A trust is a relationship among 1) a settlor (or testator in the case of a trust contained in a Will) who sets up the trust; 2) one or more trustees who hold legal title to assets; and 3) one or more beneficiaries who are entitled to the benefit of assets. Unlike a corporation, a trust itself is not a legal entity. However, the Income Tax Act of Canada (the “Act”) treats a trust like an individual for income tax purposes.
The Act has a graduated income tax rate structure. The first $26,500 of earned income for individuals in BC is subject to a combined (federal and provincial) income tax rate of approximately 24.9%. The tax rate jumps to 31% between $36,000 to $68,000, 34% for income from $68,000 to $73,000, and 38-41% for income from $73,000 to $118,000. The highest rate of approximately 44% is for income over $118,000.
Income Splitting Benefits of Testamentary Trusts
Income splitting is one of the cornerstones of tax planning. It is the process of shifting income from the hands of one family member to another, who will pay tax at a lower rate. This produces significant tax savings.
A testamentary trust, a trust created under the terms of a Will or possibly a separate document for a life insurance trust, is an effective tool for splitting income. A testamentary trust allows any investment income earned to be taxed in the trust, rather than in the hands of the beneficiaries themselves, who may have separate taxable income. The trust is considered to be a separate taxpayer in the family for tax purposes, and will be taxed at the same graduated tax rates as any individual. Therefore, the total income earned by the family can be split by having the trust pay tax on some of that income, instead of the beneficiary directly.
1. Life Insurance Testamentary Trusts
The proceeds of an insurance policy can be used to fund a trust separate and apart from the estate of a deceased person, thereby establishing a testamentary trust (allowing income splitting) while providing further benefits of probate avoidance, confidentiality and creditor proofing. On a $1 million dollar life insurance policy, the probate fees savings in BC will be $14,000.
The terms of the trust can be set out in a separate trust declaration or trust agreement, distinct from the person’s Will. If a separate trust declaration is used, the insurance details do not need to be disclosed when applying for probate and thus the proceeds, their destination and the terms of the trust do not become a matter of public record.
An insurance trust can also be set out in Will, provided that the provisions establishing the insurance trust are kept distinct from the provisions that govern the estate. For the insurance trust to be a qualifying spousal trust (discussed below), the terms of the insurance trust must be set out in a will.
The key to using an insurance trust for creditor proofing is to keep the insurance proceeds and the insurance trust separate from the estate. Section 54(2) of the BC Insurance Act provides that insurance proceeds payable to an insured’s spouse, child, grandchild or parent is exempt from execution or seizure provided there is a designation in effect (If creditor proofing is the only objective at hand, the same result can often be attained without the requirement of a trust by having the insurance proceeds paid directly to the intended recipient without the need for the trust.)
To qualify as a testamentary trust for the purposes of income splitting, the beneficiary designation cannot be irrevocable, it cannot be corporate owned or group insurance and the policy must be owned exclusively by the life insured (i.e. not owned jointly, such as a joint first to die or joint last to die policy).
An insurance trust funded by proceeds under a contract of life insurance at the death of the life insured has two components. The first is the beneficiary designation that governs the destination of the insurance proceeds on the death of the settlor. The second is the collection of terms that will govern the trust while the insurance proceeds are held in trust.
The beneficiary designation is a written instrument that designates the beneficiary of the proceeds under the policy. This beneficiary designation can be done on forms furnished by the life insurance company or set out in a Will. The terms of the trust is the collection of terms that will govern the trust while the insurance proceeds are held in trust. These terms can be set out in the designation form provided by the insurer (uncommon), the Will (required if the trust is to qualify as a spousal trust) or a separate trust declaration document.
Examples: Insurance Testamentary Trust for Income Splitting
A husband has a $500,000 insurance policy. He has a wife and two minor children. The husband dies and the wife receives the family home as a joint tenant, their jointly owned investments, the husband’s RRIF and the $500,000 insurance proceeds. See below for the different tax consequences of naming his wife the beneficiary versus designating a trust as the beneficiary of the of the life insurance proceeds.
Example #1: Insurance Proceeds Payable Directly to Spouse
The wife invests the $500,000 at 6% and earns $30,000 income per year, in addition to income from investments and employment. The wife is now in the top tax bracket (49%). Of the $30,000 in income from the insurance proceeds, almost half ($15,000) goes to tax.
Example #2: Insurance Proceeds Payable to Testamentary Insurance Trust
The wife receives the $500,000 insurance proceeds as sole trustee in trust for her and her children. The wife invests the $500,000 in the trust at 6% and earns $30,000 per year. The trust reports the $30,000 and pays 24% tax. Of the $30,000 the trust earns, less than one quarter ($7,500) goes to tax. This is a savings of over $7,500 per year compared to example #1.
Example #3: Insurance Proceeds Payable to Testamentary Insurance Trust, with Income Splitting with Children
Same as example #2 except that the wife elects to allocate income to her minor children to offset expenses (which can include any amounts paid for the support, maintenance, care, education, enjoyment and advancement of the child). The trust earns $30,000 per year. The wife, as trustee, chooses to allocate $7,500 to each child. The trust pays no tax. Each child files a tax return with $7,500 in taxable income but is entitled to the personal exemption of $7,100.
Total tax paid: $400 (less if any education credits are available). This saves almost $15,000 per year compared to example #1.
2. Testamentary Trust Wills
Wills can be drafted with multiple testamentary trusts (a separate testamentary trust created for every beneficiary) to achieve a significant degree of income splitting by multiplying the benefits of the graduated tax regime in respect of each and every beneficiary, whether an adult or minor. This strategy can significantly expand the low tax base accessible to a family.
The taxation year of a testamentary trust is generally the trust’s fiscal period, not exceeding 12 months in duration, which need not coincide with the calendar year. A testamentary trust is not required to pay installments of tax, and instead can pay its tax payable within 90 days after the end of its taxation year. The testamentary trust will be deemed for tax purposes to have disposed of all of its capital property every 21 years. The first deemed disposition will occur 21 years after the death of the settlor whose will established the trust. However, this deemed disposition and the resulting taxation of accrued gains can be avoided by distributing the assets of the trust prior to the expiry of the 21 years.
Other Benefits of Testamentary Trust Wills
Testamentary trusts also provide some insulation for claims against a beneficiary, including from potential creditors or claims that might arise in a marital property settlement.
A beneficiary of a discretionary testamentary trust can be said to have no beneficial interest in the assets which is subject to execution by the creditor. Similarly, for disabled beneficiaries, such as trust interest will not be included as an asset when calculating any means test to determine entitlement to government benefits.
Drawbacks of Testamentary Trust Wills
There will be modest administrative costs of filing a T3 trust return for each of the testamentary trusts by March 31st each year.
Example: Separate Testamentary Trusts for Adult Children
A father has an estate with a fair market value of $1.5 million and three adult children. The adult children beneficiaries are in the top marginal tax bracket. The father makes provision in his will for the creation of three separate testamentary trusts, one for each of his adult children. Testamentary trusts are taxed at the progressive rates and therefore afford an opportunity to income split, particularly where the beneficiary would otherwise be in a top tax bracket:
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NO TESTAMENTARY TRUSTS
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USING TESTAMENTARY TRUSTS
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Child 1
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Child 2
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Child 3
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Child 1
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Child 2
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Child 3
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Income from inheritance $500,000 @ 5%
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$25,000
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$25,000
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$25,000
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$25,000
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$25,000
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$25,000
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Tax Payable
(approx)
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($11,600)
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($11,600)
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($11,600)
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($6,538)
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($6,538)
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($6,538)
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Net Income
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$13,400
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$13,400
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$13,400
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$18,462
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$18,462
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$18,462
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The total annual tax savings to the three children amounts to $15,186.
Additionally, where the trust is structured to allow for income splitting to any children the beneficiary may have (the father’s grandchildren), the tax savings can be further magnified if the opportunity presents to take advantage of the personal exemption and low progressive tax rates of the grandchild. This strategy does not depend on retaining the income, as it can be paid out to the beneficiary while making a subsection 104(13.1) designation to tax it in the trust. This is a huge advantage and an excellent means to facilitate family wealth transfer and preservation.
3. Testamentary Spousal Trusts
A spousal trust can be testamentary (i.e. created in a will) or inter vivos (i.e. created during someone’s lifetime by way of a trust deed). To create a “qualifying spousal trust,” the spouse or common law partner of the settlor of the trust must be entitled to all the income during their lifetime and, second, no other person can receive or otherwise the use of any income or capital from the trust during their lifetime.
There are two significant income tax advantages to setting up a qualifying spousal trust. First, capital assets can be inserted into a spousal trust on a rollover (i.e. tax deferred) basis. Second, the 21 year deemed realization rule does not apply to a qualifying spousal trust during the lifetime of the spouse beneficiary. These advantages provide significant planning opportunities.
Income Splitting for Surviving Spouse
Testamentary spousal trusts are frequently employed as part of an income splitting strategy to split income and capital gains between the trust and the surviving spouse. The ability to do so exists because the qualifying spousal trust is viewed as a separate taxpayer and it enjoys progressive tax rates due to its testamentary status. For a spouse trust to work well from a tax avoidance perspective, legal ownership of assets needs to be structured so that at least $300,000 of income producing assets will fall into the estate of the testator upon his or her death to adequately fund the spousal trust.
Income Splitting for Successive Trusts for Children
A spousal trust can also be an effective stepping stone to successive trusts. A spousal trust may, by its terms, be divided at the death of the spouse into a collection of successive trusts for the next generation of beneficiaries. That is commonly done when children are involved. If mom dies first, a spouse trust is established for dad. When dad dies, any assets remaining in the trust established by mom for his benefit are then divided into many tax-planned testamentary trusts as there are children. Dad’s will does the same thing, and any assets in his name are divided into tax planned trusts for the children. Each of the children ends up with two trust, one from dates estate and one from mom’s. Because each trust has a different settlor, each trust will attain separate taxpayer status.
This will result in each of the children having access to three taxpayers at graduated rates (themselves and testamentary trusts from each of their parent’s estates). If the trusts are funded properly, that can give the children the opportunity to enjoy more than $100,000 of income at the lowest tax rates at the bottom tax bracket.
Other Benefits of Spousal Trusts: Control of Ultimate Destination of Assets
Spousal trusts are effective conduits to ensure capital passes to the next generation of beneficiaries or to otherwise control the ultimate destination of the capital in the trust. This is particularly important for those in second marriages with children from first marriages.
Spousal trusts also may be of interest to first marriage couples if they are concerned about possible second marriages after the first spouse passes away, with a view to ensuring that at least some of their assets ultimately go to their children.
Drawbacks of Spousal Trusts
One downside of spousal trusts is that clients must rearrange their affairs so that they each own the assets they wish controlled by the trusts in their name alone. This can involve changing jointly held accounts into separate accounts, changing the designated beneficiary of their RRSPs to “estate” and transfering the house into their names as “tenants in common” from “joint tenants, if these assets are to form part of the spousal trust. This process can take some time and involve some expense.
A second drawback is that probate fees may be payable on some assets on the first to die rather than on the second to die. That said, probate fees are 1.4% of the value of the estate, and the tax reduction benefits offered by a spousal trust can far exceed the initial probate fees payable.
Example: Spousal Trust in a Will – Income Splitting
A testator dies and leaves an estate of $700,000 to his spouse. The will instrument provides that the funds be contributed to a qualifying spousal trust, with the provision that all income and capital be payable only to his spouse, during the lifetime of that spouse, and the remaining capital to be distributed to his children upon his spouses’ death. The $700,000 is invested in fixed interest- bearing securities yielding 5% per annum ($35,000 per annum). The spouse has annual income from other sources of $35,000 per annum as well.
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No Trust
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Spousal Trust
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Spouse
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Spouse
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Trust
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Total
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Income other sources
Interest on 700K
Tax thereon to:
Spouse
Trust
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$35,000
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$35,000
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$35,000
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$35,000
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$35,000
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$35,000
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$70,000
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$35,000
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$35,000
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$70,000
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|
|
|
|
|
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$19,484
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$5894
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$5894
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|
|
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$9268
|
$9268
|
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$19,484
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$5894
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$9268
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$15,162
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