The usefulness of testamentary trusts will not been eliminated even if upcoming changes to the tax treatment of these trusts make them less tax-friendly for clients, said Frank DiPietro, director of tax and estate planning with Toronto-based Mackenzie Financial Corp., at the Institute of Advanced Financial Planners’ 13th annual symposium in Niagara Falls, Ont. on Wednesday.
On Jan. 1, 2016, testamentary trusts will be taxed at the top tax rate as opposed to graduated tax rates — although there are exceptions for those who designate their estate as a graduated rate estate and testamentary trusts that are set up for the benefit of a disabled individual who is eligible for the disability tax credit.
One way in which to use a testamentary trust more effectively is through what DiPietro called “income sprinkling,” in which the creator of the trust would name multiple beneficiaries. This would pave the way for a type of income-splitting process.
“If any one of those beneficiaries are in a low tax bracket, we can distribute income out of that trust and have that income taxed in the hands of the beneficiaries personally,” DiPietro explained. “And if they’re in lower tax brackets, then they can effectively continue to use a testamentary trust as an income-splitting vehicle.”
DiPietro also pointed out that testamentary trusts would continue to be critical vehicles for leaving assets to minor children who are unable to inherit money directly as well as the older children of clients who may not be financially responsible enough to have access to an inheritance.
“If you have clients who worry that an inheritance will be quickly squandered, then a testamentary trust can certainly be used to provide that income and capital protection,” DiPietro said. “And that trust can stipulate specific terms to allow that beneficiary to obtain access to the capital over time.”
In addition, a testamentary trust can also be useful to clients who have property in the U.S. as Canadian testamentary trusts can act as vehicles to protect clients from potential exposure to U.S. estate taxes, DiPietro said.
However, DiPietro also advised to consider creating more tax efficient investment portfolios within testamentary trusts to provide more tax-efficient income.
He also mused about the possibility that alter-ego trusts, a type of living trust, might grow in popularity thanks to the decreasing tax-friendliness of testamentary trusts.
Alter-ego trusts can be created by Canadian residents who are at least 65 years old. It allows the creator, also known as the settlor, of the trust to transfer property on a tax-deferred basis.
One of the advantages of this type of trust is that it’s taxed using the settlor’s personal income tax bracket. So, if this individual is not in the top tax bracket, he or she will have access to lower tax rates.
However, DiPietro noted that alter ego trusts are not necessarily cost-friendly as the fee to create one can be a few thousand dollars.
Editor’s note: For more information on alter-ego trusts, see Estate planning with alter-ego and joint partner trusts