Testamentary Trusts
A testamentary trust is set up through a Will for estate assets, or as an Insurance Declaration for insurance proceeds.
Of course, every situation is different, and much planning depends upon a person's unique circumstances. However, we generally recommend the use of testamentary trusts for the following reasons:
- income splitting opportunities;
- creditor and asset protection advantages; and
- individual control and flexibility.
INCOME SPLITTING
One of the goals of preplanning estate matters is to reduce the tax burden to heirs after the testator's death. This can be accomplished by leaving assets to one or more testamentary trusts, so that your spouse or children can utilize some income splitting opportunities in a way that is acceptable to Revenue Canada.
Income splitting is one of the cornerstones of tax planning. It is simply the process of shifting and dividing 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 is a terrific 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 (although no individual tax credits may be claimed). Therefore, the total income earned by the family can be split by having the trust pay tax on some or all of that income, instead of the beneficiary directly.
The first $35,000 of earned income for individuals in BC is subject to a combined (federal and provincial) income tax rate of approximately 20.2%**. As income rises, the tax rate rises, and the highest rate of approximately 44% tax is applicable for income over $123,000**. (**Rates current as per 2008).
An example with our hypothetical friend, "Sam", will show the benefits of splitting income with a testamentary trust. Sam already makes $68,000/year from his employment. Sam has received an inheritance (or insurance proceeds) totalling $500,000. Sam places these into guaranteed investments and earns 5% per year. In other words, Sam is able to make $25,000 each year from his inheritance (or the insurance proceeds). Sam will pay the following extra in tax each year:
| Tax Bracket | Rate | Extra Income | Extra Tax Payable |
| $68,000 - $70,000 | 30.1% | $ 2,000 | $ 602 |
| $70,000 - $76,000 | 32.5% | $ 6,000 | $1,950 |
| $76,000 - $80,000 | 36.5% | $ 4,000 | $1,460 |
| $80,000 - $98,000 | 38.3% | $13,000 | $4,979 |
| Total: |
|
$25,000 | $8,991 |
Now suppose that Sam had received the $500,000 in a testamentary trust, instead of outright. The trust would be taxed on the individual rates, and so the starting point on the earned $25,000 of income is the lowest marginal tax rate:
| Tax Bracket | Rate | Extra Income | Extra Tax Payable |
| $0 - $35,000 | 20.2% | $25,000 | $5,050 |
| Total: |
|
$25,000 | $5,050 |
Accordingly, simply by having the funds placed initially in a testamentary trust for Sam, Sam is benefiting by having his extra personal taxes payable reduced by approximately 44%, with savings in the amount of almost $4,000 annually ($8,991 - $5,050 = 3,941)! A tax return is required for every testamentary trust which has come into effect, which is when the creator of such a trust has died. However, here Sam will still be way out ahead every year, even after paying his accountant to file a trust tax return.
Remember, for assets passing through a Will (but not Insurance Declarations), probate fees would still be required. On $500,000, probate fees of 1.4% would incur a one-time charge of approximately $7,000. In any event, this cost from the probate fees in this example would be "recovered" within a couple of years from the trust's annual tax savings ($3,941), and then Sam would look forward to ongoing tax benefits for the rest of his life, year after year, and decade after decade.
In addition to the splitting of income between the trust and Sam, the trust can also flow its income out to still other beneficiaries, who could be Sam's children. For example, payments of up to $9,600 could be made to each of Sam's two minor children, and each child could be allotted $9,600 of the trust's income and claim it on their own returns. The trust could then consequently reduce its own income by $19,200. Provided that Sam's children had no other income, they would have no tax to pay on the $9,600 they had each received.
The more beneficiaries that there are, the greater the amount of income splitting and tax savings that can be achieved. For example, the allocation of the trust's income among many beneficiaries could in some cases result in no tax being payable in any given year, depending on the income level from other sources already being claimed by the beneficiaries.
CREDITOR PROTECTION
Another benefit of testamentary trusts is the asset protection afforded for the property in the trust. Trusts can give control, without the actual "ownership" that is required for debt collection purposes. As such, it is very difficult under normal circumstances for any creditor to try to claim a beneficiary's interest under a trust. Accordingly, you can rest assured that the inheritance you have given to a child will actually benefit that child and will not be seized by third parties due to bad debts, etc.
Marital disputes are also becoming an increasing issue. Although a testamentary trust may not provide a total shield from a spousal claim against a child, the fact that the inheritance is in a trust and not held outright makes it more difficult for a litigious former spouse to affect these assets.
CONTROL AND FLEXIBILITY
It is possible to draft Wills and Insurance Declarations so that as much control as possible over the trusts is placed directly in the hands of the beneficiaries involved. They can be the trustees of each of their own trusts, and can have full say over who in their respective family will get paid what and when. A power can also be granted to add further trustees of their choice to their own trust.
Upon the death of a beneficiary, the capital remaining in that beneficiary's trust fund can be divided among his or her own children, and held on further separate trusts until, for example, each one of these children reaches a certain age (which again, you would choose). Ultimately, all of the advantages and benefits listed above regarding testamentary trusts can continue to be available to these future beneficiaries as well.
CONCLUSION
By relying on a "Will kit" or a simple Will, you may be foregoing some fantastic opportunities. We would be happy to review your estate plan and discuss how testamentary trusts could be of benefit to you and your family. Please contact Rick Montens, Tim H.R. Brown, or Silvana Facchin at 604.682.3664.