Introduction – Taxation of Testamentary Trusts and Estates
A testamentary trust is one that is created as a result of the death of an individual. Under the Canadian income tax system, once an individual dies, all of that individual’s assets are deemed to have been disposed and then reacquired by the individual’s estate at the current fair market value. Once the estate has paid off its debts and taxes, it can then distribute its remaining assets according to the deceased individual’s will. One option is for that will to direct that some or all of those assets to be transferred to a trust, which is known as a testamentary trust. An individual can create any number of testamentary trusts in his will. Prior to January 1, 2016, all testamentary trusts were subject to graduated tax rates, which meant that much of their income was taxed at a lower rate, allowing for significant income splitting. However, as of January 1, 2016, graduated rate estates (GREs) are the only testamentary trusts that can benefit from graduated tax rates.
What is a Graduated Rate Estate (GRE)?
A graduated rate estate is a designated type of testamentary trust which arises upon the death of an individual. Each deceased individual can only have a single GRE and it must meet several criteria:
1) the estate must designate itself as a GRE in its first tax return;
2) no other estate of the individual has been designated as a GRE; and
3) the estate must use the deceased individual’s Social Security Number on its tax return.
Benefits of a Graduated Rate Estate
The primary benefit of a GRE is that it is subject to graduated tax rates on any income it earns, similar to an individual, for the first 36 months after the testator’s death. On the other hand, a normal estate or trust pays tax at the top marginal rate, 53.53% in Ontario in 2020, on every dollar of income earned. What that means is that, compared to a normal trust, the GRE can save over $20,000 a year due to the marginal tax rate, resulting in total savings of approximately $60,000-$80,000 over the GRE’s lifetime. Speak to one of our experienced Toronto tax lawyers for tax guidance about how to minimize the tax liability of your estate.
A secondary benefit for graduated rate estates is that they can choose to have a non-calendar year end and are only required to pay taxes on their income at the end of the year rather than in monthly or quarterly instalments, unlike regular trusts. This relative deferral of the GRE’s taxes helps free up funds that can be otherwise utilized by the estate.
Additionally, graduated rate estates benefit from more flexible donation tax benefits. Specifically, the GRE can claim donation tax credits in the year the donation is made or any of the following five tax years and it can carry back the donation tax credit to one of its previous tax years. It is also able to allocate donation tax credits to the deceased individual’s terminal tax return or the deceased’s tax return for the year preceding death.
Further, graduated rate estates have various administrative benefits. GREs can utilize capital loss carry backs to carry capital losses back to the deceased’s terminal tax year. They are further entitled to refunds beyond the normal assessment period and have an extended notice of objection deadline.
Pro Tax Tip – Update Older Wills
As noted earlier, graduated rate estates only came into effect in the beginning of 2016, while normal testamentary trusts created in or after 2016 also lost the ability to benefit from graduated tax rates. What that means is that any use of testamentary trusts in wills created prior to 2016 are likely to be out of date which may result is significantly worse tax results than anticipated when the will was first drafted. As such, it is important tax planning that individuals with older wills have them re-evaluated and updated by our top Toronto tax law firm.
Graduated Rate Estates FAQ’s:
If the GRE loses its status as a testamentary trust, will it also lose its benefits?
If a GRE ceases to be a testamentary trust, the eligibility benefits discussed previously will be lost, as well. A testamentary trust can be tainted in this manner — a beneficiary borrowing money from and re-contributing to the trust.
What does a graduated tax rate system mean?
Canada uses a graduated tax rate system, which means that as taxpayers cross the threshold of each income bracket, they will be paying more in taxes.
What happens if a testamentary trust loses its status?
If the trust loses its “testamentary” status, the capital losses go unused, leaving its income to be taxed at a potentially high rate.
Can a spousal trust be a graduated rate estate?
No. Insurance testamentary trusts nor separate testamentary trusts, which include a spousal trust, cannot qualify as a graduated rate estate. Once an estate takes more than 36 months to administer, it ceases to be a GRE, and it loses the benefit of graduated rates.
Can a GRE become a qualified disability trust?
A qualified disability trust (QDT) is a testamentary trust that arises on the death of an individual who jointly elects, with a beneficiary under the trust, to be a QDT. For a GRE to become a QDT, the estate must meet all the conditions before being considered a QDT.
Can a non-resident estate be a GRE?
Yes. From the definition in the Income Tax Act, the criteria for an estate to be a GRE don’t require an estate to be a resident in Canada. It also doesn’t require the deceased individual to have been a resident of Canada before they died.