Testamentary Trusts Revisited – Budget 2014

For the past several years, estate planning lawyers have touted the virtues of testamentary trusts as a tax planning tool for clients with sizeable estates. Budget 2014 will largely remove the tax benefits of testamentary trusts, and for many clients (but not all!) the simplicity of outright gifts for adult beneficiaries might now make more sense than testamentary trusts.

A testamentary trust is a trust that is set up in a Will (as opposed to a trust set up in the lifetime of a person). Testamentary trusts were given special tax treatment in the Income Tax Act; rather than being taxed at the top marginal tax rate, income earned and kept in the trust was taxed at graduated rates. If an adult child was given their inheritance in the form of a testamentary trust, that adult child would be able to take advantage of two sets of graduated tax rates: one for income earned in the trust, and one for their employment and other income.

Budget 2014 changes this. Essentially, starting in the 2016 tax year, income earned in testamentary trusts will be taxed at the top marginal tax rate. There are two exceptions:

  1. Graduated tax rates will apply for the first 36 months of an estate to give reasonable time for the estate to be administered.
  2. Testamentary trusts that are set up for disabled beneficiaries who are eligible for the federal Disability Tax Credit will still be able to take advantage of graduated income tax rates.

If you want more detail, see pages 329-331 of the federal government’s Economic Action Plan 2014.

What does this mean for clients making their Wills?

For clients whose primary goal in doing a testamentary trust was to take advantage of the graduated tax rates for adult children beneficiaries, it might not be worth it anymore. I suspect we will see a return to more straightforward Wills with gifts outright to adult children (who can then put it in their principal residence or other investments).

There are other benefits of trusts and certain situations where trusts will still make a lot of sense. For example (not a comprehensive list!):

  1. For will-makers whose children are under 19, or over 19 but under the age the will-maker would trust them to handle their inheritance responsibly without blowing it. In these trusts, the executor or another trustee holds the funds for the child, distributes whatever funds the trustee thinks are needed for the child’s care education and benefit along the way, then distributes it to the child at the age(s) set out in the Will (e.g. 50% at age 27, and the balance at 35).
  2. For disabled beneficiaries. In BC, provincial disability benefits have very strict asset and income limits. If a person receives an inheritance outright, they can potentially lose their benefits. However, as a matter of policy, if an inheritance is put in a trust where the disabled person does not have control over the funds (a discretionary trust) and certain non-discretionary trusts, it is not considered an asset of the beneficiary and they can retain their provincial disability benefits.
  3. For high net worth clients whose adult children may still want to take advantage of the income splitting possibilities of trusts. If a trust distributes all of its income, there will be no tax in the trust. Instead, the beneficiaries add the distribution received to their own income. If the will-maker’s adult children have children of their own who are in university for example (over 19, but not making a large income of their own), the income can be distributed among the various beneficiaries each of whom have their set of graduated tax rates.

If the will-maker’s goal is to protect their adult child’s inheritance in the event of a marital breakup, that is an issue to discuss with the lawyer. It may be that gently encouraging the adult child to make a marriage or cohabitation agreement that would exclude the inheritance and any future increase in value on the inheritance from any division of family assets is the best approach.