Harper Government Considering Huge Tax Increases on Income Earned in Testamentary Trusts

While reading through today’s 2013 Federal Budget, here’s the item that caught my eye:

Consultation on Graduated Rate Taxation of Trusts and Estates

Certain estates and trusts created by will (testamentary trusts) and inter vivos trusts created before June 18, 1971 (grandfathered inter vivos trusts) compute federal income tax on taxable income using the graduated tax rates applicable to individuals. Other trusts (ordinary inter vivos trusts) pay federal tax at a flat rate of 29 per cent, which is the highest federal tax rate for individuals. 

The taxation of testamentary trusts and grandfathered inter vivos trusts at graduated rates allows the beneficiaries of those trusts to effectively access more than one set of graduated rates. This tax treatment raises questions of both tax fairness and neutrality in comparison to the treatment of beneficiaries of ordinary inter vivos trusts and taxpayers receiving equivalent income directly. 

The Government is also concerned with potential growth in the tax-motivated use of testamentary trusts and the associated impact on the tax base. Current tax planning opportunities associated with the availability of trust-level graduated rates include the use of multiple testamentary trusts, tax-motivated delays in completing the administration of estates, and avoidance of the OAS Recovery Tax. Subjecting ordinary inter vivos trusts to tax at a high flat rate helps to prevent the tax-motivated use of these trusts. 

Budget 2013 announces the Government’s intention to consult on possible measures to eliminate the tax benefits that arise from taxing at graduated rates grandfathered inter vivos trusts, trusts created by will, and estates (after a reasonable period of estate administration). A consultation paper will be publicly released to provide stakeholders with an opportunity to comment on those possible measures.

This makes it sound like the only reason people create trusts in their wills is to allow beneficiaries to avoid paying their fair share of taxes.

In fact, there are many reasons for creating trusts in wills. For example, if you have a disabled child who cannot manage his or her own funds, or who will lose modest disability benefits if he or she receives and inheritance, you may want to leave part of your estate to a trustee to manage for the child. Or perhaps, you wish to provide for someone who has an addiction by appointing a trustee. Perhaps you have a child who just can’t seem to manage money. Depending on the terms you put in your will, the trustee may make payments out of income or capital as the trustee decides most benefits the beneficiary.

If the trustee accumulates income, the income is taxed in the trust. Currently, in the case of trusts created in wills, income is taxed at graduated rates. This means that the rates are relatively low for lower amounts of income, and increase with higher levels of income. The tax rates work the same way as for individuals.

What the Harper government is proposing is to tax every dollar of income in a trust created by a will at the highest marginal rate, the rate only those individuals who earn over $135,000 a year pay, and then only on the amount exceeding $135,000. Now, 29 per cent might not seem that bad, but that is just the federal tax. When you add the provincial tax rates, the highest marginal rates vary depending on the Province from 39% (Alberta) to 47% or 48 % in some other provinces.

This means that if the Harper government implements this proposal and a trust created in a will earns say $5000 income that is not distributed to a beneficiary, in most provinces over $2000 will go to taxes. That still leaves close to $3000 but with that growth the trust fund may not even keep up with inflation.

To be sure, testamentary trusts are used for tax planning. Consider for example, a senior couple with pension and investment income. They may each receive and pay taxes on half of that income. Because of the graduated rates, their tax rates may be relatively low. Then the husband dies, and all of the pension and investment income is taxed in the hands of his widow, putting her into a higher marginal rate. If the husband had investments, and created a trust in his will to hold them for his widow, the investment income could under the current rules be taxed at a low rate in the testamentary trust (just as it had while he was still alive).

At this stage, the government is saying that it will consult before implementing this change. I hope so.