Testamentary trusts arise after someone dies and are set up for various reasons—one of which is their tax treatment.
There are several types of testamentary trusts, including:
- Trust for Minors
For minors until they’re better equipped to manage funds on their own.
- Protective Trust
For special needs dependents, or beneficiaries whom the testator considers spendthrift.
- Spousal Trust
Typically seen in a second marriage, this trust provides for a surviving spouse during their lifetime, and subsequently for the benefit of the testator’s direct descendants.
Here are the tax benefits of these trusts.
1. Tax Structure of Testamentary Trusts
In Canada, testamentary trusts are taxed at the same marginal rate as individuals, which range from 15% to 29%. Conversely, an inter vivos trust is taxed at a firm 29%. Although taxed as an individual, testamentary trusts don’t have a calendar year-end of December 31—the trustee is allowed to select a fiscal year-end within a 12-month period. Other benefits also accrue to the trust, such as maximizing tax deferral, timing of income and accounting convenience. Testamentary trusts are also exempt from instalment payments, with the caveat that all taxes owing must be paid within 90 days of the trust’s elected year-end.
2. Income Splitting and Designated Income
There is some relief for beneficiaries in higher marginal tax brackets. Income payable to a beneficiary will be included in the beneficiary’s tax return, and taxed at that beneficiary’s marginal rate. The trust may elect to deduct, in whole or in part, the income payable to the beneficiary. The deducted portion will then be taxed (as not payable) at the low marginal rate of the trust, and not in the hands of the beneficiaries. Also, a beneficiary receiving Old Age Security (OAS) payments will not be able to receive the maximum OAS pension * if trust income pushes them above the net income threshold of $69,562. So, an election is made by the trustee to tax a portion of the beneficiary’s income in the trust. With this election, they receive less taxable income and are able to remain below the claw-back threshold of OAS pension.
3. Preferred Beneficiary Election
A preferred beneficiary of a testamentary trust, together with the trust, may have the tax liability of allocable income shifted to the preferred beneficiary while retaining the income in the trust. In other words, the accumulated income, which is retained in the trust, is “deemed to be paid to the beneficiary and taxable in the beneficiary’s hands.” The allocable income, when ultimately paid to a beneficiary, won’t be taxable. As opposed to designated deductions, both trustee and preferred beneficiary must file the election under subsection 104(14) in the 90-day period.
The testamentary trust, unlike an inter vivos trust, may seek reassessments of the prior years’ tax return under a fairness package that Parliament enacted to provide relief for certain taxpayers. This affords testamentary trusts the ability to take advantage of deductions, credits, or refund.
Testamentary trusts are not subject to attribution rules, which directly impact certain inter vivos trusts. That’s because income or loss may be attributable to the settlor of the trusts, and fully taxed in his hands. Since the settlor of a testamentary trust is deceased upon the trust coming into effect, he doesn’t directly benefit from the tax regime.
What to Watch For
To set up and maintain the status of a spousal testamentary trust, the testator has to be a resident of Canada prior to death; the testator’s spouse is entitled to receive all income of the trust that arises before the spouse’s death; and no person except the spouse or common-law partner is entitled to the income or capital before the second spouses’ death. It’s crucial to abide by the above; otherwise the trust stands to lose its testamentary status, and will be regarded as tainted—and treated as an inter vivos for tax purposes.
And should anyone other than the deceased contribute to a testamentary trust, it loses its status and reverts, for tax purposes, to an inter vivos trust.
Successive testamentary trusts are treated as separate and distinct taxpayers. That means each trust has the benefit of a graduated tax regime. CRA may deem all separate trusts as one if “all of the property of the various trusts has been received from one person and the income from these trusts accrues to the same beneficiary or group or class of beneficiaries.” Taxpayers should be mindful of this, especially with the CRA’s determination that members of the same family be classified as a group or class.
As well, trust assets must be distributed to beneficiaries at the agreed upon time; otherwise testamentary trust status may be lost. And if a trust is funded with the proceeds of a group life policy, it may fail to qualify as a testamentary trust.
*The original version of this article stated the beneficiary has to repay the entire OAS pension. Return to the corrected sentence.