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When the annuitant of a registered plan dies, income tax regulations generally stipulate that the value of the plan must be included when calculating that deceased taxpayer’s income for the year of death.

However, certain exceptions apply to this general principle. The most well-known is a bequest to a spouse, which can be made tax-free.

Also consider that:

  • an eligible annuity can be acquired for a minor child; or
  • funds can be transferred tax-free into an RDSP or RRSP for a disabled dependent.

Another solution was first introduced in the 2013 federal budget: establishing a lifetime benefit trust (LBT). This allows you to use the proceeds of the deceased person’s RRSP to purchase a qualifying trust annuity, of which an LBT is the owner. The beneficiary of the LBT must be financially dependent and mentally infirm.

This arrangement means the deceased can choose trustees who will administer payments to benefit the mentally infirm beneficiary of the LBT, rather than leaving the funds under the management of the guardian, curator or attorney of that individual.

Read: Creative planning for incapacity

In practice, LBTs aren’t commonly used. Yet the biggest benefits are tax deferral for the mentally infirm individual, and management of that person’s money via trustees.

However, if you don’t follow the rules for setting up a qualifying trust annuity, the deceased will be fully taxed on their RRSP for their year of death. So, if a client is considering establishing a lifetime benefit trust (LBT) to acquire a qualifying trust annuity in their will, discuss the following rules and tax considerations, and the potential costs.

LBT beneficiary rules

For a trust to be considered an LBT, the beneficiary must have a mental infirmity and be the spouse or common-law partner, dependent grandchild, or child of the deceased. Moreover, the trust deed must allow for trustees to have discretionary power so they can make distributions considering the needs of the beneficiary, particularly regarding the beneficiary’s well-being and care.

It’s not necessary for the beneficiary to be eligible for the Disability Tax Credit; the beneficiary only needs to be mentally infirm. Since the Income Tax Act does not define “mental infirmity,” the term must therefore be given its regular day-to-day meaning (see “Mental infirmity defined,” below).

Mental infirmity defined

For a person to be considered dependent due to mental infirmity, the care the person receives must only be attributable to the infirmity. As such, the mental infirmity must be severe enough to require the person to depend on someone for a considerable period, regardless of finances. It is recommended to consult a specialist to obtain proof of mental infirmity. (Read: A doctor explains how to spot incapacity)

Qualifying trust annuity

For the deceased’s RRSP to roll over to the lifetime benefit trust tax-free, the capital must be used to purchase a qualifying trust annuity, which is defined as an annuity acquired after 2005 for which the annuitant is an LBT. The annuity is either a life annuity or a fixed-length annuity equal to the difference between 90 and the beneficiary’s age on their last birthday.

Annuity payments will be collected in the LBT, but the beneficiary (i.e., the mentally infirm person for whom the LBT is set up) will be deemed to have received that amount as if he were the recipient of the annuity. As a result, the income tax payable on the annuity is charged to the beneficiary and not the LBT, meaning that the income will be taxed at the LBT beneficiary’s marginal rate, not the trust’s highest marginal rate.

As such, it’s not possible to split the taxable income between the taxpayer and the LBT, regardless of whether the trustees pay said amounts to the beneficiary. This attribution could negatively impact income-tested social program eligibility, depending on the province.

Other considerations

An LBT can be useful for distributing assets upon the death of the beneficiary of the LBT. Generally, if the beneficiary does not have the capacity to write a will, his estate will be considered intestate, and assets transferred directly could end up in the hands of the legal heirs set out under Common Law or Quebec Civil Code regulations.

With an LBT, remaining assets in the trust are not considered part of the beneficiary’s assets on his death, and will be taxed and shared based on the will of the settlor (i.e., the original deceased).

Also read:

Which tax tools require DTC eligibility

RDSPs: Plan your 10 years

David Truong, Pl.fin, CFP, CIWM, M.Fisc, works as a senior consultant, expertise centre, at National Bank Private Banking 1859. He also teaches at McGill University.
Originally published on Advisor.ca
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