Jack is a devoted father. He has a disabled son, Phillip, and he is committed to securing the best possible future for him. Jack is likely going to die before his son does, and Jack knows that. His will carefully establishes a trust for Phillip. After Jack passes away, half of his estate will be held in a trust for the rest of Phillip's life. That will allow for the careful management of the inheritance for Phillip. It is important it not run out. Phillip's sister, Corey, will be the trustee of the trust. She will handle her brother's money.
The Income Tax Act includes some special tax provisions that will be of use to this family.
The first is the preferred beneficiary election. This is a tool that allows income earned inside the trust to be retained by the trust, but taxed on Phillip's tax return. Phillip has little income of his own. His tax rate will be low -- it should never exceed 26 per cent on ordinary income. The trust will hold a significant amount of money, and will generate lots of income. The use of the preferred beneficiary election allows Corey, as the trustee, to have significant portions of the trust income taxed at lower rates. That means more money for Phillip.
It is important Corey understands how this works. She will have a tough time figuring it out on her own. That means she needs to hire knowledgeable accountants to help with the tax filing for the trust. Used properly, in the right circumstances, the preferred beneficiary election will save $10,000 to $12,000 in taxes each year.
There is another special tax provision Jack needs to know about while he is planning his will. It is a relatively new provision that allows for a rollover of his registered investments into the trust established for his disabled son.
Under the general rule, a person's registered investments are taxed at death in the same way as a paycheque. It often amounts to a big paycheque, and the taxes can be heavy. Jack has $400,000 in registered investments. The taxes on that at his death would normally be in the neighbourhood of $184,000. If he had a spouse, he could pass his registered investments to his spouse and defer those taxes. He is a widower, however.
While Jack cannot pass the registered investments to a spouse, he has the opportunity to do the same sort of thing with a disabled child. In Jack's case, new tax rules allow for the deferral of the tax while having the value of the registered investments pass into the trust where Corey can administer the money for her brother.
Here is how that works. When Jack dies, it will be time to transfer assets from his estate into the trust. The trust, governed by Corey, will purchase a qualified life annuity in the same dollar amount as the registered investments that had stood in Jack's name at his death. Jack's estate can then exclude the $400,000 from income. The annuity will pay monthly amounts into the trust. The monthly amounts will be taxed as they are received by the trust. The tax rate will be low. All of this allows for the taxes to be paid over decades, rather than right away. The effective tax rate will be roughly 20 percentage points lower. In the circumstances here, much if not all of the income will be taxed in the bottom tax bracket. The tax savings for the family should amount to $80,000.
The new rule for trusts is being used by families such as Jack's. The change was announced in 2001, and technically it still awaits final approval. The wheels of Parliament grind slowly, and Canada Revenue Agency is allowing estates to file their tax returns as if the new rule were already law.
Jack's will creates the trust. The written provisions of the trust have to qualify it as a "lifetime benefit trust" under the new rules. That takes some drafting expertise. Otherwise, this strategy appears to be good to go.
If you have a disabled family member, and plan to leave them an inheritance under your will, you should consider establishing a trust for them. You might want that trust to specifically qualify for the tax treatment described here.
Jack and his family are real. Names and details have been changed to protect the confidentiality.
John E. S. Poyser is a Winnipeg lawyer with the Wealth and Estate Law Group. Contact him at 947-6801 or firstname.lastname@example.org