Discussing wills in general is exciting for some but not so for others. Discussing testamentary trusts in wills may reduce the number of followers even further. Regardless of what one might think, testamentary trusts are currently in vogue among estate advisors in their discussions with their clients. Whether or not there is a testamentary trust in your future, you should at least make that decision armed with some knowledge of what they are.
At the simplest level, a testamentary trust is wording in a will that restricts or controls when and how an estate beneficiary receives his/her inheritance. Many people right now—especially those with children under the age of majority—already have this type of trust wording in their wills. In most circumstances, however, this type of wording creates a trust that is limited to an age that the beneficiary will reach and then will receive the balance of his/her inheritance. At that time, the trust that was established will terminate.
As an estate planning tool however, a testamentary trust can be more multifaceted than simply setting a date and terms for a minor child to benefit and ultimately inherit. Testamentary trusts can be used both as a tax efficient mechanism and to create solutions to sometimes complex family situations—disabled child, spendthrift beneficiary, grandchildren in need, second marriages etc.
To start at the beginning, a trust is a legal concept. It must have a creator such as the deceased, a trustee and a beneficiary. It must also have something that can be identified as forming the trust asset and it must have a purpose or a reason for existing, such as funds set aside to benefit someone or something.
A testamentary trust is a trust that is created in a person’s will and only becomes operational at that person’s death. This is because a person’s will only speaks from the date of a person’s death regardless of when the will was signed.
There are other trusts called inter vivos trusts which are created and are operational during a person’s lifetime but they are not part of this discussion.
What makes some estate planners and some clients excited about testamentary trusts is that not only can they be crafted to deal with particular fact situations and beneficiaries but also testamentary trusts receive special and somewhat benevolent treatment from the Income Tax Act unlike inter vivos trusts.
Income, including interest, dividends and capital gains, left in a testamentary trust at the end of a taxation year is taxed at the same normal graduated marginal rates as an individual. Contrast this to an inter vivos trust, where the income that is left in an inter vivos trust at the end of a taxation year is taxed at the highest marginal rate that an individual can be taxed.
In estate planning terms therefore, a beneficiary who has employment income but who is also a beneficiary of a testamentary trust will have two separate taxing streams: his/her employment income taxed at his/her applicable marginal rates; and income taxed in his/her testamentary trust also taxed at its own marginal rate applicable to the income earned in the trust. For a person in a high personal income tax bracket, being a beneficiary of a testamentary trust may well allow his/her trust income to attract a lower income tax rate without regard to that person’s personal income tax situation.
Because the creator of the trust (the deceased) is different from the beneficiary and the trustee, it may not matter that the beneficiary is also the trustee of the testamentary trust. It is therefore not uncommon to see a testamentary trust established for an adult child and that child’s children and to have that child also be the trustee as well as one of the beneficiaries. Incestuous perhaps but quite efficient in the right circumstances!
Depending on the interest, necessity and estate assets, testamentary trusts can be established for under-aged children, young adult children, disabled children, grandchildren, spouses, the entire family or any other group that may be of interest to the deceased. A natural sequence might be to establish a testamentary trust for a spouse and then once the spouse dies, testamentary trusts for the children and their children as well.
There has to be a sense of practicality however in establishing a testamentary trust. If the trust is simply to preserve estate assets and benefit under-aged or young adult beneficiaries, this makes perfect sense. If, on the other hand, one or more testamentary trusts are established for an indefinite period of time—lifetime of the beneficiary, as an example—then one should also be aware of the costs as well as the responsibilities associated with trusts in general and long term trusts in particular.
A testamentary trust must file an income tax return each year following the death of the testator whose will establishes the trust in the first place. If there are two testamentary trusts, then two income tax returns must be filed each year. Depending on the desire, experience and knowledge of the trustee, preparation of an annual trust income tax return and related T3 slips is usually done by an accountant. There are, obviously, fees for this service. Moreover, depending on the trustee, investing of trust assets is often referred to an investment advisor. There is a fee for this as well. Lastly, because the trustee is required by both the will which created the trust as well as the Trustee Act of Ontario, the trustee has an ongoing obligation both to watch over the performance of the trust as well as to determine how the trust can best benefit the beneficiary. The beneficiary is entitled to an accounting by the trustee of the trust assets and trust expenses both during and when the trust terminates. The trustee’s performance is also subject to scrutiny by both the children’s lawyer (if the beneficiary is a minor) and the courts in general if the beneficiary feels that the trust is being badly managed by the trustee. The trustee is entitled to be compensated for these duties and responsibilities.
The sum of the various fees payable by the trust each year may limit the viability of a trust continuing for a very long time. The ongoing liability of the trustee to the beneficiary may also limit the trustee’s interest in having the trust continue any longer than is absolutely necessary. Where the trustee is also the beneficiary, there may also be practical reasons to terminate the trust at some point in time so that the beneficiary can use the capital for some personal purpose. In many cases, the continuation of a testamentary trust will depend on the particular circumstances of the beneficiary and the trustee.
Some trusts however—those established for disabled adult children—cannot be wound up easily without causing possible financial disruption for the beneficiary. In such cases, it is always better to provide in the will for the resignation/replacement of a trustee during the term of the trust (lifetime of the beneficiary) to give the trustee the flexibility to resign and be replaced rather than to wind up the trust.
Based on the situation, the benefits of a testamentary trust may outweigh the ongoing fees payable by the trust and responsibilities of the trustee to maintain the trust. Certainly, establishing a testamentary trust for minor children is almost essential. Establishing income splitting, family and long term protective trusts may also be worthy of serious consideration. Is a long term testamentary trust for everyone? It depends!
John Peart is a partner with the Ottawa law firm of Nelligan O’Brien Payne LLP and part of its Wills and Estates Group. John is Certified as a Specialist (CS) in Estates and Trusts Law by the Law Society of Upper Canada and is also a member of the International Society of Trust and Estates Practitioners.
[This article was originally published in the June 2012 issue of Fifty-Five Plus Magazine.]