If you have children or other people living in the United States who might be beneficiaries of your estate, read on. I meet more and more Canadians who are in this position, whose children have moved to America and may inherit a large amount of money someday.
We will also review the rules on Canadian testamentary trusts, and the possibility of tax changes over the next few years.
Please keep in mind this column is not providing legal or tax advice, and you need to get any such advice from your own professional advisers.
So, back to the basics of estate planning -- you need to have a will. In that will, you can leave your estate outright to people. This means the "residue" of your estate (after paying off debts, taxes and other costs) is transferred by your executor to the people to whom you leave your property. These are your beneficiaries, or your heirs.
An alternative is to leave some, or all, of that residue to people "in trust." All wills actually contemplate this, by having a clause saying if the beneficiary is under 18, that person's inheritance will be held on their behalf by a trustee, until a certain age specified in the same will.
Such a trust described in a will is called a "testamentary trust." (Recall that the will is actually your "last will and testament.") These trusts can be very flexible, giving the trustee(s) full discretion to distribute the income and capital, or even to dissolve the trust, if they wish.
Or they can be restrictive, designed to protect the capital, as they might be in the case of a beneficiary who was incompetent (from a legal standpoint), young, inexperienced, subject to influences, had a problem with substance abuse, gambling or creditors, or had a shaky marriage.
There are several reasons to leave inheritances in trust, as my father did for me, rather than outright. The protections from creditors, marriage breakup or beneficiaries' own impulses might not be a problem now, but could become issues in the future. The trust arrangement provides a measure of protection, depending on how it is written up in the will, which protection can be utilized if and when needed.
Tax advantage is another reason to use such trusts. The testamentary trust is a separate taxpayer from the beneficiary, and the trust has benefit of the graduated tax rates. That means investment income earned in the future on the inheritance may be taxed at lower tax rates than investment income earned by the beneficiary directly, because investment income earned directly by the beneficiary is taxed on top of the beneficiary's regular salary or other income.
Spoiler alert -- as we mentioned last week, the March 2013 federal budget gave notice the government is going to "consult" with interested groups on whether to continue this decades-long tradition of graduated tax rates for testamentary trusts. So, it is possible that a few years from now the tax benefits will be decreased or removed, leaving only the protection and management reasons to maintain the trusts.
In the case of U.S. beneficiaries, the situation is different. First, leaving an inheritance in a Canadian trust for the benefit of a U.S. resident or citizen beneficiary causes the IRS to consider them beneficiary of a foreign tax entity, putting them in the same category as folks with offshore accounts designed to evade taxes. The investment income has to be claimed, even if not received, which is one of several negatives.
The solution for some people is to have a U.S. attorney set up a U.S. inheritance trust. This has several of the benefits listed for Canadian trusts, though not the current tax advantage. However, these also act as generation-skipping trusts and can avoid U.S. estate taxes for the beneficiaries on their subsequent passing.
U.S. estate taxes are less worry than last year, with a new large exemption, but the exemption levels have been changed so many times in the past five years such planning is probably wise, in the case of large estates.
When a U.S. trust is set up, the Canadian will is then changed to specify payment to that trust, for the benefit of the U.S. beneficiary, on their share.
David Christianson, BA, CFP, R.F.P., TEP, is a financial planner, adviser and vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.