Jack always tried to keep things organized from an income-tax perspective. He had a good accountant. He tried to read books and articles when they crossed his path. The more money he kept, and the less he paid in taxes, the more money for his family and less for the government.
He played by all the rules. He never tried anything fancy or aggressive from an income-tax perspective.
His lawyer did recommend that Jack put a sophisticated last will and testament in place. The will was designed to set up a separate testamentary trust for each of his two children, John and Liz. The pair of trusts would come into existence when he died.
The trust for John would hold a half-share in the estate for John and his family. The trust for Liz would hold the other half-share for Liz and her family. The two children were named as joint executors of his estate and then were named as trustees of the two trusts.
Jack passed away this year and the children had to step in and get things rolling. Jack had made sure they were referred to the accountant and the lawyer who had been involved in setting up the will. They all worked together to get though the estate and fund the trusts. Here is what they needed to know about income taxes.
The trusts formed part of an income-splitting strategy. Each of the two trusts held roughly $1.5 million. That money was invested and earned income. The income was taxed at graduated rates on a separate tax return that was filed by each trust. This enabled separate access to each of the bottom tax brackets, where tax rates were lower. Each child was able to split their income, having some taxed on their personal income-tax return and some taxed in the trust on separate tax returns filed for the trusts.
The tax savings effectively amounted to $20,000 per year. That was money kept in the family that would otherwise have been paid in taxes if the sophisticated will was not in play. Jack would have been happy.
When it came time to file taxes for the estate and trusts, their accountant explained how the trusts could be used not just for income splitting, but also for tax deferral.
She told them they could pick a tax year for estate and the trusts other than the normal calendar year. They picked a tax year that allowed them to defer taxes on income earned in the trust. That allowed them to hold on to a pool of tax money and put it to work in their own investment accounts before sending it to the government when it eventually fell due. Over the lifetime of the trusts that would have a cumulative effect to the good. The trusts would operate for the rest of the children's lives.
The accountant also pointed out that the trusts did not have to pay installment tax. That was another advantage. It worked the same way, allowing a pool of tax money to be kept on hand and invested for longer before having to be sent to the government.
There were other things they needed to know -- things that might amount to disadvantages unless carefully managed.
The trusts were subject to a special capital gains rule that would trigger capital gains tax on assets held in the trusts every 21 years. It turns out that the capital gains could be avoided, or more precisely deferred, if the assets were transferred out of the trust and into the hands of the children just prior to that anniversary date. The transfer out was optional. The accountant had them diarize the date and they will decide later, when the tax event is closer. If the children are still saving $20,000 each year in taxes, they might choose to leave the assets in the trust and simply weather the tax event.
Jack and his family are real. Names and details have been changed to protect the privacy of the children. Many well-heeled families, like Jack's, pursue this kind of structuring in their wills.
John E. S. Poyser is a Winnipeg lawyer with the Wealth and Estate Law Group. Contact him at 204-947-6801 or firstname.lastname@example.org.