By: Halldor K. Bjarnason, Lawyer
Wiser folks than us have said: “There are only two certainties in life: death and taxes”. This maxim definitely applies to trusts.
As we often create trusts as part of our estate plan for our son or daughter with disabilities, it is worth taking a look at how Canada’s income tax laws affect trusts. The following is a summary of key income tax issues that affect trusts where the beneficiary is a person with a disability.
For taxation purposes, a trust is treated as a separate taxpayer (but without the personal deductions available to a human being). As a result, each year the trustees must file an income tax return (a T-3 Return) for the trust and pay tax on all of the recorded income. However, the date of filing, and the rate of tax, is dependent on the type of trust.
For inter vivos or “living” trusts – trusts that are created while the settlor or creator is still alive – the tax filing date is 90 days after the December 31 year-end (March 31). The trust pays tax at the highest marginal rate – currently, a little over 43% – on all income earned by the trust.
Tax-wise, a testamentary trust has greater flexibility. A testamentary trust comes into effect upon the settlor’s death – usually through a will, but it can also be created as a separate document. The testamentary trust has a flexible year-end, in that the trustee(s) can set the date when the trust is established. As well, a testamentary trust is taxed at a graduated rate, much like a living person. For the first $34,000 of income, a testamentary trust is taxed at the lowest marginal rate – currently 20.7%. The tax rate gradually increases until the highest marginal rate – currently, a little over 43% – applies to trust income over $120,000.
While the tax rates for a testamentary trust are clearly preferable to those of an inter vivos trust, the trustee needs to be very careful to not “taint” the testamentary trust. If funds, or other assets, from a source other than the deceased are ever added to the testamentary trust – for example, gifts or inheritances from other relatives – the trust is deemed tainted by the Canada Revenue Agency. As a result, all income of the trust is taxed at the highest marginal rate – about 43%.
Payments to and from the trust can also have income tax implications. When capital assets, such as stocks or vacation property, are transferred into a trust, the transfer constitutes a “disposition of assets”. The settlor (the person giving the asset to the trust) will be required to pay tax on all capital gains that have accrued on the property prior to the transfer to the trust. Similarly, when a capital asset is transferred from the trust to a beneficiary, income tax is payable on all capital gains that accrued while the asset was in the trust.
When the trust transfers income to the beneficiary, or uses trust income on behalf of the beneficiary, the income can be taxed in the beneficiary’s hands, at the beneficiary’s marginal tax rate. For a beneficiary whose only source of income is their disability assistance, this invariably means paying less income tax. The risk is that paying trust income directly to the beneficiary will typically affect his or her eligibility for benefits, pursuant to the Disability Assistance legislation. As a result, the end result might not be as helpful as anticipated.
One potentially useful tax-saving tool that is only available to trustees of trusts with a disabled beneficiary is the Preferred Beneficiary Election (“PBE”). The Income Tax Act provides that if a trust is for the benefit of a person with a disability (ie. someone who qualifies for the Disability Tax Credit) and the trust has been settled by the person with a disability, or his/her spouse, parent, grandparent, or great-grandparent, the trustee can opt to use the PBE. The PBE permits the trustee to declare that the trust income is to be taxed in the beneficiary’s hands, at his or her marginal tax rate, while keeping the income within the trust for reinvestment purposes.
The PBE must be filed within 90 days of the trust’s year-end, with both the trustee and the preferred beneficiary (or his/her guardian or representative) signing it. The PBE does not have the same potential negative affects on a beneficiary receiving disability assistance as does a direct payment of income. However, the Ministry of Health has indicated that they DO consider amounts claimed under a PBE as income of the beneficiary. This can result in people who receive home care facing an increase in daily user fees. This makes it important to weigh the benefits of using the PBE.
Unless the trust is created as a charity, trusts have a maximum life expectancy. The reality is, many trusts do not make it past their 21st birthday. This is because of the 21-year deemed disposition rule. In order to keep people from “hiding” capital property in a trust, the federal government introduced a rule which states that every 21 years, a trust is deemed to dispose of all of its capital property, and immediately reacquire it at market value. This deemed disposition triggers capital gains, and requires the payment of tax on all such gains. For example, if you put a $100,000 summer cottage into the trust, and 21-years later, it is worth $250,000, even though it hasn’t been sold, income tax is still owed on a $150,000 capital gain. This can be a nightmare for a trust which does not have substantial cash assets, and often means that the trust must sell the property in order to pay the tax bill.
A helpful exception to the deemed disposition rule is the principle residence exemption. Where a trust owns a property which is the principle residence of a beneficiary or the child or spouse of a beneficiary, the Income Tax Act allows the trust to claim the same benefit as when an individual owns their own principle residence: Capital gains on the principal residence are exempt, and no tax is payable. This can provide significant financial relief as the 21-year deemed disposition creeps up on the trust.
The foregoing is a summary of some of the key income tax rules that affect disability-related trusts. This article is not intended as legal advice, and we strongly encourage trustees to get proper advice from a chartered accountant or tax lawyer with respect to specific tax issues affecting your trust.