Testamentary Trusts
a) What Are They?
Trustees hold assets for the benefit of other people-beneficiaries. There are two types of benefits a person can derive from a trust–an income or a capital benefit–and the trustees may be given different instructions for the distribution of one as compared to the distribution of the other. For example, a trust can hold assets to be invested and, while a widow(er) lives, the income is to be split between the widow(er) and the deceased’s children. At the death of the widow(er) the capital is divided between the children. The trustees can be severely restricted by the trust document in how they can distribute the income or they can be given absolute discretion on how to divide the income and the division can change from year to year.
A TESTAMENTARY TRUST IS A POWERFUL WAY TO REDUCE TAX ON INCOME AFTER THE DEATH OF A TESTATOR, AS WELL AS A USEFUL TOOL TO CONTROL THE EVENTUAL DISTRIBUTION OF ASSETS.
One necessary characteristic of a testamentary trust is that it comes into being at the death of an individual. Usually this occurs through a will but can be created through other documents (for example, see the discussion of Life Insurance Trusts).
b) Splitting Income–A Primary Tax Advantage
The income from investments owned by the trust can be taxed in a number of tax returns. Any or all of the income beneficiaries can be taxed on the portion of income received by the beneficiary. In addition, the trust itself can be taxed on income that is not distributed to beneficiaries and therefore retained by the trust itself. A Testamentary Trust has a graduated tax scale, just like an individual.
IT PROVIDES A TREMENDOUS OPPORTUNITY TO SPLIT INCOME AMONG A NUMBER OF DIFFERENT TAX BRACKETS. EVEN IF THERE IS ONLY ONE INCOME BENEFICIARY, THE TRUST ITSELF PROVIDES A SECOND TAX BRACKET WITH WHICH TO SPLIT INCOME.
c) Tax on Capital Distributions
The trust holds assets on behalf of capital beneficiaries so when the assets are distributed to the beneficiaries there is no tax on the disposition. The beneficiary acquires the trust’s adjusted cost base and will therefore pay the deferred tax when s/he subsequently disposes of the asset. The key is, there is no tax at the time the trust hands over the assets to the beneficiary.
There is one qualification to this rule. At each 21st policy anniversary the trust is ‘deemed’ to have disposed of the assets it holds and the tax on capital gains et cetera, are payable based on that deemed disposition.
d) Spousal Trusts
A spousal trust is a form of testamentary trust that has an added advantage in that assets that might otherwise be subject to capital gains tax can be ‘rolled over’ to the trust and deferred until the subsequent death of the spouse. In order to qualify for this treatment only the spouse may be entitled to any of the income or capital from the trust during his/her lifetime. This limits the income splitting to only two potential tax returns-the spouse and the trust. This is still preferable to being required to file the taxable income in one return–the trust’s lower marginal tax rate will provide tax saving opportunities.
e) Life Insurance Trusts
Usual beneficiary designations in life insurance policies are named individuals or one’s ‘estate’ meaning the proceeds will form part of the estate for probate purposes. An alternative is to designate a named trust as the beneficiary. This trust would only arise upon death and would, therefore, be a Testamentary Trust and eligible for the splitting of income treatment described above. The proceeds would not form part of one’s estate for probate purposes.
Care must be taken in drafting the trust. It is not recommended to simply designate a trust and hope it will come into existence in a suitable manner at death. It is recommended the trust be created in one’s Will where the provisions can be clearly set out or a separate trust document be drafted at the same time the beneficiary designation is made.
f) Multiple Trusts
It is possible, within reasonable limits, to establish a number of different trusts creating multiple tax brackets between which to split income. Provided a reason, other than purely reducing tax, exists any number of tax brackets can be created. The need for a pure spousal trust, a trust to provide discretion to split income between a spouse and each child (a trust per child), and a trust to receive life insurance proceeds outside of the estate all combine to provide multiple trust opportunities and therefore significant income splitting.
|
