The start of a new year typically marks the start of new tax rules; 2016 is no exception. In this Q&A, Stuart Dollar, Director, Tax and Insurance Planning, explains changes involving testamentary trusts and the impact they may have on clients.

Q: Rules involving testamentary trusts have changed — how so?

A: Graduated rate taxation for testamentary trusts came to an end on December 31, 2015.

As of January 1, 2016 — just like inter vivos trusts — income from a testamentary trust is taxed at the top tax rate (applicable in the province of residence of the trust). And neither type of trust can take advantage of personal tax credits like the basic personal amount.

But there are exceptions:

  • Qualified disability testamentary trusts (QDTs) continue to benefit from graduated rates, provided the beneficiary qualifies for the federal disability tax credit.
  • A graduated rate estate (GRE) testamentary trust is taxed at graduated personal tax rates for the first 36 months after the settlor dies. Only one GRE is permitted per settlor, however.

Q: How will these changes affect clients?

A: A client whose will is relatively straightforward likely won’t feel any effects, as long as:

  • their tax and legal advisors anticipate only one trust being created as a result of the client’s death (that trust would be a testamentary trust, and would likely qualify as a graduated rate estate), and
  • an estate can be settled within 3 years of death.

For clients with more complicated situations requiring multiple trusts, and with estates that take more than 3 years to settle, the changes will limit or prevent their access to graduated tax rates.

Essentially, these changes can make estate planning more complicated and potentially more costly.

About testamentary trusts

In estate planning, trusts fall into one of two categories:

  • Inter vivos trusts are trusts that come into effect during the settlor’s* life. Inter vivos is a Latin phrase that means through life or during life.
  • Testamentary trusts are trusts that come into effect after the settlor dies. In most cases, the terms of a testamentary trust are included in a person’s will — but not always. Clients can create testamentary trusts, separate from wills, simply by creating trusts that won’t take effect until their death. If the trust is in the person’s will, the settlor is called the testator.

*The settlor is the person who created the trust.

Q: How can i help clients manage these changes?

A: Encourage clients to review their estate plans with their legal and tax advisors. If clients’ plans involve multiple testamentary trusts, and if those trusts were set up for tax reasons, they may want to make some revisions.

Prior to the introduction of these changes, when a client’s objective was for income to accumulate inside a trust, tax planners often recommended testamentary trusts (over inter vivos trusts) to take advantage of testamentary trusts’ more favourable income tax treatment.

These changes are a good reminder for those who qualify for the disability tax credit, or their caregivers, to assess their estate plans and review all the benefits available. The QDT is only one of several results from changes made to tax laws in recent years, designed to help people with mental or physical impairments.

Q: Is there anything else to be aware of?

A: The GRE rules aren’t entirely settled. Many tax experts believe that 36 months isn’t enough time to settle a complicated estate, especially when there’s litigation involved.

Other groups have flagged additional concerns involving changes to alter ego, joint spousal and spousal trusts. Under the new rules, the disposition of trust assets resulting from the death of the individual or last spouse to die is deemed payable to the deceased, not to the trust. Among other things, this can result in losses being trapped in the trust, and a mismatch between funding in the trust and the tax liability going to the estate. Discussions between interested groups, the Department of Finance and the CRA are ongoing.

Q: How can advisors and clients learn more?

A: Advisors can contact their Sun Life Financial sales team or visit the tax and legal section on Sun Life’s advisor site. Clients can learn more from their legal and tax advisors.

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