The use of testamentary trusts in a will can be a very effective planning tool. Such trusts can provide for income splitting even after death.
Many taxpayers split certain types of income with their spouse/partner. For example, investment income from a jointly held investment portfolio is often split between both spouse’s income tax returns. Similarly, the new pension-splitting rules allow pension income and income from registered savings plans to be split between spouses if they qualify.
The Canadian income tax system is such that as income increases, the tax rate also increases, so when income is split between a couple, that couple will pay less tax overall then if the income is only reported by one individual.
However, a problem does arise if one spouse dies, and the surviving spouse has to report all the income that was previously split between the two of them. In most cases this results in the income being taxed at a higher tax rate, and can result in the repayment of Old Age Security payments and the loss of income tested government benefits, such as the Ontario Trillium Benefit and the HST credit.
The good News is that, with some relatively simple steps and good professional advice, income splitting can continue after death by setting up a testamentary trust.
A testamentary trust is different from other trusts; the creation of the trust is documented in a will but the trust is not actually established until the trust creator/settlor dies. The advantage of a testamentary trust is that the income earned by the trust is taxed at graduated tax rates, like an individual.
In most cases when married people prepare their wills, they leave their assets to their spouse and Canadian tax rules generally provide that no tax is triggered on assets left to a surviving spouse.
Properly setting up a testamentary trust for a spouse does not change this outcome; rather, instead of assets passing directly to a spouse, they are left in a trust for the benefit of the surviving spouse and can remain in his or her control. As a result the income is taxed in the trust, rather than on the spouse’s income tax return.
Other advantages of creating a trust is the ability of the trust settlor to direct what happens to the trust assets when the surviving spouse dies. This is often attractive to those who wish to ensure that their spouse is taken care of during their lifetime, while also ensuring that certain beneficiaries eventually receive their assets (for example in second marriage situations).
Testamentary trusts can also be established for children. On the death of the second spouse, estate assets can be transferred to a separate testamentary trust for each child. If the child is in one of the higher tax brackets, the use of a children’s testamentary trust will provide annual tax savings to the child.
With proper professional advice, testamentary trust planning is relatively simple and inexpensive to implement, and can result in substantial annual tax savings.
Column submitted by Carol Brubacher, senior tax manager of Collins Barrow Wellington-Dufferin District.
