Estates, testamentary trusts face higher tax bills

Exemption will continue to allow graduated tax rates for the first three years.

Matthew Elder 9 July, 2015 | 5:00PM

When someone dies, their assets are immediately deemed to be transferred to an estate. This is essentially a trust administered by the estate's executor or executors, and it is subject to taxation on any income earned. The bad news: Taxes are heading higher, starting in 2016.

Affected by the pending tax changes is any income earned after the date of death. This is deemed to be earned by the estate and is reported on the estate's tax return.

Under existing regulations, estates and testamentary trusts -- those created through the terms of a will -- pay income tax at the same graduated rates that apply to a living individual.

What this means is that the lower the income, the lower the tax rate. For example, in Ontario the first $41,000 or so of interest income is taxed at 20%, the amount between $41,000 and approximately $44,700 is taxed at 24%, the $44,700 to $72,000 amount is taxed at about 32% and so on until the top bracket (income over $220,000) is taxed at more than 49%. Dividends and capital gains are taxed at somewhat lower rates within the same income brackets.

However, under new legislation that takes effect beginning in 2016, graduated tax rates will no longer apply to estates and testamentary trusts. Instead, they'll be taxed at the top marginal tax rate applicable in the estate's province or territory. (Trusts not resulting from someone's death are already taxed at the top marginal rate.)

In addition, they will be required to use a calendar fiscal year-end (Dec. 31). Many trusts have year-ends at other times of the year, based on individual circumstances and/or to facilitate tax planning. They also will be required to pay tax in quarterly instalments, which has not been required under the existing rules.

A testamentary trust that is created by the terms of a will typically is used to hold assets for heirs for children and young adults until their age specified in the will. For example, a will might leave money to a child or grandchild, to be held in trust until the heir reaches age 21, at which point they might receive half the assets, and receive the remaining amount at age 25 or 30. The trustees might also be given authority in the will to use some of the assets to pay the heir's education expenses, or expenses related to health-care needs. In some cases, the terms of a trust will allow income to be paid to the beneficiary.

A key exception to the 2016 tax changes is that estates will be exempt from the new rules for three years after the date of death. During this period, they'll continue to be taxed under graduated rates.

Since three years is ample time for most estates to be settled, many executors will not have to adopt new tax-planning techniques in the process of settling an estate. If estate matters drag on after the three-year deadline, which can happen when an estate is tied up in litigation, then the new rules would apply.

Another exception to the new rules will apply to a "qualified disability trust," which is a testamentary trust that has a beneficiary who qualifies for the disability tax credit, available when filing their income-tax return. These trusts will continue to be taxed according to graduated rates, even beyond the three-year exemption period.

To qualify for graduated tax treatment, an estate must formally designate itself as a "graduated rate estate." In the case of a trust established to benefit a disabled person, the trust and the beneficiary must jointly elect for the trust to be designated a qualified disability trust.

Testamentary trusts that will no longer qualify for graduated taxation must adopt a Dec. 31, 2015 year-end and use calendar year-ends in the future.

Existing estates and testamentary trusts that have been in force for more than three years will also have to use a Dec. 31, 2015, year-end. This means that a trust that doesn't currently have a calendar year-end will have two periods ending in 2015 for which to report income. Consult your tax advisor to make the proper arrangements to file tax returns.

Despite next year's tax changes, testamentary trusts still can be a useful tool to achieve tax savings for your estate. According to a report by KPMG, a testamentary trust will continue to be an effective means of income-splitting by having a trust pay income to beneficiaries with low or no incomes.

"As well, trust income that has vested in a beneficiary under 21 years of age can be taxed in their hands, but the income can be retained in the trust as long as it is distributed to the beneficiary before he or she turns 40," KPMG says.

Other potential savings can be achieved where a non-spousal testamentary trust is maintained in a province with a lower tax rate than that in a beneficiary's province of residence.

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Matthew Elder

Matthew Elder