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Many clients put estate planning on the backburner because they are unsure of what their options are when it comes to the distribution of their assets after they have passed. A client’s understanding of the various types of testamentary trusts available may provide some relief when considering how to distribute their assets when completing their estate plan.
Testamentary trusts can be incredibly useful planning tools for clients who want to appoint a trustee to retain legal control and management of their property upon their passing. Unlike a living trust, a testamentary trust can be set up through the will and becomes effective after death. These trusts are commonly set up where clients want to leave an inheritance to minor children, children with disabilities, spendthrifts, children with addiction issues, protection against spouses and creditors, heirs who aren’t capable of managing or receiving the assets in full, etc.
Common testamentary trusts
Age trusts – providing for minor children and young adults
An age trust is designed to provide a distribution to beneficiaries at specific ages that are determined by the testator (will maker), rather than a beneficiary receiving their full inheritance upon the passing of the testator. Since there is no way to determine how long an individual will live, this type of trust ensures that if beneficiaries are not at an age where the client is comfortable leaving them their full inheritance, they are able to plan accordingly. For example, let’s say a child is currently 20 years old – perhaps the client would not want them to receive their inheritance until they are older, let’s say half at age 25 and the balance at 30. Clients can also include a discretionary component so that the trustee (the individual administering the assets for the benefit of the beneficiary) is able to release certain proceeds in advance, at their discretion, for things like a home down payment, university tuition, a vehicle, or wedding, for example.
Discretionary trust – providing for spendthrift beneficiaries
Sometimes age isn’t the issue. Your client could have a child who is younger but is financially savvy and would use their inheritance wisely. On the other hand, they could have a child who is elderly and does not have financial management skills. In this case, your client may choose to have a fully discretionary trust in their will. The trustee would have full unfettered discretion and authority in determining the capital and income that should be paid from the trust. This can be advantageous for clients who don’t know what the future holds in terms of the beneficiary’s lifestyle. This type of trust is common for beneficiaries who spend extravagantly and recklessly. If a beneficiary who spends without thinking and does not have the capability to manage their finances, this is an option your client should consider exploring.
A trust like this may also be set up for children with addictions ranging from gambling to drugs or alcohol. There may be a requirement that the child go for drug testing to ensure there is a negative test before the trustee is able to make a payment to the beneficiary.
Henson Trust – protecting beneficiaries with disabilities
This type of discretionary trust is commonly used to protect the assets of a person who has a disability and to maintain their eligibility for government assistance. Every client leaving an inheritance to a disabled individual receiving government benefits should ensure they are receiving proper advice from an estate lawyer regarding their planning. For the most part, a person’s entitlement to government benefits related to disability is income- and asset-tested. When an individual owns certain assets or receives income over the specified amounts, they are in jeopardy of losing or being disqualified from government support. A Henson Trust provides the trustee with full discretion in determining the capital and income that should be paid from the trust. When set up properly, the assets held inside a Henson Trust would not generally count toward the asset thresholds for government benefits, allowing clients to maximize the government support.
Spousal trust – planning for blended families
Blended families are on the rise in Canada and a testamentary spousal trust can be an effective way of providing to the spouse during their lifetime and having the remainder pass to the testator’s biological children on the death of the spouse. The surviving spouse would be entitled to receive all the income from the testamentary spousal trust and is the only person who can receive capital from the trust until their passing. Restrictions can be imposed on the distribution of capital to the spouse.
A lawyer may also suggest a spousal trust if the testator is worried that their spouse may remarry in the future. Other reasons for a spousal trust could be that the spouse is not financially savvy or perhaps there is a business involved and the testator wants their spouse to reap the benefits of the business proceeds but ultimately have the children inherit the business.
Residence trust – protecting beneficiaries that reside in the family home
Often, a testator has a loved one residing with them and wants to ensure that the beneficiary will be able to use and occupy the home upon their passing. The testator can decide whether the trust exists for a certain amount of time; for as long as the beneficiary wishes; or if the beneficiary can remain in the property for their lifetime. The testator can decide whether the beneficiary or the estate will be responsible for maintenance and operating costs, and this should be clearly documented. The language in the trust may need to include a provision for a fund to pay for expenses.
Cottage or vacation property trust – preserve ownership within the family
Cottage properties are a source of happiness and memories for a lot of families. Many want to keep the property in the family so it can be enjoyed by their children and grandchildren. A trust can define how the property should be shared and include language to provide for a first right of refusal to help prevent disputes and litigation.
Taxation of testamentary trusts
Since January 1, 2016, testamentary trusts are no longer taxed at graduated rates but instead are subject to top-rate tax, similar to that of living trusts. However, there are two exceptions:
1. Graduated Rate Estate
A Graduated Rate Estate (GRE) is an estate that designates itself as such and is subject to graduated rate taxation for the first 36 months after date of death. There are a number of conditions that must be satisfied. For example, the estate is a testamentary trust for tax purposes, the estate designates itself in its T3 for its first tax year as the individual’s GRE, etc.
2. Qualified Disability Trusts
A Qualified Disability Trust (QDT) is one that jointly elects with the beneficiary under the trust in its T3 to be a qualified disability trust for the year. To qualify the individual named as the beneficiary must be the named individual in the will, the individual must qualify for disability tax credit, must be factually resident in Canada, etc.
Where a testamentary trust allocates its income to one or more beneficiaries, the income would generally be taxed at the recipients’ marginal tax rate instead of the top-rate within the trust. As such, a testamentary trust may provide an income-splitting tax benefit. In addition, it is important to keep in mind that there is a deemed disposition rule for trusts. Generally, a trust is deemed to dispose of certain capital property at fair market value every 21 years after the trust is created. There is an exception to the rule for testamentary spousal trusts, where the first deemed disposition is deferred until the passing of the surviving spouse.
Despite the change in the taxation of testamentary trusts, they are still an extremely useful tool in helping clients meet their estate planning objectives. Clients may consider making updates to their will if they feel a testamentary trust would help fulfill their estate plan. As shown, it can be a great way to protect assets, beneficiaries and families.
This should not be construed as legal, tax or accounting advice. This material has been prepared for information purposes only. The tax information provided in this document is general in nature and each client should consult with their own tax advisor or accountant. We have endeavored to ensure the accuracy of the information provided at the time that it was written, however, should the information in this document be incorrect or incomplete or should the law or its interpretation change after the date of this document, the advice provided may be incorrect or inappropriate. There should be no expectation that the information will be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise. We are not responsible for errors contained in this document or to anyone who relies on the information contained in this document. Please consult your own legal and tax advisor.