The 2013 Federal Budget announced that the Department of Finance intends to conduct a review of the tax benefits associated with testamentary trusts. Like any planning technique, there are a number of tax and non-tax benefits to consider in utilizing a strategy. The notes in the budget announcement indicate that the government feels the preferred tax treatment afforded to testamentary trusts raises issues with respect to tax fairness and neutrality, when compared with other taxpayers. As well, they indicate concern with the perceived potential growth in the tax-motivated use of testamentary trusts and the impact on the tax base.
A testamentary trust is one that is established upon the death of an individual (the “testator”). A testator could consider using one or more testamentary trusts to accomplish specific objectives when distributing assets of his or her estate to each beneficiary or class of beneficiaries. The following is a collection of strategies that make use of a testamentary trust to accomplish the objectives of the testator.
- A testamentary trust is taxed based on the graduated (or “marginal”) income tax rates available to individuals. This means there is an income-splitting opportunity where some income is retained and taxed in the trust and some is distributed and taxed to the beneficiary. The testamentary trust effectively allows the surviving family to have one or more “extra taxpayers” to report some of the family’s income at lower marginal rates, therefore lowering the family’s overall annual income tax liability.
- A testamentary trust could protect spendthrift beneficiaries from themselves. The trust could be designed to pay out, from the income and capital of the trust at the discretion of the trustee, sufficient funds for the beneficiary to meet reasonable lifestyle needs. This allows the beneficiary to inherit a long-term allowance. Since the beneficiaries have limited access to the capital, they are protected from themselves and cannot completely deplete the inheritance.
- A testamentary trust could hold the beneficiary’s inheritance and put in place an appropriate investment manager that would take into consideration the beneficiary`s needs. This strategy allows the testator to provide a beneficiary who is an inexperienced investor with professional investment management, rather than leave it up to the beneficiary to invest the capital from the inheritance.
- A testamentary trust could be designed to motivate certain behaviours from the beneficiaries. For example, the testator may feel that education is very important, so could design a trust to fund the education of the beneficiaries. Another example would be a testator who feels earning an income builds character, who could design a trust that pays a distribution based on the amount of income earned by the beneficiary. The testator should be aware, however, that there are legal barriers that may prevent the testator from controlling certain behaviours through the trust. Some conditions are outside of good public policy (for example, a provision that restricts marriage outside of a faith) and would be voided by the courts. As such, discussion with legal counsel in the establishment of the documentation can provide guidance on unique issues.
- A testamentary trust could be designed to provide income for a second spouse while ensuring the testator’s wealth eventually passes to his or her children. Many family situations involve a second marriage and children from the first marriage, leaving the testator with multiple obligations to his or her dependants. A trust could be designed to pay all of the income to the surviving second spouse, along with some access to capital to maintain lifestyle. Any capital remaining upon the second spouse’s passing would be distributed to the children of the testator.
- A testamentary trust can be designed to stage the inheritance of the beneficiaries. A beneficiary receiving a substantial amount of money all at once could face a steep learning curve with respect to managing money, and could make investment or spending mistakes. Sometimes the beneficiary will not be able to recover from these missteps and the inheritance could be lost. A trust could be designed to pay a beneficiary’s inheritance in stages, such as one-quarter at each of ages 25, 29, 33 and 37; this type of staged distribution provides the beneficiary with the opportunity to learn about money management throughout the distribution period, and minimizes the possibility of a major depletion of funds from an error.
Testamentary trusts are an integral element of each of the planning strategies outlined above to meet the testamentary wishes of the deceased and specific needs of the beneficiaries. Because of the breadth of needs and diversity of beneficiaries, testators will often need several testamentary trusts to implement their wishes. In these situations, the multiplication of testamentary trusts is based on needs and is not income-tax-motivated.
Testamentary trusts allow for effective planning in order to accomplish the deceased’s testamentary wishes. It is hoped that as the Department of Finance completes its review of these trusts, they will appreciate their value and ensure testators have as much flexibility in the future as they do today
E.O. & E.
This commentary is published by the Institute in consultation with an editorial board comprised of recognized authorities in the fields of law, life insurance and estate administration.
The Institute is the professional organization that administers and promotes the CLU and the CHS designations in Canada.
The articles and comments are not intended to provide legal, accounting or other device in individual circumstances. Seek professional assistance before acting upon information included in this publication.
Advocis*, the Institute for advanced financial education.
(The Institue”), CLU, CHS, FHF.C and APA are trademarks of the financial advisors Association of Canada (TFAAC).
The institute is a wholly-owned subsidiary of Advocis. Copywrite TFAAC. All rights reserved. Unauthorized reproduction of any images or content without permission is prohibited.
Copywrite ISSN 0382-7038
Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.