Today I want to talk about relationships. Not marriage. Although marriage is a fine institution because it teaches us about loyalty, patience, understanding, perseverance, and a lot of other things we wouldn't need if we had stayed single. No, I want to talk about a special type of relationship called a "trust."
You see, a family trust, or any type of trust, is not a legal entity. Rather, it's a relationship between three parties: The settlor, who creates the trust by placing assets – called the "trust property" – into the hands of the second party, the trustee. The trustee holds and manages the property, not for his or her own benefit, but for the benefit of the third party – the beneficiary.
At the most basic level, there are two types of trusts: Inter vivos trusts, which are created during the lifetime of the settlor, and testamentary trusts, which are created after a person's death. Today I want to talk about testamentary trusts, because changes to the tax rules around these become effective on Jan. 1, 2016.
Under our tax law, there are now three types of testamentary trusts: a Graduated Rate Estate (GRE), Qualified Disability Trust (QDT), and all other testamentary trusts (OTTs). It used to be that all testamentary trusts were generally taxed in the same way – at the same graduated tax rates as any individual – just like you and me. No longer. Starting Jan. 1, 2016, OTTs will be taxed at the highest federal tax rate (GREs and QDTs are not).
First, let me explain GREs. When you pass away, the assets you leave behind form your estate. It's the job of your executor or administrator to take those assets and distribute them to your beneficiaries in accordance with your will (or the intestacy laws of your province if you die without a will). But this can take time. Between the date of your death and the distribution of the last of your assets, your estate continues to exist, and it's considered under our tax law to be a testamentary trust – a GRE.
A GRE is not specifically set up by any provisions of your will; rather, it's automatically established when your estate comes into being at the time of your death. This type of testamentary trust continues to be eligible for graduated rates of tax for the first 36 months following your death. There will be a deemed year-end when the estate ceases to be a GRE, no later than the third anniversary of your death, and from that date forward the trust will be subject to the highest tax rate going. Further, the trust will have a Dec. 31 year end from that point onward under the new rules.
Nevertheless, these graduated rates can allow for tax savings after you're gone – for up to three years (36 months).
How are taxes saved? The assets in your estate may generate income each year. Once the assets are distributed to your heirs, your heirs will pay the tax on that income going forward. But during that time while your GRE exists and holds your assets, the estate itself can pay the tax at graduated rates. So your heirs can split income with the GRE. To be clear, the savings here are not a reduction of taxes due at the time of your death, but are taxes saved by your heirs from splitting income with the GRE in years after you're gone.
Suppose, for example, that your GRE earns $70,000 of income on your assets in the year following your death. Suppose also that your beneficiary has $70,000 of her own income. If your assets had been distributed to her immediately upon your death, she'd have to add the $70,000 income from your assets to her taxable income resulting in total income of $140,000, and a tax bill of $43,532 (in Ontario at 2015 rates).
If, on the other hand, the assets are still in your GRE, your estate would pay tax of $17,276 on that $70,000 and your beneficiary would pay $14,800 in tax on her own $70,000 of income, for total taxes of $32,076. The tax savings to your beneficiary as a result of splitting income with your GRE is $11,456 ($43,532 minus $32,076) in the year after your death. Over three years, the savings could be three times that amount, or $34,368 in this example.
Prior to the rule changes the annual tax savings could have continued indefinitely. The savings aren't as high now, but are still worth writing home about. Next time, I'll talk about QDTs, OTTs, and more on the rule changes.
Tim Cestnick is managing director of Advanced Wealth Planning, Scotiabank Global Wealth Management, and founder of WaterStreet Family Offices.