All of us like to save taxes.
Most of us set up our wills to give all or a substantial portion of our estate to our children (after appropriate provision for our spouse). Except for exceptionally large estates, usually the gifts to our children are outright and absolute, at least after they reach a certain age. As a result, our children will enjoy their inheritance with freedom of choice as to how they invest or use it. The gist of the Will says something like this:
Everything to my spouse, and if my spouse does not survive me, divide it among my children equally when they reach age 25.
Have we just squandered an opportunity for our children to save taxes?
For adult children who already have substantial income, or even for young children who show substantial promise of ability to earn a substantial income in later years, the outright gift to children in the Will forgoes an opportunity to split income between a child and a trust for the child set up in the Will (called a “testamentary trust”).
Suppose instead of giving it directly to children at a certain age, the Will directs that each child’s share go into a testamentary trust. In Canadian tax law, a testamentary trust is taxed like an individual, but with no personal tax credits. This means that a trust enjoys a full set of graduated tax rates.
Consider your daughter, Jane. She is already earning a high salary which puts her taxable income above $132,400. This is the threshold for 2012 to which the top rate of 46.41% applies. If she invests her inheritance from you to help build a retirement nest egg and earns, say, interest of $20,000, her net interest income after tax will be $10,718. If she had been able to invest it in a testamentary trust subject to the graduated tax rates, the applicable rate of combined federal and Ontario tax on this interest income would have been about 20.1%, increasing her net income after tax to $15,980. Assuming that interest rates and tax rates stay the same every year, the saving is $5,262 every year in this example.
It is right to ask whether, by doing so, we have deprived our children of the freedom to use the money as they see fit in the same way as if it had been left to them outright. Although one of the classic reasons for using trusts in Wills is to set up restrictions on use and access by the beneficiaries, this does not have to be the case. A well drafted Will could leave the share of the estate to your children as trustees of their own trust, with a power to use both the income and capital as they see fit for their own benefit. Instead of investing it in the testamentary trust for her benefit to save taxes, this power permits Jane to take out income or capital from her testamentary trust to renovate her house, or buy a shiny new Mercedes.
The gist of such a Will says something like this:
Everything to my spouse, and if my spouse does not survive me, divide it and pay it to each of my children to be held by each child of mine in a separate trust, with the power to use all or any of the annual income and capital to or for the benefit of such child in their sole and absolute discretion.
A carefully worded testamentary trust to this effect still leaves your child in full control of her inheritance in the same way as if it had been given to her outright.
If you have three children, three testamentary trusts multiply the savings. It is fair to assume however that Canada Revenue Agency is not overwhelmed with the elegant beauty of splitting income with multiple testamentary trusts, and in fact, it has the power, when the source of funds to multiple trusts is the same, to deem multiple trusts to be a single trust if the income of the trust accrues to the same beneficiary or class or group of beneficiaries . In the one relevant case of which I am aware (Mitchell v. MNR), four separate trusts were allowed for the taxpayer’s four children. It is also understood that there is an administrative policy to permit multiple trusts if the Will clearly intends separate trusts which do not have any common beneficiaries, and that during the administration of the estate, the accounting is kept separate for each trust.
There are lots of other potential applications of this tax planning strategy. For example, leaving your spouse’s entitlement in a trust of which she is the sole trustee will allow her to split income with her testamentary trust and retain full control of it, which may be very useful if your spouse has and is likely to continue to have a high taxable income in his or her own right.
A word of caution: please don’t try this at home. Your Will will likely be your single largest transfer of assets in your lifetime, and drafting such testamentary trusts effectively, without introducing other concerns, requires an expert. This is especially the case when Wills contain testamentary trusts.
For more information on wills and estate matters, contact Wesley Brown by phone (416) 368-0600, fax (416) 368-6068 or email at email@example.com.
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