Using Trusts In Wills To Split Income
By: John Osgoode Smith
A so-called ‘simple will’ is not always the best will. Creative drafting and testamentary trusts may be valuable additions to an estate plan. There are, of course, obligations and costs associated with the maintenance of a trust, including proper recordkeeping and the preparation and filing of trust income tax returns.
The important thing in creative estate planning is ensuring that there is enough flexibility and authority given to the trustees to effectively deal with changes such as:
- the value of the property held in trust
- the tax rules
- the needs of the beneficiaries
If, for example, there comes a time when the value of the assets and the tax savings do not warrant the costs, then it should be possible to vary or terminate the trust.
While trusts have many uses, one of the main benefits of using a testamentary trust is to split income among different taxpayers in order to reduce taxes.
A testamentary trust is created by the transfer of money or other property on death to a trustee for the benefit of certain beneficiaries, usually as a result of a direction in a will. Unlike an inter vivos trust, which is created when money or other property is transferred from a living settlor to a trustee for the benefit of certain beneficiaries and which are taxed at the highest tax rate for individuals (about 46 per cent for residents of Ontario), testamentary trusts are taxed on a graduated scale and income splitting is permitted.
Here are two examples of will plans that contain testamentary trusts to allow for income splitting and the reduction of tax.
SPOUSAL AND FAMILY TRUST IN A WILL
The Harrisons each have substantial income – Mr. Harrison from his employment, and Mrs. Harrison from investments received as an inheritance.
Mr. Harrison and Mrs. Harrison each make a will naming one or more executors and trustees. While the surviving spouse could be the sole executor and trustee, a trust company may be more appropriate, either alone or as co-trustee with the surviving spouse. Other than personal articles, they divide the rest of the estate into two trusts, a spouse trust and a family trust. The trustee decides how to allocate the assets of the estate between the two trusts depending on the composition of the estate at the time of death.
The spouse trust is for the exclusive benefit of the surviving spouse during their lifetime. It is designed to qualify for the deferral of capital gains tax permitted under the Income Tax Act for certain spousal transfers. The surviving spouse must be paid all of the income of the trust and only the surviving spouse may benefit from the capital until their death.
Meanwhile, the surviving spouse continues to have income of their own which they had before the death of the first spouse. As well, they have the additional benefit of all of the investment income from the trust. What is paid to them from the trust can be taxed either in their hands or in the trust. Income that would otherwise have been included on the surviving spouse’s tax return can be split in two, taking advantage of the graduated tax rates.
To allow for changes in circumstances, the terms of the spouse trust may permit the trustee to transfer out all of the capital to the surviving spouse (and terminate the trust) if the need arises during their lifetime. The spouse trust would come to an end at the death of the surviving spouse, and what remains would be divided among the beneficiaries, or the trust could continue and be split into trusts for new beneficiaries, such as the children of the deceased.
The family trust is for the benefit of the surviving spouse and others, such as the children and/or grandchildren of the deceased. They may have little or no income of their own. The assets going into the family trust would not qualify for the rollover. The family trust permits payment of income or capital to the beneficiaries as determined by the trustee (usually the surviving spouse). The income from this trust can be reported either in the trust or by the lower income beneficiaries. The income splitting opportunities are as varied as the number of beneficiaries. For example, trust income might be paid to a 22-year-old grandchild to pay for university tuition.
To allow for changes in circumstances, the terms of the trust may permit the trustee to distribute part or all of the capital to the surviving spouse and/or the other beneficiaries if the need arises. For example, it may be advisable to distribute trust assets to avoid the deemed disposition of capital property held by the trust on its 21st anniversary. Not only may the deemed disposition generate a large capital gains tax payment sooner rather than later, the assets may be illiquid and funds may not be available to pay the tax.
SEPARATE TRUSTS IN A WILL FOR ADULT BENEFICIARIES
Mr. Jones is predeceased by his wife and has two adult children, Jack and Jill, who are both 45 years old. Mr. Jones makes a will that names executors and trustees. These could be Jack and/or Jill, or a trust company alone or as co-trustee with Jack and/or Jill, depending on how mature and responsible Jack and Jill are, how skilled they are at managing money, and whether it is necessary to have an objective independent trustee, the trust company, to ensure fairness among the beneficiaries, especially when it comes to distributions to the beneficiaries. In this case, Mr. Jones will divide his estate into two trusts – one trust for Jack and his family and one trust for Jill and her family.
The trusts for Jack and Jill are similar to the family trusts described above. They will direct that the income from these trusts can be paid to Jill or Jack, their spouses, their children, or grandchildren as the trustees decide. Discretionary payments of capital from their individual trusts can also be made to Jack or Jill, their spouses, or their children. This provides the potential to split income not only between Jack and Jill and their trusts, but also among family members who may have lower incomes. If Mr. Jones wishes, the will could be written to make it clear that if Jill genuinely needs all of the money, or if it is advisable for other reasons, then trust property can be transferred to her. If the trusts are still in existence on the death of Jack and Jill, then what remains is divided among their respective surviving children.
Not only may this type of trust be effective for income tax planning, it also has the effect of reducing the estates for the purposes of probate tax planning because the trusts are never part of Jack or Jill’s estates, except to the extent of distributions actually made to them.
OTHER TESTAMENTARY TRUSTS
Testamentary trusts may be useful in a variety of circumstances, and for a variety of purposes (not just income splitting), including:
- Trusts for young children or grandchildren until an age greater than the age of majority: These trusts may allow for income and capital to be used for the minor or young adult at any time at the trustee’s discretion with a complete distribution at a certain age – for example, age 25 – or a staggered distribution at different ages – for example, 1/10 th at age 23, 1/3 rd of the balance at age 28, and the remainder at age 33.
- Trusts for the surviving spouse of a second marriage: This type of trust may ensure that a substantial benefit from the estate will eventually be received by the deceased spouse’s children from the first marriage.
- Trusts for mentally/physically disabled beneficiaries: This type of trust is designed to maximize any government benefits to which the disabled person may be entitled, but at the same time, provide for the security of the disabled person in the event that the government benefits are insufficient.
- Trusts for family cottages: This type of trust may be useful to ensure that the cottage will be available for future generations without conflict or misunderstandings.
- Trusts for spendthrifts or trusts which provide protection from creditors: These trusts can be arranged for beneficiaries who are poor at handling their own financial affairs.
- Trusts to hold life insurance proceeds: This type of trust may be useful if the contingent beneficiaries of a substantial life insurance policy are minors because it allows for discretionary payments, but, at the same time, keeps the insurance proceeds out of the estate to reduce probate taxes. Wills, particularly those involving testamentary trusts such as those described in this article, are complex and difficult to prepare. It is very important that your will be written properly. You should seek professional advice about your estate planning and the type of will that is best for you and that satisfies your objectives.
John Osgoode Smith is director, wealth services, at BMO Harris Private Banking.