Testamentary trusts may come into being at and as a result of a person’s death. Commonly this is done using a Will, less often using an insurance or RRSP/RRIF beneficiary designation, and occasionally as a result of a court order.
For decades the tax benefit of such trusts has been their entitlement to use graduated tax brackets, as opposed to top bracket treatment for inter vivos trusts. As of 2016, testamentary trusts no longer have this preference, except for the first 36 months of an estate and for certain trusts for disabled beneficiaries. In the former case of an estate, there are limited opportunities to engage in meaningful tax planning.
On the other hand, trustees can and must act strategically on behalf of disabled beneficiaries. In the first place, there is a positive obligation to file an election to preserve those graduated brackets, and only one trust can be so-elected. This can complicate how a parent approaches trust drafting in isolation, let alone where multiple contributors may be contemplated.
As well, trustees need to be certain how existing trust tax rules for disabled beneficiaries may be affected. At the head of that list is the continuing use of the preferred beneficiary election.
Income Tax Act (ITA) Canada – 104(14) — Preferred beneficiary election
The term “preferred beneficiary” is a defined term in the ITA, and for present purposes includes someone who has a mental or physical impairment that entitles the person to claim the disability tax credit.
Section 104(14) sets forth that: “Where a trust and a preferred beneficiary under the trust … elect in respect of the particular year … such part of the accumulating income of the trust … shall be included in computing the income of the preferred beneficiary for the beneficiary’s taxation year”.
The effect of the election is that some or all of the trust income is allocated to the beneficiary. Tax is calculated based on the beneficiary’s graduated rates, and the trust pays that tax. The net income remains in the trust under the care and control of the trustee.
ITA 122(3) — Qualified disability trust (QDT)
As noted, testamentary trust usage of graduated tax brackets is now very limited. However, where the QDT definition is met, a trust remains entitled to use graduated brackets to calculate its taxable income. To qualify, a joint election must be filed by the trust and a beneficiary of the trust who, by reason of mental or physical impairment, is entitled to claim the disability tax credit.
Importantly, the electing beneficiary cannot “jointly elect with any other trust, for a taxation year of the other trust that ends in the beneficiary year, to be a qualified disability trust.” To the point, there may be only one QDT for a given person in any taxation year.
2015-0605111E5 (E) — Qualified Disability Trusts – Preferred beneficiary election
The taxpayer described a hypothetical situation in which an individual with a disability has four grandparents and each grandparent establishes under his/her will a trust for the individual. It is acknowledged that only one of the trusts could be a QDT for the 2016 and subsequent tax years. The inquiry goes on to ask whether the trustees of the additional three testamentary trusts created for the benefit of the same individual can make a preferred beneficiary election for each additional trust.
In response, the CRA author confirms that there have been no changes to the preferred beneficiary election rules as a result of the changes to the rules applicable to testamentary trusts, including the introduction of the QDT.
Both the QDT and preferred beneficiary election are elective provisions, and those elections are not mutually exclusive. As such, the trustees together with the disabled beneficiary can choose which joint election will be made, if any, and it is indeed possible for a trust that has made a joint election to be a QDT to also make a preferred beneficiary election.
- As of 2016, most testamentary trusts cannot use graduated tax brackets, but the new qualified disability trust preserves that treatment for disabled beneficiaries.
- For existing trusts, additional tax filing obligations are required to assure QDT treatment, which fortunately may be coordinated with the preferred beneficiary election.
- For families in the preparatory stages, they should confirm with legal counsel that appropriate powers and permissions have been explicitly drafted into trusts and other planning documents.