Income splitting from beyond the grave

One effective way to use a trust structure to minimize tax for an estate and its beneficiaries is to income-split by using multiple trusts in a will.

Testamentary trusts (which are created within the body of a will) are taxed at the same graduated tax rates as an individual. By contrast, inter vivos trusts (a trust created while the donor is alive to hold property for the benefit of others – usually heirs), are taxed at the top marginal tax rate. There are potential significant tax savings if a deceased person’s will creates multiple trusts for the beneficiaries, particularly if they are in the top marginal rate of tax.

Each trust under a will is generally treated as a separate taxpayer. Based on current tax rates, roughly the first $127,000 of income in the trust will be taxed at a lower marginal tax rate than would happen if a high tax bracket beneficiary received property directly – as opposed to from a trust – and then earned investment income on it.

Further, if a trust provides discretion to the trustees to distribute income among a group of beneficiaries, income can be “sprinkled” among them and taxed in their hands at lower tax brackets.

Here’s an example of income splitting using a testamentary trust:

Martha Dion’s will gives a $1 million gift to her daughter, Claire, a top tax bracket taxpayer with a young family.

If Claire invests these funds and earns 6% interest per annum, she’d pay about $28,000 in tax on the $60,000 of interest she receives in the first year, leaving only $32,000 in her hands after tax.

If, instead, her mother’s will establishes a testamentary trust for her, the income could be taxed in the trust at its lower graduated rates, but still be paid to Claire. On $60,000, the trust would pay about $19,000, as opposed to approximately $28,000 payable by Claire – an annual tax saving of about $9,000.

If the trustees, who can include Claire, are also given broad discretion to distribute the trust’s income to Claire and her children to help Claire in raising her family, more income-splitting and resulting tax savings can be achieved.

Each of Claire’s children could have funds paid for their benefit equal to their basic personal credit per annum. No tax would be paid equal to their basic personal credit, assuming they have no other income. While the trust can’t take advantage of the basic personal credit, the remaining income could be taxed in the trust at its lower marginal rate.

If Claire has two children who each receive approximately $10,300, this would leave approximately $39,400 to be taxed in the trust resulting in tax of about $9,500. Overall, tax of roughly $9,500 would have been paid annually, as opposed to the $28,000 otherwise paid by Claire annually – an annual savings of about $18,500.

Margaret O’Sullivan

Tax & Estate

Margaret O’Sullivan is founder of O’Sullivan Estate Lawyers LLP.