Tax erosion on estates and trusts after death

Recent changes to the way trusts are taxed can have shocking consequences. Your investments may be eroding your estate. Find out what this means and how to avoid the pitfalls of poor planning.

January 1, 2016, marked a change in the way that income on property held within testamentary trusts is taxed. The elimination of the graduated tax rates means that income generated in these types of trusts is now taxed at the top marginal tax rate. With the changes still in their infancy, many Canadians set to receive distributions from these trusts have yet to feel the impact. The impact of these changes may be particularly hard felt for Canadians who have recently lost a friend or family member. Under these new rules, a testamentary trust will be taxed at the top rate from the very first dollar earned on trust property, with no basic exemption or alternative minimum tax.

Testamentary trusts remain popular for allocating future trust income to low-income trust beneficiaries or minors. Trustees filing their first return since these changes took effect may be shocked to see such high rates on their T3 in March of 2018 (for trusts with a calendar year end).

For estates created after January 1, 2016, tax rates will be graduated for the first 36 months or until the estate assets are transferred to a separate testamentary trust or other beneficiary, provided the estate representative designates the estate a Graduated Rate Estate (GRE) on the first T3 return.

With the CRA’s strict policy against late-filing this election, an estate cannot be a GRE if it has not been designated as such in the first tax return. After a maximum of 36 months, the benefit of graduated rates will expire. In addition to GREs, Qualified Disability Trusts (QDT) also retain marginal tax rates. A Canadian testamentary trust can elect to be a QDT where at least one beneficiary is eligible for the federal disability tax credit.

This begs the question of how to adapt. Given that trust income can typically be taxed at either the trust level or personally to a beneficiary, knowing which investment assets to hold goes a long way in terms of tax efficiency. Subject to the provisions of the will, you may be able to sell income-producing investments and replace them with tax-deferred capital growth investments. In cases where distributing trust income to a beneficiary is not desirable, prioritizing capital growth investments will reduce or eliminate income that could only be retained by the trust and taxed at the top marginal rate.

After 21 years, trusts face a deemed disposition of their capital property. With the correct planning, it is possible to defer taxes on trust property for up to 21 years. A taxable event may be deferred even further where the trustee is able to distribute trust property in-kind to beneficiaries. It is advised that you speak to your financial advisor, accountant and lawyer regarding investment strategies.

Failing to plan is a costly mistake. As your estate will ultimately get passed on to your loved ones, your decisions on handling these matters can last generations. Working closely with an accountant and communicating your goals to a financial planner can help maximize your beneficiary’s income streams.

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The views and opinions expressed in this article are those of the author and do not necessarily reflect that of CPA Canada.  This is a general source of information only. It is not intended to provide personalized tax, legal or investment advice, and is not intended as a solicitation to purchase securities. The author is solely responsible for its content.

About the Author

Maricel Ramos

Maricel Ramos , CPA, CGA, CFP, RRC, is a financial consultant with Investors Group Financial Services in Toronto.