Tag: Trust taxation

Testamentary trusts: Tax cutter, practice builder

Rules in the Income Tax Act (Canada) governing trusts enable beneficiaries under a Will to receive their entitlements in a tax-advantaged manner. 

For financial advisors – apart from enhancing after-tax investment returns – trusts can be an effective means for bridging over to the next generation of clients. 

This month’s column reviews the nature of trusts, variations for using them to reduce taxes and some of the key creation criteria to be aware of.

Key elements of trusts

A trust is a taxable entity but it is not a legal entity. Rather, a trust is a property relationship among three elements:

Settlor – The original property owner who creates the trust

Trustee – The new legal owner and manager of the trust property

Beneficiary – The new beneficial owner for whom the property is managed  

While there can be only one settlor, there is no limit on the number of beneficiaries. Likewise, there is no limit on the number of trustees, though for practical reasons one trustee is usually sufficient, with perhaps two or three named in complex situations requiring specialized skills. 

Why use trusts?

Property may be placed in trust for a number of reasons, including: 

Protective care 

Creditor protection

Business planning, and

Tax advantage, particularly in managing an estate 

Tax advantages of testamentary trusts

One of the main distinctions among trusts is between those created during a person’s lifetime (inter vivos trusts) and those created at death (testamentary trusts). There are little or no tax benefits to using inter vivos trusts.

All trusts are separate taxpayers from their beneficiaries. This separation can be particularly valuable for testamentary trusts as they are entitled to marginal tax bracket treatment similar to individuals, though they cannot claim personal tax credits available only to natural persons. 

As an example, if a beneficiary in the top tax bracket receives an inheritance directly, almost half the related income will be lost to taxes. By comparison, a testamentary trust set up for that beneficiary will pay less tax on every dollar earned up to the top bracket level, currently at $126,264 in 2009. Even at more modest levels, if the combined income of the trust and beneficiaries exceeds even the lowest tax bracket threshold, the door is open for an opportunity to save taxes.  

Tax-cutting strategies

Income splitting – The main strategy is effected by the settling of the trust itself, with the creation of a new taxpayer being the trust.

Spousal trusts – Tax-free spousal rollovers of capital property can be extended to one or more spousal trusts.

Income sprinkling – Selective distribution of trust income among beneficiaries can reduce the total tax bill for all beneficiaries.

Multiple trusts – The testator can create at least as many trusts as there are beneficiaries – more if life insurance is in place.

Long-term tax savings – Trusts can be effective tax-management vehicles for up to 21 years or more.

Obtaining the benefits

While a formal written trust document is not needed in all cases, to obtain the most desirable tax benefits, a well-considered estate planning process and clearly drafted Will are essential.

ED: Significant changes to trust taxation occurred in 2015, eliminating many of the tax-reduction benefits discussed here.

EstateWISE – Taxation of trusts

A trust is a common structure used in estate planning to hold property, but it is not a legal entity.  It is nonetheless a taxable entity, and may present some interesting tax advantages. 

Who is responsible for the payment of a trust’s taxes?

  • The trustee is required to manage the trust property for the beneficiary, and part of that responsibility is to maintain tax records and to file tax returns when required.
  • In fact, it is the residence of the trustee, not the beneficiary, that determines the province that holds taxing authority over the trust property.
  • If the trustee is in another country, in principle that country has tax authority … but the field of offshore trusts is a very complicated discussion beyond what we are addressing here.

For a trust resident in Canada then, how is it taxed?

  • The main distinction one has to make is whether the trust is “inter vivos” or “testamentary”
  • An “inter vivos” trust is one settled during a person’s lifetime, and it is taxed at the highest personal marginal tax rate of the province where the trustee is resident, which can approach 50%.
  • On the other hand, a “testamentary” trust is generally created out of a person’s Will and is taxed like an individual except that it does not get personal credits.  
  • Other than that, it is entitled to marginal tax bracket treatment so that it is taxed at roughly 20% on its first $30,000 or so of income and that tax rate creeps up to the top provincial rate as the trust’s income approaches about $115,000. 

Can you give an example of how a testamentary trust can be used to tax advantage?

  • A husband dies and leaves his GIC portfolio directly to his wife (in Ontario).  
  • She’s a doctor and already has a taxable income of $120,000.
  • Every dollar she earns in the portfolio will be subject to her personal tax rate of about 46%.
  • Had the husband instead set forth a trust in his Will with his wife a beneficiary, the early income of the trust would have been taxed at about 20%, and would not have reached 46% until well over $100,000 of investment income.  There would be $10-15,000 tax savings every year.

Does this only work for those with such large income?

  • Essentially if the income of the beneficiary and the income in the trust together break over a marginal tax bracket (as low as $35,000) then there may be an opportunity to save taxes.
  • The costs of setting this up can be as little as adding a few paragraphs to your Will — but make sure you have your lawyer do it because if it is done incorrectly it may be treated as an inter vivos trust or it may be collapsed immediately thus losing the tax benefits.