The role of trusts in financial plans

The concept of trusts reminds us of Warren Buffet’s saying, “Give your children enough so they can do anything, but not so much they can do nothing.”

This is a real dilemma for many professionals, as most of them do not come from “lucky womb syndrome,” where you are born into wealth and happen to have a last name like Buffet or Rockefeller—or in Canada, Irving, Thomson . . . or even some high-profile politicians.

Instead, most professionals in Canada studied and ground it out and they continue to grind it out for every last dollar. As a result, the reality is that they can expect to leave their children a much larger estate than what they received, and with that financial legacy comes a lot more responsibility.

In the financial world, trusts have been around for hundreds of years, and there are many types of trusts out there – immigration trust, health and welfare trust, charitable remainder trust, bare trust, age 40 trust, life insurance trust, blind trust, Henson trust, family trust, spendthrift trust, real estate investment trust, joint survivor trust, alter ego trust, spousal trust, and more. In and among those your client can have an inter vivos trust (living) or a testamentary trust (upon instructions in their last will and testament after your death); and within those categories they can have discretionary, non-discretionary, revocable and irrevocable trusts.

Trusts can be part of a plan to achieve an objective: minimize taxes or protect and deal with a family need. Today we will look at specifically the testamentary trust.

Testamentary trusts

Establishment of testamentary trusts

The trust is not formed until after your client passes away and all debts and taxes are paid. Assets are then transferred from your estate into the testamentary trust.

There are two major benefits – and then some minor benefits – of using testamentary trusts in your clients’ estate plans:

• Protection of Assets
• Tax Savings

Protection of Assets

According to Statistics Canada, roughly 43% of marriages end in divorce with the average length of marriage being around 14 years. Take note, Yukon has the highest divorce rate, followed by BC and Ontario. Nunavut, Northwest Territories and Newfoundland have the lowest divorce rate.

The reality is, for anyone with children, there is a high risk that either your client’s or one of their children’s marriages will end in divorce (unless they live in Nunavut of course!).

Why is this relevant? Anyone with a normal will has what’s called a net family property exclusion. The Family Law Act allows for inheritances (other than a matrimonial home) to be excluded under the equalization process of a divorce.

In theory that makes sense, but in practical terms it often doesn’t play out that way. Bottom line, there is a good chance our hard-earned money will be up for grabs if our children inherit and then end up in a divorce.

However, with the use of a Testamentary trust, as long as the assets stay within the trust, they are protected. Here, the trust gives that extra layer of protection from potential marriage breakdowns, as well as from future creditors. If ever one needs a lump-sum from the trust temporarily, with the appropriate legal consultation, they may want to consider a loan from the trust at a prescribed rate of interest. This way those funds may still be viewed as assets within the trust.

Tax Savings

To illustrate the tax savings, let’s look at a hypothetical scenario if one were to pass away 30 years from now with no trust structure vs. with a trust structure in place.

Example Assumptions

• $6,000,000 after-tax estate
• 2 kids (aged 32, 34 each with 2 kids of their own); both are professionals taxed at the highest marginal rate
• Inheritance invested at 6% interest
• Trustee fees are nil (administered by a family member)
• Trust tax returns cost $500 annually

Scenario 1 – First 3 years of estate

The above scenario shows that the tax savings would be $58,450 per year per child for the first 3 years in existence.

• In the first column, the income is taxed at son and daughter’s highest personal tax rate at 53.53%.
• In the second column, the income is split $65,000 to each grandchildren and $50,000 (allocated less given there is no personal exemption) in the graduated rates of the trust.

After 3 years, we no longer have the advantage of income splitting with the trust.

Scenario 2 – After 3 years

The above scenario shows that the tax savings would be $53,940 per year per child until the trust is dissolved or converted, or the grandchildren start to have other income.

• The first column is the same as before.
• In the second column, the income is split $90,000 to each grandchildren.

The above scenario makes certain assumptions about tax rates, the personal basic personal exemptions, and so on.

Overall, if done properly there could be a significant savings when splitting income.

Other factors to consider:

Probate

Another benefit of a trust is avoiding a second round of probate.

Costs

The initial cost of documenting a testamentary trust is included in the lawyer’s fee for preparing the will.

For Spendthrifts (children who enjoy spending the rewards of your client’s thriftiness)

If your client has a child or children who happen to not be the most savvy with their investments, structuring your testamentary trust as a protective trust may help with money management.

For Family Members with Special Needs

If your client has a child with special needs, they may want to ensure that the child is taken care of financially after the client is gone. If a potential beneficiary qualifies for the federal disability tax credit, they may want to consider a qualified disability trust.

Without a trust, many of these support benefits could be clawed back if a certain amount of income is generated.