The use of trusts in a will (testamentary trusts) can be a very effective tax planning tool. Such trusts can provide for income splitting even after death.
During their lifetimes, many taxpayers split certain types of income - particularly investment income - between themselves and their spouses/partners (hereinafter referred to simply as "spouses"). But this structure has a problem: if one spouse dies leaving all assets to the surviving spouse, that surviving spouse must report all the income that was previously split between the two of them.
In Canada, the income tax system is such that, as income increases, tax rates increase. In a simple example, two spouses whose only income is $40,000 each in interest income will pay combined income tax in Ontario in 2012 of approximately $12,825 per year. If one passes away and leaves the other to report $80,000, the income tax bill increases to $19,237 per year.
The good news is that, with some relatively simple steps and good professional advice, this increased income tax bill can be reduced significantly. Such planning involves setting up a testamentary trust.
The trust concept can be difficult to understand: a trust is not like a company, nor is it a live person, nor a partnership. Essentially, a trust involves a person who settles, or creates, the trust (the settlor), with other people who manage the trust property (the trustees) for the benefit of those for whom the trust was created (the beneficiaries). The settlor's instructions control how the trustees manage the trust property. In a testamentary trust, the settlor's instructions are set out in his or her will. The beneficiaries are those to whom the assets pass. In the above example, the beneficiary is the spouse of the deceased.
The trustee is often the most difficult person to appoint from a practical perspective. In many cases, the trustee is the same person as is named executor under the will, but professional advice is required to ensure compliance with the income tax rules.
In most cases when married people make their wills, they leave their assets to their spouses. Canadian tax rules generally provide that income tax is not triggered on assets left to a surviving spouse. Properly setting up a trust for the spouse does not change this. It simply means that, rather than passing outright, the assets instead are left in trust for the surviving spouse. In this manner, the income earned on those assets is taxed in the trust rather than in the spouse's hands.
A properly constituted testamentary trust is taxed at the same marginal income tax rates as apply to individuals. A trust may not, however, claim the personal tax credits available to individuals, so the combined tax paid by the trust and the surviving spouse is not exactly the same as it would be when such income is split between two individuals. But it is close.
Using the example above of $40,000 of interest income annually, the trust would pay $8,060 of income tax and the surviving spouse would pay $6,412, for a total tax tax bill of $14,472 - annual savings of $4,765.
There are several technical details that require careful attention when such a trust is set up, and one must be careful that assets are not owned jointly prior to death. Other advantages of such planning include the ability of the trust settlor to direct what is to happen with assets when the surviving spouse dies. This often is attractive to those who wish to ensure that certain beneficiaries eventually receive their assets, while also ensuring that a spouse is taken care of during the spouse's lifetime.
With proper professional advice, this planning is relatively simple and inexpensive to implement, and can result in substantial tax savings. Similar savings can be achieved by setting up testamentary trusts for other beneficiaries as well. Contact your Collins Barrow advisor for more information.
Karen Sands is a Tax Partner in the Kingston office of Collins Barrow.
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