By Ermos Erotocritou
Legislation has recently been passed that will eliminate the graduated tax rates currently available for testamentary trusts as of January 1, 2016. No grandfathering for existing structures is proposed.
Therefore, for the most part, the income taxed within a testamentary trust will all be taxed at the highest marginal rate. There will be two exceptions to this:
- First, graduated rates will apply for the first 36 months of an estate, where the estate is a Graduated Rate Estate (“GRE”).
- Second, graduated rates will continue to be available in respect of Qualified Disability Trusts (“QDTs”).
Consider Triggering Capital Gains in 2015 to take advantage of Graduated Rates
Where the testator is deceased and the trust is already in existence, consider triggering capital gains in 2015 while the graduated rates are still in effect. Testamentary trusts that do not already have a calendar year taxation year will have a deemed taxation year-end on December 31, 2015. If the trust has an off-calendar year-end, then it is possible that it may have two year-ends in 2015.
For example, an existing testamentary trust could have a regular year-end on October 31, 2015 and a deemed year-end at December 31, 2015. This means that two trust returns will be filed in short succession. The trust will not have the ability to use graduated rates commencing with the year that ends on December 31, 2016. It may be worthwhile for the client to trigger unrealized capital gains at various times during the year in order to take advantage of the graduated rates of tax, in some cases in two different tax periods.
What About 2016?
If the sole reason for the trust was tax-motivated, then it may be worthwhile to wind up the trust after 2015, if the terms of the trust allow for that (the trust should be reviewed by a legal advisor to confirm whether or not it is possible to wind up the trust). However, in many cases there will be other reasons to keep the trust. For example:
- Trust is being used for control – Was the trust established to maintain control? (e.g. young or financially irresponsible beneficiaries, second marriage, etc.);
- Trust allows for distributions to lower income beneficiaries – Do the terms of the trust allow the funds to be paid out to lower income beneficiaries to access their lower tax rates? If so, consider keeping the trust in place. It is possible that testamentary trusts may still provide tax benefits where the beneficiaries are in lower tax brackets, as in many cases the income may be paid out to or used to assist the beneficiaries and therefore taxed on their individual tax return.
Assume a client’s adult daughter is incurring ongoing expenses for her own children. If a discretionary trust has been established for the benefit of the daughter and her children, it can still create a significant tax savings opportunity for the daughter. The trustee or trustees can direct that the income from the trust be used to pay for a wide range of expenses that benefit the daughter’s children (private school tuition, music lessons, sports registration fees, post-secondary education, etc.), allowing the trust income to be taxed in the hands of the beneficiaries. It is only where all the potential beneficiaries are in high tax brackets themselves that the income splitting advantages may no longer be available.
- Trust is necessary to protect the beneficiary from creditors or preserve social assistance – in some cases parents will establish a trust for a disabled person in order to maintain their eligibility for social assistance, or will be established for a child with creditor issues in order to avoid having the assets being seized.
- Trust will be used to reduce probate on the death of a beneficiary in common-law jurisdictions – When the testator of the existing trust died, probate fees applied on the assets that flowed into the trust. If and when any of the beneficiaries of the trust die, then unless the terms of the trust specify that the trust assets are paid to the dead beneficiary’s estate, the trust assets will avoid probate upon that beneficiary’s death. Whereas if the trust is wound up and assets distributed to each beneficiary, when each beneficiary dies, probate will likely be payable. This may be of particular interest with respect to trusts where the life interest beneficiary is elderly.
Review Trust Terms to see if they should be Re-drafted
Where the trust is not yet established (the client is still alive), your legal advisor should review your will to make sure it is flexible enough to allow any testamentary trusts to be wound up at a reasonable time (i.e. perhaps not when beneficiaries are minors). Once clients lose capacity, it will be too late to change the terms of the trust.
Changes for certain “Life interest trusts”
The legislation also impacts the taxation of spousal or common-law partner trusts, alter ego trusts, and joint spousal or common-law partner trusts.
On the death of the life interest beneficiary (or on the second death in the case of a joint spousal or common-law partner trust), the trust will have a deemed year end at the end of the day of death and all income incurred in the trust for the shortened year (including any capital gains realized on the deemed disposition) is deemed payable in the year to the deceased life interest beneficiary. The result is that the capital gains on the deemed disposition is included in the deceased life interest beneficiary’s terminal year return, not the trust’s return. This may cause unintended consequences.
Mike and Carol are in a second marriage. Mike has established a spousal trust, with his spouse Carol being the primary beneficiary, and Mike’s children from his previous relationship being the contingent beneficiaries. Carol has children of her own who will inherit her estate. Upon Mike’s death, the spousal trust is established. Upon Carol’s death, any unrealized capital gains in the trust are triggered, but instead of the tax liability being assessed to the trust, it is assessed to the estate of Carol.
Mike may want to include a clause in his trust indicating that it will be the trust that is liable for the tax liability, not the estate of Carol. Mike and Carol should speak with their advisors about the implications of doing this, as it may result in Carol’s estate no longer being a graduated rate estate.
Anyone who still has the capacity to change their documents should be urged to review their documentation with a legal advisor to confirm whether or not any changes should be made in light of the new legislation.
Ermos Erotocritou is a Regional Director with Investors Group Financial Services Inc.
Disclaimer: This is a general source of information only. It is not intended to provide personalized tax, legal or investment advice, and is not intended as a solicitation to purchase securities. Ermos Erotocritou is solely responsible for its content. For more information, please contact an Investors Group Consultant. Insurance products and services distributed through I.G. Insurance Services Inc.