Last Will & Testament / Pour-Over Last Will & Testament / Testamentary Trust


         Tax Planning With Testamentary Trusts

Testamentary trusts are often overlooked by estate planners when preparing a client's estate plan. But testamentary trusts can provide significant tax benefits because of preferential treatment such trusts receive under the Income Tax Act. Placing assets in trust can also provide significant non-tax estate planning benefits.
What is a Testamentary Trust?

A testamentary trust is simply any trust that arises on death through a person's last will and testament. Like all other trusts, a testamentary trust creates a legal relationship between the settlor of the trust (in this case the deceased person or the "testator"), the trustee (who is often the executor of the will but who could also be a separately named trustee under the will) and the beneficiaries of the trust (family members or other individual beneficiaries of the testator or charities). The terms of the trust can provide for the payment of income or capital or both to the beneficiaries. Either the interests of all beneficiaries can be fixed in the will or discretion to allocate the income and/or capital among the beneficiaries can be left to the trustee. Although the beneficiaries of the trust have an interest in it, the trustee is the legal owner of the property held in the trust and has the authority to control the management of the assets. The trustee's obligations include making decisions about the investment of the trust assets and preparing and filing tax returns on behalf of the trust. It is possible to establish multiple testamentary trusts in a will.

Taxation of Testamentary Trusts

Like all trusts, a testamentary trust is treated as a separate taxpayer under the Income Tax Act and must file a return reporting its income, gains and disbursements to beneficiaries in each year. A trust may have a non-calendar year-end. Generally, a trust will receive a deduction from its income and gains in a year for amounts paid or made payable to the beneficiaries in that year. However, trusts pay tax on income and gains retained in the trust at the highest marginal rate for individuals. Tax is payable the province of residence of the trust, usually where a majority of the trustees reside. This is a significant disadvantage and generally necessitates the allocation of the income and gains to the beneficiaries in each year. Such disbursements maintain their character as income, dividends or capital gains and are taxed in that manner in the beneficiaries' hands.

What makes testamentary trusts different from other trusts is the favorable tax treatment they receive under the Income Tax Act. Unlike other trusts, testamentary trusts pay tax using the graduated rates in the Income Tax Act on income retained in the trust, although they do not receive the personal deductions available to individuals. Access to these graduated rates makes it much more beneficial to retain income and gains and have them taxed in the trust rather than taxed in the beneficiaries' hands. The trustee can elect to have the income and gains taxed in the trust even if these amounts have been paid or are payable to a beneficiary. In this way, income that would otherwise be taxed at the highest marginal rate in the hands of a beneficiary who already pays tax at the high rate can be taxed at a graduated rate in the trust. This is the main tax benefit to putting income producing assets in a testamentary trust. For example, a portfolio of investments worth $750,000 and earning 8% per year or $60,000 in income can generate approximately $8,500 in tax savings each year at current rates.

There are other income tax considerations related to testamentary trusts. First, because testamentary trusts only arise on death, the assets placed in a testamentary trust must be owned by the testator at death. Under the Income Tax Act, all capital properties are deemed to be disposed of at their fair market value by a testator at death. Depending on the adjusted cost base of the capital property in question, the deemed disposition may trigger a significant capital gain which will be taxed in the hands of the testator's estate. The estate plan needs to address this gain.

Second, because the assets that will be placed in the testamentary trust pass through the testator's estate, probate tax is payable on the fair market value of these assets. Probate tax in Nova Scotia is approximately 1.3% or $9,750 in tax on the $750,000 of assets noted previously. However, this probate tax can be offset by future income tax savings within the first year.

Third, assets placed in a testamentary trust are subject to the "21 year deemed disposition rule" in the Income Tax Act. That provision creates a deemed disposition of all capital property held in a trust every 21 years, with any consequent capital gains taxed at that time. An actively-traded portfolio can effectively manage the implications of this rule.

Fourth, although not strictly an income tax issue, all trusts are subject to the "rule against perpetuities". This rule prevents property from being tied up in a trust indefinitely unless the trust has charitable purposes or a charitable beneficiary. Proper planning can easily address this limitation.

Fifth, certain rules known as the "attribution rules" in the Income Tax Act which serve to attribute income back to the settlor do not apply to a testamentary trust. This is another benefit to using such a trust.

A final consideration is the administrative cost associated with the creation and use of testamentary trusts. A trustee is required to file tax returns on an annual basis, to hold trustee meetings if there is more than one trustee and to prepare and issue trustee's resolutions confirming the exercise of discretion by the trustee. These administrative costs must be weighed against the significant income tax benefits.

Spousal Testamentary Trusts

One very common type of testamentary trust is a spousal testamentary trust. In this case, assets are left by a testator to a testamentary trust for the benefit of the testator's spouse, usually for the spouse's lifetime. The terms of the trust must provide that all of the income be paid or payable to the spouse during his or her lifetime and may also include access to capital in the trustee's discretion or at the request of the spouse. On the spouse's death, the assets pass to other specified beneficiaries (typically children or charities) either outright or in a continued trust.

A trust established in this way provides an additional tax benefit in that the assets initially transferred to the spousal testamentary trust are "rolled" in to the trust at the testator's adjusted cost base. In this way, the tax that would otherwise be payable on any capital gain inherent in those assets is deferred until the second spouse's death. However, there may be circumstances where one might elect out of this rollover and crystallize a gain at the time of the testator's death, perhaps to take advantage of unutilized capital losses or the enhanced capital gain exemption on qualified small business shares. Furthermore, separate tax returns can be filed for the spouse on his or her own income and gains and for the spousal testamentary trust, giving the spouse access to two sets of graduated income tax rates.

Non-Income Tax Benefits of Testamentary Trusts

Testamentary trusts also have many non-income tax benefits. First, assets placed in trust for a beneficiary under a will can help maintain continuity of ownership and control of those assets. Because the trustee has legal title, particular assets (such as a cottage property) can be placed in the trust and held for the benefit of family beneficiaries. The terms of the trust would outline how the family members can access the property and how repairs and maintenance will be addressed. If the asset is non-income producing, a sum of money may need to be added to the trust to cover ongoing expenses. Such trusts would be subject to the rule against perpetuities and the 21 year deemed disposition rule discussed previously.

Second, depending on the terms of the trust, beneficiaries of testamentary trusts typically have no right to demand that the assets of the trust be conveyed to them. As such, testamentary trust assets are free from the claims of beneficiaries' creditors, including both commercial creditors, such as bank lenders, and also family creditors, such as spouses. The trust structure can also provide protection for a spendthrift beneficiary. In this way, testamentary trusts can be a good tool to ensure an estate passes only to the intended beneficiaries.

Third, a testamentary trust can make funds available to finance a disabled child's needs in case of death of both parents. The trustee manages the assets in the trust for the benefit of the child and distributes the income and capital to the child at the trustee's discretion. The terms of the trust can provide discretion to the trustee to give no more than the government's allowable maximum so that the disabled beneficiary can continue to collect any government assistance that he or she currently receives.

Finally, using a testamentary trust can avoid double probate tax. Although the assets initially placed in a testamentary trust are subject to probate tax in the original testator's estate, the terms of the trust can provide for their later disposition through the trust, thereby avoiding a second round of probate tax on the same assets.

When Might One Consider a Testamentary Trust?

A testamentary trust can be useful in many situations:

a. for a spouse who has enough assets in his or her own name to permit the other spouse's assets (or a portion of them) to be held in trust without full access to the capital. Because tax is paid by the trust, the savings noted previously can occur;

b. for children or grandchildren who have their own assets and who want the tax advantage of having the trust as a separate taxpayer. There can be as many testamentary trusts as there are children or grandchildren, each with access to the graduated rates. In this situation, it is recommended that each child or grandchild be the beneficiary of a separate trust so that the Canada Customs and Revenue Agency does not challenge the overall structure;

c. to protect assets from a widow or widower's new suitor or children's spouses on marital breakdown. Because the beneficiaries do not have a full interest in the trust, the trust assets are generally protected from the claims of beneficiaries' spouses or other creditors;

d. to protect a spendthrift or disabled child. The terms of the testamentary trust must be carefully drafted in these situations;

e. for particular assets that are not necessarily income producing, but where continuity of ownership and control is important. This could apply to a cottage or shares of a small business corporation; and

f. where the estate plan includes benefiting a charity or charities, but where the assets are required to continue support for a spouse or children. In this case, the assets could be left to a testamentary trust or a series of trusts for the lifetimes of the family beneficiaries with provision that the assets will pass to specific charitable beneficiaries upon the deaths of the individual beneficiaries. If the trustee has no power to encroach on capital during the lifetimes of the individual beneficiaries, a charitable tax receipt can be obtained from the charitable remainder beneficiary, which can be used to offset some of the capital gains that may occur through the deemed disposition on death.

There are significant tax and non-tax reasons why testamentary trusts should be considered as part of an overall estate plan.

2002 Cox Hanson O'Reilly Matheson

   Elvis Presley's "Last Will and Testament" is a great example of a testamentary trust [see Item IV].  Although it cost his heirs an untold amount of money to probate his estate and then set up the testamentary trust plus administration fees . . . it served it's purpose.

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C. Francis Baldwin
Updated Wednesday, May 26, 2004