6 Reasons to Consider Using Testamentary Trusts

A trust is a legal entity created when a person transfers the ownership of property to one or more trustees, who manage the property for the benefit of a particular person or group of persons (called the 'beneficiaries'). A testamentary trust is usually set up in a will and takes effect upon the death of the settlor. A will can create any number of trusts for different beneficiaries. The will names the beneficiaries and the trustees, identifies the assets going into the trust, and states how and when the income and capital is to be distributed.

A key quality of trusts is that the Income Tax Act treats them as a separate individual taxpayer. A second key characteristic is that testamentary trusts benefit from the graduated personal income tax brackets, whereby lower income pays tax at a lower rate. A third important feature is that assets in a trust, while they are there, legally belong to the trustee and not the beneficiary.

What are the six reasons that people should consider using a testamentary trust?

1. Tax Savings from Income Splitting for Children and/or Grandchildren - consider a grandparent who wants to leave money for minor children - instead of leaving everything to the parents who then must include the income it generates in their own income, which may be at a high rate already, the inheritance is put into a testamentary trust. Minor children are likely to have little or no other income, so the trust distributes income to the children who pay no tax. The inheritance can perhaps provide tax-free income for many years. If the parent is named as trustee, and the instructions in the will give the discretion, he/she can still control all the spending on behalf of the children. Each child can have a trust, further sub-dividing the income. For an adult child with a high income already, the trust may be in a lower tax bracket so it could retain the income to be taxed instead of distributing it to the child. A properly set up trust can have the ability to change from year to year whether it distributes any, some or all income, so that overall taxes are minimized.
   
2. Tax Savings from Income Splitting for a Spouse - in a similar manner as for children, sending an inheritance into a trust that has discretion whether to pay out income or retain it in the trust and have it taxed there may reduce overall taxes and allow the spouse to keep income tested OAS payments. That does not prevent the withdrawal of capital from the trust for money to spend.
   
3. Protection of Funds for Disabled or Spendthrift Beneficiaries - for people not capable of managing an inheritance, especially when it has to last and support someone who cannot go to work and earn a living, a trust can be very beneficial; in addition, since a trust is a separate legal entity, creditors cannot come after funds held in a trust for a bankrupt person
4. Protection of Funds from a Spouse of a Beneficiary - this could be a child in a shaky marriage, or a widow(er) in a second marriage; since the trust owns the assets, the other spouse can be prevented from laying claim
5. Avoidance of Probate a Second time and Capital Gains Deferral through Rollover to a Spousal Testamentary Trust - tax rules allow a spouse, and only a spouse, to receive inherited assets exempt from the usual rules whereby capital property is deemed to have been disposed of at death at fair market value and capital gains tax has to be paid. This can allow capital gains to be spread over time, reducing taxes and to be deferred, allowing greater growth. When the assets are eventually distributed by the trust, they do not pay probate a second time as they do not pass through the will of the spouse.
6. Control of the Funds - the trust can be set up so that children receive the capital to spend as they wish only when they are older, and hopefully wiser, or only for specific purposes; meantime a trustee, perhaps a parent, can decide what the trust will disburse. The trust can also mandate that income is used to support a spouse till death, after which any remaining assets are given to someone else, perhaps grandchildren or a charity.
   

About the only negatives of testamentary trusts are:

• administration cost / trustee fees if done by a company or third party professional; in my view, a professional trustee is not necessary for many if not most circumstances; it can be quite straightforward, I've done it
• extra tax returns and record-keeping: the trust must file a return every year even if it is only to report that it is distributing all its income to the beneficiaries. Though a trust can pick any date for its year end, if you are going to manage it yourself and use a discount broker to hold the assets in an account, the broker will only send out forms based on the calendar year, so you have to do a lot of manual work adding up the revenues
• limited choice of discount brokers for investments in a testamentary trust: when I decided to manage the investments myself and approached various brokers, some said they did not handle trusts and others did not even know what a testamentary trust is. There was a presumption that you should deal with the full service broker side of their business.

The testamentary trust is embodied in clauses in the will. Despite my ardent DIY philosophy, I would never try setting one up using a will kit. I think it wise to use a lawyer to get it right since the wrong words may invalidate the trust.

More detailed reading:
Richard White, Advantages of establishing a testamentary trust at the Ontario Medical Association - child income splitting example
Thompson Dorfman Sweatman, The Tax Planned Will - Creating Savings for Your Spouse and the Next Generation - OAS example
Richard S. Niedermayer, Testamentary Trusts, at ProfessionalReferrals.ca
Kenneth C. Pope, Trusts - give examples of set up and professional management fees
Glenn C. Davis, Spousal trusts Protect Assets, Income and Heirs at SunLife Financial
Green Financial Group, Tax Planning with Testamentary Trusts - good income splitting for spouse tax saving example

Inheritances and Inheritance Tax for Canadians

Question from a Reader:
"My wife has landed immigrant status in Canada, and has lived here for over 20 years. Her father has recently past and has left her aprox $30,000 Cdn. What are the laws in Canada towards this Money. Is it declared as income? Is there an inheritance tax that she will have to pay once she receives the money? Everything I read says Canada does not have an inheritance tax but I'm sure our Government will take a chunk some how."

Answer
A Canadian taxpayer receiving an inheritance from inside or outside the country does NOT include that money in their income. It is tax-free. Our tax collector the CRA says so here.

There is no inheritance tax in Canada, thankfully. The closest thing is the rule that a deceased person is deemed to have sold everything on the day before their death, which can trigger capital gains to pay, or a very large income all at once, for instance when RRSPs are considered to have been terminated and all of the proceeds are taken into income. The person who pays such taxes is the dead person, or more accurately, the estate of the deceased. By the time the cheque arrives to the inheritor, all those taxes must have been paid out of the estate, otherwise the executor is liable (not the recipient). Executors make sure they are not exposed by getting a written clearance certificate from the CRA stating that all taxes have been paid.

The only taxes your wife would pay is on any gains or income from investing that money afterwards.

Inheritances that a Canadian receives from abroad are also not taxed as income by the recipient. The foreign country with an estate or inheritance tax, like the USA or the UK, will have levied its taxes before the money can be distributed.

In general, even in countries which have an inheritance tax, by the time the money is delivered to the recipient, any inheritance owing should/will have been paid. It's the estate that pays.

My condolences on her losing her father.

Hooray for TFSA! Canadian Federal Budget Delivers on My Wish List

Well, you read it here first on my Christmas Wish List 2007. Minister Flaherty has delivered on my request to institute a tax-free savings account just like the ISA that exists over here in the UK. Wonderful. These accounts are so simple and straightforward, they achieve much better than RRSPs the goal of getting people to save. There are no books written about ISAs, unlike the tome Preet Banerjee recently put out about RRSPs, because there's so little to write about. The worst thing about the new accounts is their awful acronym - TFSA. How the heck do you pronounce that - TaFSA? Didn't they learn with RRSP, where is the marketing savvy?

The $5,000 annual contribution limit is too low; better would have been double that and even better would have been four times higher, which would start killing off RRSPs. The "if you don't use it, you don't lose it" feature of the annual contribution limit is a great measure for added flexibility since many families with young children might not get the chance to save for a number of years.

I'd expect the new TFSA, as the info sheet suggests, to be heavily used by seniors, for instance for funding inheritances. The money can be put aside, grow tax-free and be non-taxable at death. While it is in the TFSA, it can serve as a safety cushion for unexpected health care costs and if not needed, passed along to the next generation. Increasing life expectancy could allow amassing a tidy sum.

In short, I believe the info sheet blurb is not too far off (except for the niggardly $5k) when it says "It’s the single most important personal savings vehicle since the introduction of the Registered Retirement Savings Plan (RRSP)."

It was nice to see our government paying attention to this humble blogger. I suppose they are waiting for the next budget to put in an annual tax-free capital gains exemption.

Canadians Receiving Inheritances from the UK

A friend recently asked me what would happen with an inheritance that he expected to receive sometime down the road from a relative in the UK. Since it might be of interest to others out there, here is some information that may help you get started.

For inheritances, whether from Canada or from the UK, there wouldn't be any tax to pay on the lump sum received. However, once in your hands, you would be liable to taxes on any interest, dividends or capital gains the invested money might generate. That would be the case whether you physically repatriated the money to Canada or invested it in the UK. People considered residents of Canada for tax purposes are liable to pay income tax on their worldwide income.

Any UK inheritance would first be taxed according to UK laws, notably the inheritance tax, which kicks in above a tax-exempt 300,000 (in 2007-08) pounds sterling amount at a rate of 40%. Afterwards, once in your hands, if left/invested in the UK, there would be UK taxes on whatever income was earned. The UK taxes would count as a credit on your Canadian tax return so you wouldn't get taxed twice.

An interesting potential alternative is for your relative to put in his/her will to create a trust in a low/no tax place like the Isle of Man or the Bahamas. This is called an Inbound Inheritance Trust, which would hold the funds instead of you. The money could then grow on a tax-free basis, much like it does in an RRSP. Any payment to you of the original capital would be tax-free, while you would pay Canadian income tax on withdrawals of any income or gains. An added advantage is that disposal of the trust would not be subject to probate fees ($5 per thousand on the first $50,000 and $15 per thousand on the excess in Ontario). Below are a couple of links to articles that describe the Inbound Trust. Note the comment in the first article that this is a practical strategy for a substantial inheritance of $500k or more and that was back in 2002. Much as I am in favour of do-it-yourself, the complexities of such a vehicle would have me speaking to a lawyer and accountant specialized in such matters in order to get it right and not have it invalidated by the Canada Revenue Agency.

• Michael Berton's article in Advisor.ca
• Lawyer Lorne Saltman of Cassels Brock's presentation. This one also has notes on how the rules in the United States work.