All About Estates

Testamentary Trusts – Are they Dead?

Dating back to the 12th century when the English court of equity created the concept of the “use”, which in modern day is known as the “trust”, trusts have been an important tool in estate planning for both tax and non-tax reasons. Prior to January 1, 2016, testamentary trusts had enhanced tax benefits for purposes of incorporating into an estate plan. Effective January 1, 2016, changes to the Income Tax Act (the “ITA”) eliminated one of these enhanced tax benefits that testamentary trusts offered, leading practitioners to ask whether testamentary trusts continue to serve a purpose in a individual’s estate plan.

The ITA defines a testamentary trust as “a trust that arose on and as a consequence of the death of an individual”.  A testamentary trust is usually created in an individual’s Will. In contrast, an inter vivos trust is a trust that is created during an individual’s lifetime.

As of January 1, 2016, testamentary trusts, other than graduated rate estates and qualified disability trusts[¹] are no longer entitled to marginal rates of tax, which, prior to this change, was one of the significant income tax benefits afforded to testamentary trusts as compared to inter vivos trusts.  Inter vivos trusts have been taxed at the highest marginal rates of tax on all income since June 18, 1971, and as a result of the income tax changes, testamentary trusts are now too subject to the highest marginal rates of tax.

Prior to 2016, an election under subsection 104(13.1) or 104(13.2) of the ITA permitted income to be paid to a beneficiary but taxed in the trust where the marginal rate of tax of the beneficiary was higher than the marginal rate of tax of the trust.  It was useful to incorporate a testamentary trust into an estate plan in order to take advantage of this income tax benefit.  New subsection 104(13.3) of the ITA precludes this advantage by providing that an election under subsection 104(13.1) or 104(13.2) of the ITA is only available to the extent that there are losses in the trust.

Another income tax change that impacted testamentary trusts beginning on January 1, 2016 was the loss of the ability to choose any period not exceeding 12 months from the date of death of the testator as the year-end for taxation purposes. This allowed the opportunity for beneficiaries of a testamentary trust to defer the payment of tax where the tax year-end of the trust ended early in the calendar year. For example, if a testamentary trust had a year-end of January 31, a beneficiary under such trust would be required to report income from the trust for the 12-month period from February 1 to January 31 in his or her terminal return, which would not be due until April 30 of the following year. Effective January 1, 2016, similar to inter vivos trusts, testamentary trusts, other than graduated rate estates, must use a calendar year-end as their taxation year-end.

Despite the elimination of several income tax benefits for testamentary trusts, specifically, the ability to income split between testamentary trusts and their beneficiaries, it remains possible to income sprinkle among low tax-rate beneficiaries of discretionary testamentary trusts. For example, in a discretionary testamentary trust, trust income can be paid to beneficiaries who otherwise have little or no income, such that the trust will be entitled to a deduction for such income and such income will be taxed at a lower rate in the hands of the beneficiary than if it remained in the trust.

Additionally, the many non-tax reasons for continuing to incorporate testamentary trusts into an estate plan remain, as they always have, an important rationale for use in an estate plan. The main non-tax advantage of a testamentary trust is control. There are many reasons why a testator may not want a beneficiary to have outright ownership and control of certain assets after his death. A testamentary trust allows a testator to control the ownership and management of certain property after his death.

The following are examples of various non-tax benefits of testamentary trusts:

  • Where there is concern about preserving a family inheritance, particularly in a blended family situation, a testamentary spousal trust may be used to preserve capital for the deceased’s children of a first marriage, while providing income for the surviving second spouse.
  • Where there are minor children, a testamentary trust can stipulate at what age(s) and in what amounts the children will receive their inheritances.
  • Where a beneficiary is incapable of managing his or her affairs due to a lack of mental capacity or the inability to prudently manage his or her financial affairs, a testamentary trust may provide a protective structure to ensure that assets are properly invested, generating an appropriate rate of return and beyond the reach of financial predators of a life interest beneficiary.
  • Where a beneficiary suffers from a disability, a testamentary trust may be an essential tool to preserve eligibility for provincial social assistance payments.

Notwithstanding the profound changes to the ITA relating to testamentary trusts, testamentary trusts continue to offer utility in estate plans. Although testamentary trusts solely designed to take advantage of the beneficial tax rules that existed prior to 2016 may be used less frequently, testamentary trusts will, as they always have, remain a key estate planning tool in many contexts.

[¹] The rules pertaining to “graduated rate estates” and “qualified disability trusts” will not be discussed in this blog post.

About 
Brittany Sud is a member of the Trust, Wills, Estates and Charities Group at Fasken, Toronto office. Brittany is developing a broad estates and trusts practice with a focus on planning and administration matters. As part of her practice, Brittany assists high net worth clients, entrepreneurs and professionals with Wills, powers of attorney, domestic contracts and trusts. She has experience developing and implementing cohesive estate plans that reflect the financial objectives and short and long-term goals of clients, including advising on probate planning, family business succession planning, asset protection strategies and disability planning. Brittany’s estate administration practice includes preparing applications for probate and administering the Canadian estates of non-residents. Outside of the office, Brittany enjoys playing softball and tennis, travelling and cooking. She is a dedicated volunteer of the United Jewish Appeal, Jewish National Fund, One Family Fund and Baycrest Foundation. Community Involvement • Host, Baycrest Foundation - Game Night for Baycrest, 2015 • Chair, Pitch for Israel Softball Tournament, 2014-2016 • Vice-Chair, United Jewish Appeal Young Lawyers Leadership Campaign Canvassing Team, 2016 Memberships and Affiliations • Member, Canadian Bar Association • Member, Ontario Bar Association - Trusts and Estates Law Section • Member, Ontario Bar Association - Young Lawyers’ Division • Student Member, Society of Trusts and Estates Practitioners (STEP) Canada