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Estate Planning For The Senior Executive

By: Jim Innes
September 2007

When developing their estate plans, many high net worth individuals miss one of the simplest, yet most profitable, tax planning strategies available – the testamentary trust. If properly structured, a testamentary trust can save a taxpayer and his family hundreds of thousands of dollars in taxes.

A testamentary trust is created when, on the death of an individual, all of his or her assets – not owned jointly with someone else – are transferred automatically into their estate. The estate or trust created is considered to be a ‘Testamentary Trust.’ The estate executor then manages those assets based on the instructions provided in the individual’s last will and testament.

While testamentary trusts are subject to special tax rules, proper tax planning can take advantage of these. This article will introduce these concepts to you.

TAXATION OF A TESTAMENTARY TRUST

A testamentary trust is taxed using the same graduated tax rates as for individuals. The trust, however, does not have the benefit of the personal exemptions.

Using the personal tax rates means the trust benefits from the lower marginal tax rates. For example, if a trust is resident in Ontario, the tax rate on the first $34,758 of taxable income earned in 2006 is 21.3 per cent. If the trust did not qualify for graduated personal tax rates, it would be taxed at the top marginal tax rate of 46.41 per cent. As you can see, there is an opportunity for substantial savings.

INCOME SPLITTING WITH A TESTAMENTARY TRUST

The low tax rates within the trust and the ability to allocate income to beneficiaries provide the main tax advantage – income splitting. Income splitting is the technique of allocating income to other taxpayers, in this case either the trust or members of your family, with lower incomes and, therefore, lower tax rates. (For more on income splitting, see Using Trusts In Wills To Split Income, by John Osgoode Smith on Page 28.)

Estate PlanningFor example, if an individual left $1 million to his wife and she earned $100,000 of investment income per year in addition to her regular income, the extra tax would be $46,410, assuming she was resident in Ontario in 2006 and was already earning substantial income from other sources.

If, instead of the wife, the money had been left to one testamentary trust, the tax would be reduced to $31,555. If the investment income had been split between four testamentary trusts (each with a different beneficiary), the total tax would be $21,300.

The tax can be further reduced by allocating income to beneficiaries who have little or no other income. With enough low tax rate beneficiaries, it may be possible to reduce the income tax to zero.

Since these trusts can be designed to continue for many years, the tax savings can grow to be in the hundreds of thousands of dollars.

INCOME TAXABLE TO A BENEFICIARY

When a trust allocates income to a beneficiary, there are a few basic rules to follow.

First, the income allocated will generally maintain its nature. This means, if the trust earns a capital gain and allocates it to the beneficiary, the beneficiary will report a capital gain.

Second, for the trust to receive a deduction and not pay tax on the amount allocated to the beneficiary, the amount allocated must be paid, or payable, to the beneficiary at the end of the year. For an adult beneficiary, that generally means that the amount allocated has been paid. For children under the age of 18, the funds can be set aside and paid to them when they reach 18 years old. The funds may also be paid to a guardian and spent on items for the benefit of the child.

It is very important to remember that when you allocate income to a child or other beneficiary, the money belongs to them.

MULTIPLE TRUSTS

For larger estates, it is possible to enhance the income splitting benefit by creating multiple trusts.

Multiple trusts are possible when there are a number of beneficiaries. For example, if there are four children, you could consider creating a trust for each child. This would allow each beneficiary to manage their own pool of funds, as well as earn more income because of the lower marginal tax rate.

MOVING TO ALBERTA

Further tax savings can be obtained by moving the trust to a province with a low income tax rate. However, in order to move a trust for income tax purposes, you need to have a trustee resident in that province. One technique for moving the trust is to appoint a professional trustee resident in the province of choice.

In cases where the income is quite high, moving the trust from Ontario to Alberta could result in significant savings. Since Alberta has a low provincial tax rate of 10 per cent, the top marginal tax rate (including federal and provincial taxes) in Alberta on regular income would be 39 per cent, compared with, for example, 46 per cent in Ontario.

DEFERRAL OF INCOME TAX

Another tax benefit of a testamentary trust is that you are able to choose the yearend. The choice of year-end, combined with the fact that income is taxed as if it were all earned on the last day of the trust’s fiscal year, allows tax deferral for up to one year. For example, consider a trust with a January 31, 2007, year-end. If you held the investment personally, you would be reporting much of the income on your 2006 personal tax return. However, when it has been earned in the trust and then allocated to the beneficiary on January 31, 2007, it will be reported on the beneficiary’s 2007 personal tax return. In this way, you can defer paying tax for one full year.

There is also another benefit to earning the income in the trust. If an individual earns income throughout the year, they would generally be required to pay tax installments throughout the year. However, trusts are not required to pay installments. If the trust was taxed on the income earned, you could defer the payment of the related tax for up to a year.

OTHER BENEFITS OF TESTAMENTARY TRUSTS

In addition to the benefits discussed above, there are a number of non-tax benefits that can be obtained through the use of testamentary trusts.

Creditor protection is a good example of a benefit of using a testamentary trust. For example, consider a child with severe financial problems. How would you feel if you thought all of your hard-earned life savings could, on your death, immediately be used to pay off that child’s creditors? Or, even worse, what if your contribution fell short of their total debts and they still ended up bankrupt.

When you leave money to a trust, it is separate from the various beneficiaries. Depending on how the trust is set up, the funds should be out of the reach of the beneficiaries’ creditors. Often we set up the trust to allow the beneficiary to decide if the funds will be used to pay off creditors or passed on to another beneficiary.

You can extend the creditor protection to include individuals with matrimonial problems. While it is generally believed that an inheritance would not be shared in a marriage breakdown, this is not always the case. Without getting into the details of matrimonial law, it is possible to provide better protection for funds by leaving them to a beneficiary via a trust.

We also see trusts used to allow individuals to control how their estate is managed after they pass away. This is particularly useful if there are minor children or if there is concern about how well an adult beneficiary will handle the funds.

Finally, using a testamentary trust can help avoid double probate tax. This is useful when a husband and wife are planning to leave everything to each other and then pass their estate on to the next generation. There may be probate on the death of the first spouse, but the trust could avoid a second round of probate tax on the same assets.

TESTAMENTARY TRUSTS FOR YOUR PARENTS

Hopefully, you can now see the benefits of creating testamentary trusts when doing your own estate planning. However, after you have completed your own estate planning, you should consider planning for individuals that may be including you in their wills.

A common example is an individual’s parents. If your parents’ estate is not significant, you could consider giving them some of your investments now so that on their death, they could leave it to you in a testamentary trust.

GETTING STARTED

Including testamentary trusts in your estate planning starts when you draft your will. It can be a very simple document that outlines what assets are being placed in the trust, who the beneficiaries are, who the trustees are, and how the assets in the trust are to be treated. Still, professional advice is recommended. You should consult with both your tax accountant and your lawyer to ensure you leave your estate to your beneficiaries so they can benefit the most.

Jim Innes is a chartered accountant with 29 years of experience providing tax advice to individuals and businesses. He is a partner in the firm of Innes Klayman LLP, Chartered Accountants. He can be reached at 416-590-1728 x 314.

 

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