February 2005

Estate planning with testamentary trusts

Donald has decided that it is time to update his will. He has heard some talk about the benefits of testamentary trusts and visits Crawford, Smith & Swallow for advice.

We begin by having Donald explain to us his personal situation and ask him how he would like to see his estate divided amongst his family. We learn that Donald is married to Melania and that he has two adult children both of whom are active in his family business. He would like to ensure that the children ultimately inherit his shares of the business. Donald explains that he currently owns a real estate business worth $5 million and has an investment portfolio worth $5 million.

After presenting to Donald various alternatives, he asks for more details on testamentary trusts. We begin with the following introduction.

A trust is established when property is transferred to one or more persons who hold the property for the benefit of others. A testamentary trust is a trust provided for in a person’s will and established on his or her death.

Under these proposals, any loss realized in a particular year will not be deductible against other sources of income unless, in that year, it is reasonable to expect that the taxpayer will realize a cumulative profit from that business or property over the period in which the taxpayer has carried on, and can reasonably be expected to carry on, that business or has held, and can reasonably be expected to hold, that property. Although not yet legislated, these proposals are scheduled to apply to taxation years beginning after 2004.

There are essentially two types of testamentary trusts: spousal and non-spousal. The distinction being that with a spousal trust: 1) the surviving spouse must be entitled to the income of the trust and none, some or all of the capital of the trust during his or her lifetime and 2) tax on accrued gains on assets transferred into a spousal trust can be deferred until such time as they are disposed of by the trust or on the death of the surviving spouse.

Donald indicates that he is very intrigued by the spousal trust given the $5 million deferral on the accrued gain that would otherwise be taxed at the time of his death. He is leaning towards a non-spousal trust, however, because he wants to ensure that the shares are ultimately inherited by his children.

We explain to Donald that if he names his children as the ultimate capital beneficiaries of the spousal trust, they will receive the shares on the death of Melania. Donald is satisfied with that result, but wants to know more about the available tax savings.

We begin by indicating that the tax savings arise as a result of a testamentary trust being taxed on its income at graduated tax rates in the same manner as an individual. In contrast, his spouse (should she survive him) would pay tax at the highest marginal personal tax rate on any additional income when it is combined with her other sources of income. A testamentary trust also has no requirement to pay instalments of tax.

In order to reinforce the concept and quantify the amount of the annual tax savings for Donald we show him the following chart:

Source of Income	No Trust	Trust	Annual Savings
Interest of $100,000	$46,000	$33,000	$13,000
Dividends of $100,000	$31,000	$18,000	$13,000

Donald then asks whether many of the above benefits would still be available should his spouse predecease him and he sets up a non-spousal trust.

We explain that the annual tax savings in our chart would still be available but that the tax-deferred rollover would not be available at the time of his death. We recommend to Donald a number of options for eliminating the potential double taxation that might occur as a result of the deemed disposition of his shares on death.

The non-spousal trust will also be deemed to have disposed of its property at fair value every 21 years. This could only be avoided by transferring the trust property to the beneficiaries before this time.

We indicate that he could set up a separate trust for each of his two children in order to multiply the amount of the tax savings.

We advise Donald that he should take some time to make sure that he is comfortable with our suggestions and that he should contact us should he have any questions or should he want to proceed.

The above is only an excerpt from the meeting that was held, there were a number of more detailed tax and non-tax issues discussed that have not been covered in this article. For this reason, we recommend that both your accountant and lawyer be involved early on in the decision of whether to establish a testamentary trust.

The names and situation in this article are fictitious and have been used solely to illustrate the effectiveness of testamentary trusts. Any resemblance to a real estate mogul with his own TV show is purely coincidental.

Chris Bodnar, C.A.
Tax Partner, Crawford, Smith & Swallow, LLP

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