The Benefits of Testamentary Trusts

Testamentary trusts can provide both significant tax and non-tax estate planning benefits, but are often overlooked in estate planning.

A testamentary trust is created in a Will and comes into effect only upon the testator’s death. A testamentary trust, like all trusts, creates a legal relationship between the testator (the one creating the trust), the beneficiaries and the trustee. Simply stated, the testator funds and creates the terms of the trust. The trustee assumes legal title to the trust property and manages the trust in accordance with its terms, for the benefit of the beneficiaries. The terms of the trust may dictate such items as whether the payment of income and capital is to be fixed or at the discretion of the trustee, how the trust fund is to be invested and at what age or ages the beneficiaries are to receive their entitlement.

Income tax benefits

Testamentary trusts receive favourable tax treatment under the Income Tax Act. Testamentary trusts are essentially separate taxpayers and are taxed using the graduated rates applicable to individuals. This feature can provide significant income splitting opportunities.

Income earned by a testamentary trust may be taxed in the trust, rather than in the beneficiaries’ hands. The trustee can elect to have income and gains taxed in the trust even if these amounts have been paid  or are payable to a beneficiary. As a result, income that might otherwise be taxed at the highest marginal tax rate in the beneficiary’s hands can be taxed at a lower graduated rate in the trust. For example, trust investments worth $1 million and earning 4% per annum generate $40,000 in income. Taxing this income
in the trust rather than in the hands of a beneficiary at the top marginal rate, may generate approximately $8,000 in annual tax savings at current rates.

Such tax savings may be increased by creating multiple testamentary trusts for multiple beneficiaries.

Where the beneficiary of the trust is the testator’s spouse, the standard deemed disposition at death may be deferred. In other words, appreciated capital assets can be rolled into a qualifying spousal trust at their cost base thereby deferring capital gains until the assets are sold or the beneficiary spouse dies. In all other cases, care must be taken to avoid the negative impact of the “21-year deemed disposition rule”. This rule creates a deemed disposition of all capital property held in a trust every 21 years, with the
resultant capital gains taxed at that time. The implications of this rule can be avoided by careful planning.

Non-income tax benefits

There are also a number of non-tax reasons you may want to consider a testamentary trust; including: the management of family assets for the benefit of adult and/or minor family members; charitable purposes; the protection of assets from claims of other parties. For instance, testamentary trusts can be useful in achieving the following estate-planning goals:
Protecting a special needs beneficiary
In most provinces, a special discretionary trust, sometimes known as a Henson Trust, can be created to provide a mentally or physically challenged beneficiary with access to income and perhaps capital, without disqualifying the beneficiary from provincial disability benefits. A discretionary trust can also be used to protect an adult spendthrift child from mismanaging their inheritance.

Preserving family assets

A testamentary trust can be used to protect assets such as a family business or cottage from potential claimants such as a widow or widower’s new partner, or children’s spouses in the event of marital breakdown. In certain provinces, a trust may be the only way a parent can insulate assets bequeathed to their children from matrimonial claims in the event of marriage breakdown.

Safeguarding children from a previous marriage

A testamentary trust can be designed to provide an income stream for a spouse while ensuring that capital is preserved for the testator’s children from a prior marriage. Care must be taken in establishing such as trust in order to take advantage of the tax-deferred spousal rollover.

Creditor Protection

A fully discretionary testamentary trust under which the beneficiary has no enforceable right to the assets and may in fact forfeit all entitlement in the event of bankruptcy, can offer protection against the claims of creditors.

Charitable giving

Individuals with philanthropic interests may wish to create a charitable trust in their Will. A charitable testamentary trust may take effect immediately on death or may only take effect following the death of an intervening life interest. For example, an individual may wish to provide a surviving spouse with an income stream for life, with the capital of the trust going to charity on the death of the surviving spouse. Enhanced charitable receipts are available when gifts are made in the year of death.

Providing oversight

A testamentary trust allows you to provide guidance and exercise some control over how an inheritance is managed and spent. Essential in the case of minor beneficiaries, such control may also be desirable in the case of adult beneficiaries who may be financially immature. Payment of income and capital may be fixed or at the discretion of the trustee and capital payments may be staggered to ensure that the inheritance is not simply squandered.

The Butler / Laing Group and our professionals from across the Scotiabank Group have the knowledge, resources and expertise to help you understand your options and determine what is ultimately appropriate for you.  Contact us at (604) 535-4749, or use our contact page.