INTRODUCTION
The combination of life insurance and testamentary trusts provides an excellent estate planning strategy.
Satisfies many of the estate planning objectives of our clients.
Very flexible: trusts can be personalized to suit virtually all client needs.
Very reasonable cost: if death benefit is more than $100,000, the tax savings should easily justify the cost.
Life Insurance Testamentary Trusts
What are they?
How are they established?
Income splitting examples.
Trust strategies.
What are Testamentary Trusts?
Testamentary trusts are trusts that come into existence or are funded on the death of an individual.
A trust is an arrangement where property or investments are held by a trustee for the benefit of one or more beneficiaries.
In a typical testamentary trust, the property or investments come from the deceased (or insurance owned by the deceased) and are held by one or more trustees – who are usually the deceased’s executors. The beneficiaries are usually the surviving spouse, children and grandchildren.
Often there is one trust for each surviving family member.
Based on definition of “testamentary trust” in s.108(1) of the Income Tax Act of Canada:
“a trust or estate that arose on and as a consequence of the death of an individual”
Restrictions:
the trust cannot be created by a person other than the individual who dies
no one can contribute anything to the trust except the deceased
Testamentary trusts are primarily used for:
income splitting
tax deferral
financial security for surviving spouse
control of assets
protection from creditors and others
ensuring assets go to certain children
ease of management
minimizing or avoiding probate
minimizing or avoiding a challenge under the Wills Variation Act
How are Testamentary Trusts Established?
There are 3 possible ways to establish a testamentary trust:
1. By the Will of the deceased
2. By Court Order (e.g. the Wills Variation Act)
3. By life insurance trust designation
Our focus is on a testamentary trust created by a life insurance trust designation under s.144 of the Insurance Act of B.C.
The trust designation is essentially a trust prepared by a Trust Lawyer and signed by the insured that attaches to all or part of the proceeds of a life insurance policy.
The terms of the trust and the names of the beneficiaries are included in the trust designation and are filed with the insurer.
The trust designation can be revocable or irrevocable.
On the death of the deceased, the life insurance proceeds (or the portion referred to in the designation) are paid or transferred to the trustee(s) named in the trust.
Life insurance proceeds are paid directly to the trust and avoid probate, creditors and a challenge under the Wills Variation Act.
The Canada Customs and Revenue Agency (“CCRA”), formerly known as Revenue Canada, considers that such a trust meets the income tax definition of a testamentary trust: Technical Interpretation 9605575.
The trust is considered a separate taxpayer and is assigned its own CCRA Business Number.
The trust can be designed to invest the insurance proceeds (stocks, bonds, real estate, businesses and personal assets) or to distribute capital to beneficiaries.
Income Splitting with a Testamentary Trust
All testamentary trusts qualify for the graduated rates of tax on income as a separate taxpayer*
The graduated tax rates permit income splitting where the taxable income of the beneficiary would otherwise exceed $30,000 per year.
Maximum tax savings arise where the taxable income of the beneficiary would otherwise exceed $100,000 per year.
* subject to a s.104(2) designation by the Minister
** compared to tax paid by beneficiary at the highest marginal rate
Example #1
Mr. Smith has a $500,000 life insurance policy.
He has a spouse and 2 adult children and 4 grandchildren.
The policy names his wife as beneficiary.
Mr. Smith dies.
Mrs. Smith now owns:
their family home
their jointly-owned investments
Mr. Smith’s RRIF
$500,000 death benefit
Mrs. Smith invests the $500,000 at 6% and earns $30,000 per year in addition to other investments and RRIF income previously split between Mr. and Mrs. Smith.
Mrs. Smith is now in the top tax bracket (49%) and is unhappy. Of the $30,000 she makes, almost half ($15,000) goes to tax.
Example #2
Same as example #1 except Mr. Smith designates a trust as the beneficiary of his life insurance rather than his wife.
Mr. Smith dies.
Mrs. Smith receives the $500,000 death benefit as sole trustee in trust for her, for her children and for her grandchildren.
Mrs. Smith invests the $500,000 in the trust at 6% and earns $30,000 per year.
The trust reports the $30,000 and pays 24% tax. Mrs. Smith is happy. Of the $30,000 the trust earns, less than one quarter ($7,500) goes to tax.
This is a savings of over $7,500 per year compared to example #1.
Example #3
Same as example #2 except that Mrs. Smith doesn’t need all of her annual income and wants to give some to her 4 grandchildren.
The trust earns $30,000 per year.
Mrs. Smith, as trustee, chooses to allocate $7,500 to each grandchild.
The trust pays no tax.
Each grandchild has $7,500 in taxable income but is entitled to the personal exemption of $7,100.
Total tax paid: $400! (less if any education credits are available)
This saves almost $15,000 per year compared to example #1.
OAS Clawback
A testamentary trust can avoid the OAS clawback if it’s possible and practical to keep the beneficiary’s taxable income below the threshold amount (around $54,000). The balance of the income can be taxed in the trust (a designation may be made pursuant to s.104(13.1) or s.104(13.2)).
Income Splitting Strategies
Shift income from the beneficiary to the trust until the income of the surviving spouse is less than the trust.
Consider keeping beneficiary’s income below the OAS clawback threshold.
Trust Strategies
Assuming that there are sufficient benefits to justify the establishment of a testamentary trust as part of the clients’ overall estate plan, there are a number of ways the trust can be structured.
1. Testamentary Trust for Surviving Spouse Only
surviving spouse is sole beneficiary during his/her lifetime
on death, remaining proceeds divided amongst surviving children, or other beneficiaries
2. Separate Testamentary Trusts for Spouse and Children
proceeds divided into separate trusts immediately
one trust for spouse
one trust for each child
on death of spouse, remaining proceeds distributed equally to the children’s trusts
3. Separate Testamentary Trusts for Children Only
surviving spouse adequately provided for through jointly-owned assets or assets that “roll over” to surviving spouse
one trust for each child
include grandchildren for additional income splitting
Other Strategies
Invest entire insurance proceeds to maximize income splitting. Use other assets in the estate to satisfy liabilities and taxes.
Consider more than 1 trustee for each trust for ease of administration and added protection.
Try to allocate taxable income earned by the trust to beneficiaries who have no other income to use up their personal exemption and unused credits.
Consider loans by the trust to beneficiaries rather than outright distributions to control and protect the funds.
Consider owning assets in the trust, such as a home for a beneficiary.
Consider buying shares of the family-owned business from the estate (if no corporate-owned insurance to fund a buy-sell).
Use a qualifying spouse trust for assets which require the spousal “rollover”.
Conclusion
The ability to use life insurance to avoid probate, creditors and the Wills Variation Act
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The ability to use a testamentary trust to reduce taxes, protect assets and direct proceeds to particular beneficiaries
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A tremendously valuable estate strategy for most clients.
It is largely under-used and can add great value to insurance.
By
Thomas P. Fellhauer, Tax and Trust Lawyer
Pushor Mitchell LLP
February 23, 2001
