Will Trusts Provide Tax Savings and Other Benefits

By arranging to put part or all of your estate into trust after your death, you can save your beneficiaries some income tax and help keep the farm in the family.

A carefully structured trust can be a useful estate planning tool that provides both tax and non-tax benefits. Even if you do not consider yourself wealthy, trusts may have strategic value depending on your personal situation.

Two types of trusts often used in estate planning are testamentary trusts and living trusts. A testamentary trust, also known as a will trust, is created only after your death, based on specific instructions contained in your will. A trustee (usually the estate’s executor or administrator) of your choosing maintains legal ownership of some or all of your assets for the benefit of specific individuals named as the trust’s beneficiaries. A living trust, also known as an inter vivos trust, takes effect during your lifetime as soon as you transfer assets to it. This article will focus on testamentary trusts. Living trusts will be left for a future column.

The trust document part of your will must provide directions on which of your assets are to be transferred to the trust, how the assets are to be managed, the names of the trustee(s), the lifetime of the trust, and the names of your beneficiaries.

For tax purposes, a will trust is considered to be a separate taxpayer. A significant tax advantage is that the income earned and retained in the trust for income tax purposes is taxed at the graduated rates available to an individual — about 21% on the first $34,000 of taxable income for a B.C.-resident trust, for example, and at progressively higher rates on higher levels of income. This could lead to income-splitting opportunities for your beneficiaries that otherwise would not be available if the property was distributed directly to them under the will.

For example, you want to leave a sizeable inheritance to your adult daughter who lives in B.C. She earns an annual taxable income of $50,000 and is in a 31.15% marginal income tax bracket. Say she invests her inheritance and earns $30,000 of interest income annually. When you add this income to her other taxable income, it moves her to a 39.7% income tax bracket. Her after-tax income is $59,808.

However, if you leave the inheritance to her in a trust, the trust can invest it and earn the same $30,000 interest. Because the trust’s annual income is only $30,000, it is in a much lower marginal tax bracket (21.3%) and pays only $6,389 in taxes, resulting in an after-tax income of $23,611. If that after-tax amount is then paid to your daughter tax-free, she has a total after-tax income of $63,422, which is $3,614 more (on an annual ongoing basis) than if she invested the inheritance directly.

Similar income splitting opportunities would exist if you were leaving your estate to a spouse who has other sources of income such as employment, pension or investment income.

Income paid to a beneficiary can be reported either by the beneficiary or on the trust’s tax return, at the discretion of the trustee. Although the trust cannot claim any personal tax credits, individual beneficiaries can claim the basic personal amount, which permits almost $9,000 of income to be received tax-free. For named beneficiaries with few or no income sources, such as grandchildren, additional tax savings can be achieved by distributing income in order to use up their basic personal amounts.

Will trusts also can have significant non-tax advantages. Spousal trusts, for example, are a specific form of will trust. Traditionally, they were used to provide trustee management of an estate on behalf of a surviving spouse who might not have the necessary skills. Even if your spouse is capable of managing your estate, there are other scenarios in which a spousal trust could help ensure your wishes are carried out.

For example, while you might choose to leave your farm and other assets to your spouse upon your death, you also want them to be passed on to your children when your spouse dies. But what if your spouse should remarry? He or she could decide to leave everything to the new spouse — or even the new spouse’s children. Without a trust, there would be no guarantee that your farm and other remaining assets would be passed on to your children.

A spousal trust would allow your assets to be held for the benefit of your spouse for his or her lifetime, with the amount remaining in the trust to be transferred to your children at the time of your spouse’s death. This is particularly useful in guaranteeing that a family farm is passed on to your children.

Minor or disabled children — or adult children who are not well-equipped to manage an inheritance — are other reasons to consider a will trust. The trustee could ensure that the estate is well managed until such time as the children are able take on management themselves. Separate trusts can be created under a parent’s will for each child and his or her family.

A testamentary incentive trust is designed to encourage your heirs to behave in a certain way. You might, for example, set up a trust to reward your children for continuing their education and earning a university degree or for giving back to the community in some way.

Confidentiality is another benefit of a will trust. By using a trust, the names of your beneficiaries need not be disclosed as the trustee transacts business in the name of the trust.

A testamentary trust also can safeguard assets from claims by creditors. Because the property does not belong to the trustee, although he holds the legal title and control, and does not belong to the beneficiary until it fully vests in his/her name, the assets are usually protected from claims by creditors.

Although will trusts have these advantages, they do add complexity to your estate plan. There are some things to consider before deciding whether you should include one in your estate planning. Because there are costs involved — legal fees to set up the trust and annual management and administration fees, including tax filings — most experts suggest that the assets to be transferred to a trust should be at least $150,000. You also will need to ensure you have a trustee, either a family member or a professional trustee, who will be able to manage the trust for as long as it needs to exist. And you will need to consider how much discretion and flexibility you’re prepared to give the trustee so he or she can adapt to the future needs of your beneficiaries as well as changes to the tax and legal systems.

It goes without saying that setting up a will trust is a complex matter. It is essential you seek help from legal and tax advisors who are knowledgeable in this area.