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.

When is a Trust Really a Trust?

Trusts are simple arrangements whereby the settlor of the trust places property in it for the benefit of one or more beneficiaries. The settlor will also appoint a trustee whose job it is to ensure the terms of the trust are followed. These terms and any other rules required for the operation of the trust are established by the settlor.

From a wealth planning perspective, the difficulty with understanding trusts stems from the fact that there are both legal and tax issues that must be satisfied in order for an arrangement to truly be considered a trust. This article will discuss these issues.

Inter-Vivos & Testamentary Trusts

Trusts occur in two forms, either Inter-Vivos or Testamentary. Inter-Vivos (living) trusts are set up by an individual (referred to as the settlor) while he/she is alive, with the intention that the property placed in the trust will be managed by the trustee according to the terms of the trust. Alter Ego, Joint Spousal and even Informal (Oral In-trust accounts) trusts are different types of inter-vivos trusts. Information on Alter Ego and Joint Spousal trusts can be found on SC Online at PCFS/Wealth Planning.

Testamentary trusts differ from inter-vivos trusts in that they are only created upon the death of the settlor and are done so through the settlor’s will. Testamentary trusts are created for a number of reasons. One of the more common is to help reduce a surviving spouse’s tax liability by splitting income between assets owned directly by the spouse, and assets held by the testamentary trust. The type of trust that accomplishes this is referred to as a Spousal Trust.

Informal (Oral) Trusts

Informal trusts (sometimes referred to as “oral trusts”) occur where funds are set aside for the benefit of another “in-trust” without the benefit of a formal trust deed or indenture. These in-trust accounts are usually created for the benefit of a minor child and are typically labeled as “Jane Doe In-Trust for John Doe”. Due to their informal nature, these types of accounts, although referred to as such, may not actually be trusts. Establishing a trust involves more than just placing the words “in-trust” on an account application.

The 3 Certainties of a Trust

From a legal perspective, three “certainties” must exist in order for a trust to be recognized under law. These certainties are known as the Certainty of Object, the Certainty of Subject Matter and the Certainty of Intention. These certainties must be present for any type of trust to be recognized by both the courts and the Canada Customs and Revenue Agency.

The Certainty of Object refers to the objectives of the trust in so far as it must be possible to ascertain who is to benefit from the trust i.e.what is the objective of the trust. The Certainty of Subject matter refers to the fact that a trust must have in its possession, an identifiable asset that has been conveyed by the
settlor of the trust. Lastly, the Certainty of Intention demands that the settlor clearly had the intention to pass the asset on to the trust with the explicit intention of having a trust created.

Are In-Trust Accounts Considered Trusts?

A trust exists as long as the three certainties exist. A trust does not have to exist in writing, but it is highly recommended that written evidence exists that documents the terms of the trust. This is particularly an issue where in-trust accounts are concerned.

Due to the informal nature of in-trust accounts and the fact that very little in the way of written evidence is established when they are created, many of these accounts are not considered actual trusts. The problem is twofold. The first has already been discussed. That is, since no written evidence exists, it is difficult to establish that the three certainties have been met. It is not impossible to do, just difficult.

The second problem is a little more technical and has to do with the income splitting benefits that are usually associated with setting up in-trust accounts.
Section 75(2) of the Income Tax Act (ITA) states that if under the terms of the trust, the property in the trust:
can revert back to the settlor or pass to some other person or
the property in the trust cannot be dealt with without the settlor’s permission,
then any income or capital gain from the account becomes the settlor’s.

Since in-trust accounts are rarely put into written form, The Canada Custom and Revenue Agency’s position is that it will be difficult for the parties involved to establish that the informal trust does not contravene section 75(2) of the act.

As an example, parents and grandparents who establish in-trust accounts don’t typically understand the limits imposed on them if these arrangements are truly to be considered trusts. Many believe they can take these assets back at their own discretion. Believing that this is possible, not to mention actually doing it, would indicate that the certainty of intention had never been met. As well, the conditions of 75(2) would not have been met and would therefore make any tax advantage that would have otherwise been gained, null and void.

In conclusion, although the setting up of a trust can be a rather straightforward matter, it is imperative that both advisors and their clients fully understand the implications of setting up trusts and trust accounts, to avoid any future misunderstandings, tax or otherwise. 

Contact us at (604) 535-4749, or use our contact page.

Note: The above article is for information purposes only and should not be construed as offering tax advice. Individuals should consult with their personal tax advisors before taking any action based upon the information in this article.