Estate trusts

Budget delivers knockout punch to estate trusts

March 14, 2014

Finance Minister Jim Flaherty delivered his 10th, and likely last, federal budget on Tuesday.  In spite of the gold rush from our Olympic athletes threatening to drown out this news, he still got lots of attention.

On the personal tax front there are some tinkering improvements that affect limited numbers of people, which I will list later. 

However, most of us in the tax and advisory community were hoping for good news on the taxation of testamentary trusts.  What we got was clarity, but bad news.

Starting in 2016, any income earned within testamentary trusts will be taxed at the top tax rate, rather than at the graduated tax rates that have applied until now. This top rate will also apply to estates after their first 36 months of existence, and to “grandfathered” inter vivos trusts. (Don’t worry – if you have one, you know it.)

The only good news is that they listened to us and provided an exemption for trusts that are for the benefit of a disabled person.

To explain, testamentary trusts are ongoing trusts created out of an estate, which are described in a person’s last will and testament, but only come into effect after that person dies.  These trusts could be for the benefit of a spouse, children, grandchildren or other people.

Until now, these trusts were taxed like a regular taxpayer, with the low, middle and top tax rates applied, depending how much total income was earned by the investments in the trust.  The trust did not get the benefit of the personal exemption, however, which allows each of us to earn about $10,000 tax-free each year.

There are lots of reasons to create these trusts other than the tax benefits.  They keep inherited assets separate from marital property, so they are not included in the property division if the beneficiary suffers a marriage breakdown in the future.

The trust arrangement can be very valuable for young beneficiaries, those inexperienced with money management, potentially under the influence of another person, or to protect beneficiaries who have gambling, compulsion or addiction issues.

The potential tax benefits certainly made this arrangement more attractive, and so this was a strategy we always considered with our high net worth clients.

Solution

In the first three years after death, an estate will still be allowed the benefit of the graduated tax rates, and we recommend taking advantage of this.

Ongoing trusts still may be advantageous or necessary for the reasons mentioned above.  The solution to the new punitive tax treatment is to allocate the income to the beneficiaries each year, some of whom will hopefully not be in the top tax bracket.  The allocation does not have to be equal. 

Since the beneficiaries can include your children, grandchildren and future grandchildren - even if they don’t currently exist - there may be opportunities for ongoing tax savings through income splitting.

However, the days of getting a special tax treatment if you are willing to die for it are apparently behind us.  My late father’s careful planning is about to go out the window.

In further tightening of tax strategies, the budget extended the reach on the “kiddy tax” (top tax rate treatment to income allocated from a parent to a minor child) to now include rental income and business income.  In this case, Mr. Flaherty’s bullet missed my head, as my kids are now over 18.  (Not that I’m taking any of this personally, you understand.)

The budget provided timely good news for high-level amateur athletes, as tax-sheltered money that goes into their amateur athlete trusts will now qualify to create RRSP room.  Kudos.

There is an increase to the adoption tax credit, a new tax credit for search and rescue volunteers, an extension to the extra 15% credit on flow-through share investments, and a rule regarding transfers out of pension plans, designed to prevent people leaving underfunded plans from having an inaccurately high amount of that transfer taxable. 

The only offset to the testamentary trust provisions is an increase in flexibility around donations made in the year of death, starting with deaths after 2015. On balance, I think the families of deceased people have come out way behind in this budget.

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Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.

Please consult legal, tax and investment experts for advice on your unique situation.

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David Christianson, BA, CFP, R.F.P., TEP, CIMis a financial planner and advisor with Christianson Wealth Advisors, a Vice President with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.