstructing the RESP 

Three core tax features make the RESP a valuable education savings vehicle. First, though not tax-deductible, contributions may be augmented through federal grant money, as well as from some provincial assistance. 

Second, while inside the plan, the savings are entitled to tax deferral on growth and income earned. Assuming later schooling proceeds as the rules require, income recognition will be delayed for years or even decades.

Third, when grant money and investment growth are withdrawn as education assistance payments (EAPs), that growth is taxed to the student beneficiary, as opposed to the (presumed) higher marginal tax rate parent or grandparent contributors.

And remember those non-deductible contributions? That component can come back to the subscriber tax-free. Be careful though, as this could mean loss of future grants for a time — an important reminder that strategic coordination of contributions, investments and drawdown is a must for the RESP investor and advisor.

In-trust account for a minor

So how do the tax features of a trust compare to the RESP? In particular, how can an in-trust account for a minor work in coordination with an RESP?

As with an RESP, contributions come from after-tax funds. Annual income is either taxed to the trust (at top marginal rate) or attributed to the parent as “settlor” in trust law. A significant exception is that capital gains may be distributed and taxed to the minor child. And, attribution ceases if the settlor dies, or when the child reaches age 18.

Clients also should be aware the CRA may require proof the account is managed as a true trust. Failing that, all income and related taxation may be treated as that of the settlor or trustee personally. 

If a higher degree of control over trust funds is desired, including keeping the property in trust beyond age of majority, it may be prudent to execute a formal trust indenture document. 

Clearly, matching government grant money is a strong incentive to invest in an RESP. These instruments, in essence, provide an immediate return of 20% or more on contributions. 

Above the matching grant level, however, a trust alternative may be the preferred option, particularly when long-term equity investments are planned. Not only may capital gains be taxed to the child, those investments can also generally be rolled out at cost base to that child, further deferring tax on unrealized gains. 

Had the same investments been held in an RESP, the earnings and growth would be completely deferred until withdrawal, but would be fully taxable as regular income to the beneficiary child.

But should the child not attend a qualifying program (and assuming no sibling or subscriber RRSP rollover), all grants must be returned, and the subscriber will be taxed on the growth, including a 20% penalty tax. 

Conversely, while an in-trust account is often established with the intention of assisting with later education, legally it need not be restricted to that purpose.