By Halldor K. Bjarnason, Lawyer (PLAN Family Partner)
Many of us set up trusts for our sons and daughters. Trusts are a useful way of protecting their inheritances (or other funds) from misuse and/or to ensure that they continue to qualify for provincial disability assistance. However, the way a trust is created can have long term income tax consequences. The terms “testamentary” and inter vivos (or “living”) describe how a trust is created. As a trust is a separate taxpayer for income tax purposes, the way it is created affects how it is taxed, and ultimately, how much income tax it will pay each year.
Of the 51-odd trusts described in the Income Tax Act, the majority are inter vivos or “living”. That means that the trust has been created during the lifetime of the settlor (the person who contributed the assets to the trust). Trusts must file a tax return each year, and with inter vivos trusts, they pay tax at the highest personal tax rate – currently about 43% – on the trust’s income.
On the other hand, a testamentary trust gets significantly better tax treatment. A testamentary trust is created as a result of the settlor’s death. This usually means that it is created within the settlor’s will. However, there are also ways to create separate testamentary trusts. The benefit of a testamentary trust is that it is taxed at a graduated rate – just like human beings. The first $30,000 of income is taxed at around 21%, and this rate gradually increases until all trust income over $120,000 is taxed at about 43%.
From an income tax perspective, testamentary trusts are a much better deal. The downside is, you must die first. Hence, if you need the trust NOW, you are stuck doing an inter vivos trust.
The one other thing to keep in mind is that the Canadian Revenue Agency is very protective of the preferred tax status given to testamentary trusts. Hence, even if you manage to create a proper testamentary trust, if it becomes “tainted” by a contribution of money from any source other than the deceased, it will immediately be redefined as an inter vivos trust and pay a much higher tax rate.
Halldor teaches the Wills, Trusts and Estates Planning workshop at PLAN and is an attorney at ACCESS Law Group. Become a PLAN Family Partner and receive a 15% discount on this course, and up to 30% discount on legal services provided by ACCESS Law Group.