Keep Calm & Plan: 2 Key Changes to Trust Taxation Effective in 2016
June 26, 2015
By Catherine D.A. Watson Coles, Partner at McInnes Cooper
Looks like it’s really going to happen. The trust taxation changes the Federal Government announced in 2013, and proposed and enacted in 2014, will take effect in the 2016 tax year: graduated tax rates for testamentary trusts will be eliminated and the tax burden of life interest trusts (such as spousal, alter ego and joint partner trusts) will shift. Many hoped the Federal Government would backtrack even a bit – but that hasn’t happened. There’s always the chance there will be more changes before the end of 2015, but the general consensus seems to be that the changes will take effect as expected. It’s time to keep calm and plan: the changes will have a significant impact on estate planning, but there are solutions.
Here are the 2 key changes to trust taxation that will take effect in 2016 and tips to help start planning for them.
1. Elimination of Graduated Tax Rates for Testamentary Trusts. This change affects testamentary trusts: a trust a person created in a will that only takes effect on her death.
Now. When any income generated within a testamentary trust is taxed within the trust itself, it’s taxed at graduated rates: the rate an individual would be taxed if the trust income were her only income. This allows trust beneficiaries to effectively income-split with themselves. Here’s an example of how it works. Wilma is a professional in the top-tax bracket and the beneficiary of a trust her late mother, Betty, created in her will. The trust assets of $1M generate $50,000 in income in the run of a year, all payable to Wilma. Now, this income can be allocated to Wilma, who can elect to have the income taxed in the trust at the graduated rate (the rate she would be taxed if her total income were $50,000).
2016. As of 2016, the current flat top-rate (the rate applicable to income over $175,000 in 2015) – and not the graduated rate – will apply to testamentary trusts, grandfathered inter vivos trusts and certain estates. In Wilma’s example, this means that all the income generated in her testamentary trust will be taxed at the highest tax rate within the trust, or at Wilma’s tax rate (still the highest rate, in her case) if it’s taxed in her hands. There are exceptions for the first 36 months of an estate and for trusts for people eligible for the federal disability tax credit. The practical impact is an end to the kind of self income-splitting Wilma enjoyed – and to the tax savings: Wilma’s tax savings were about $10,000/ year in NS.
The Plan. All’s not lost. People with testamentary trusts should review their plans and decide whether and what changes to make, but there are solutions. Here are some ideas:
- Testamentary Trust Tax Planning Still has Life. There are still situations in which the same testamentary tax planning that has always worked still does – even with the changes. Here’s one example: imagine that the terms of Betty’s testamentary trust for Wilma include Wilma’s 3 children as beneficiaries. Wilma’s children are all in university and have no (or minimal) income. If Wilma receives the entire $50,000 of trust income, it will all be taxed at the highest rate. But if Wilma divides the trust income and allocates one third to each child to pay school expenses (which she would have assisted with anyway), each child will be taxed on her income at lower, graduated rates because of her individual low incomes – and Wilma’s tax savings will be significant.
- Testamentary trusts are about more than taxes. There are other good reasons to use testamentary trusts as part of an estate plan that might still make it the right vehicle. For example, by using a testamentary trust, a person can control adult beneficiary(ies)’s use of the inheritance income and capital – especially important for large inheritances or spend-thrift beneficiaries – or to protect assets from creditors or marriage breakdown. Spousal trusts are still effective to protect and maintain control over the surviving spouse’s use of the trust’s assets, to protect assets if the surviving spouse remarries and to dictate the ultimate beneficiaries when the surviving spouse dies – even though the tax changes largely eliminate their tax benefits.
- Alter Ego and Joint Partner Trusts might be the answer. Alter ego and joint partner trusts are inter vivos trusts (a trust someone makes that takes effect during her life) to which a taxpayer can transfer capital property on a tax-deferred basis. Income generated within these trusts is taxed at the highest marginal rate. They can be very effective when a person’s objectives include privacy and probate tax elimination, or asset management through incapacity. Until now, many people favoured testamentary trusts over alter ego or joint partner trusts. First, the expected annual savings by using a testamentary trust often exceeded the one-time probate tax savings achieved by using an alter ego or joint partner trust. Second, any trust created in inter vivos trusts on the beneficiary(ies)’s death ) isn’t considered “testamentary” for tax purposes, and can’t enjoy graduated tax rates. This taxation change could make alter ego and joint partner trusts a more attractive estate planning vehicle for some. To learn more about alter ego and joint partner trusts, including the conditions for them, the benefits and the common planning issues, read McInnes Cooper’s: Post Federal Budget 2014 Tax And Estate Planning – From Testamentary Trusts To Alter Ego And Joint Partner Trusts?
2. The Shifting Tax Burden. This change affects taxation when there’s a “life interest trust” created: a trust where a person (called the “life tenant”) enjoys the benefit of a trust for her lifetime. After the life tenant dies, the trust assets typically go to another person (or people). Common examples of a life interest trust are alter ego trusts, joint partner trusts, and testamentary spousal trusts.
Now. Now, the trust itself bears the tax burden of the trust assets when the life tenant dies. The life tenant enjoys the benefit of the trust for her lifetime – but the trust, not her estate, pays the taxes associated with the trust assets payable on her death. This led to the practice of reducing tax in a high-rate province (like NS) with cross-jurisdictional planning. Here’s an example. A life interest trust is created in Alberta for a beneficiary resident in NS; this is achieved by ensuring the control and administration of the trust is in Alberta. When the life beneficiary dies, the tax liability associated with any gain in the trust assets is within the trust, at AB rates – not the much higher NS rate.
2016. Effective in 2016, the tax burden on life interest trusts will shift from the trust to the life beneficiary’s estate. The intent of this change is to end this cross-jurisdictional planning. With the change, in the example above the NS beneficiary will be liable for the tax – and the benefit of the AB resident trust is eliminated. The practical impact is potentially unintended – and unfair – tax consequences. And one of the most problematic scenarios is also one of the most common: the blended family. Take this example: Adam is a widower with two children. Cathy is divorced, also with two children. Adam and Cathy meet, fall in love, and marry. They want to provide for the other when one dies – but they also want their own assets to go to their own children from their respective first marriages after they both die. Each creates a spousal trust in their will that provides for the surviving spouse for his/her lifetime, with the trust assets going to their respective children after the survivor dies. Adam dies first. All of his assets go into a spousal trust for Cathy, who gets the income and capital during her life. The plan is that when Cathy dies, these trust assets – which where Adam’s – go to Adam’s children, with Adam’s estate bearing the tax liability for the assets. But under the new rules, Cathy’s estate is liable for the tax on the trust assets. Adam’s kids get a windfall of money tax-free while Cathy’s kids are stuck paying the taxes on Adam’s assets out of Cathy’s estate and end up with even less – a result that’s unfair and that neither Adam nor Cathy intended.
The Plan. Estate plans for blended families must take this shifting tax burden into account. For example, the will might specify that taxes associated with a life interest trust are to be paid from trust assets, or to require the capital beneficiaries to sign a contract accepting liability for the tax that the life tenant’s estate must pay on the trust assets.
Please contact your McInnes Cooper lawyer or any member of our McInnes Cooper Estates & Trusts Team or our Tax Solutions Team to discuss this topic or any other legal issue.
McInnes Cooper has prepared this document for information only; it is not intended to be legal advice. You should consult McInnes Cooper about your unique circumstances before acting on this information. McInnes Cooper excludes all liability for anything contained in this document and any use you make of it.
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