Preferred Beneficiary Election

The preferred beneficiary election allows a trustee of a trust to allocate income to a beneficiary of the trust so that the beneficiary pays Canadian income tax on the income without actually paying the income to the beneficiary. The trustee may then deduct the elected amount from the trust’s income in the trusts income tax return. The effect is to transfer the liability for income tax from the trust to the beneficiary. If the beneficiary’s income tax rate is lower than the trusts, using the preferred beneficiary election will reduce the amount of tax that is paid.

The preferred beneficiary election is most likely to save on tax in an inter vivos trust. An inter vivos trust is created by someone (the “settlor”) transferring property to a trustee during the settlor’s lifetime, as opposed to a testamentary trust which is usually created in a will and only comes into effect after the will-maker’s death. Income earned and retained in an inter vivos trust is taxed at the highest marginal rate applicable to individual tax payers. The preferred beneficiary election allows the trustee to retain income, with the income taxed at the beneficiary’s marginal tax rate if it is lower. The income accumulated in the trust need not ever be paid to the preferred beneficiary.

But the preferred beneficiary election is only available in very limited circumstances.

First, the beneficiary must have a disability and either qualify for a disability tax credit under 118.3(1) of the Income Tax Act, Canada, or be at least 18 years of age and be a person for whom a dependant tax credit under section 118 (1) can be claimed by another individual. The criteria are fairly stringent, and not everyone with a disability will qualify.

Second, the beneficiary must fall within certain relationships with the settlor, or in the case of a trust created by will, the will-maker. The beneficiary may be the settlor, the settlor’s spouse or former spouse, a child, grandchild or great grandchild of the settlor or a spouse (but not a former spouse) of a child, grandchild or great grandchild of the settlor. Spouse includes a common-law spouse (as defined in the Income Tax Act), and child is given an extended meaning and includes a spouse’s child.

Third, the election must be made by both the trustee and the beneficiary. If the beneficiary is incapable of signing the statement making the election, then it may be signed by the beneficiary’s guardian on behalf of the beneficiary.

Canada Revenue Agency has published an Interpretation Bulletin on the preferred beneficiary election, which you may read here.

If the Harper Government implements the proposal to tax income accumulating in a testamentary trust at the same high rate that applies to inter vivos trusts, then the preferred beneficiary election may be used much more frequently. In my experience, trusts for disabled beneficiaries are much more prevalent in wills than in inter vivos trusts. Because testamentary trusts have graduated rates there is less incentive to use the preferred beneficiary elections if a trust for a person with a disability is created in a will.

In fairness the availability of the preferred beneficiary election should be expanded if the proposed changes in taxation of testamentary trusts are implemented.