Financial advisors need to familiarize themselves with pending changes to the taxation of testamentary trusts and consider alternatives when discussing options for their clients’ heirs.

“The proposed implementation of flat, top-rate taxation to testamentary trusts is a game-changer in the world of tax and estate planning, especially for higher net-worth clients,” says Glenn Hines, tax and wills and estates lawyer with Scott Petrie LLP in London, Ont.

Doug Carroll, vice president of tax and estate planning with Invesco Canada Ltd. in Toronto, adds that you may want to suggest to your clients who have created a testamentary trust in their will that “it’s time to change your will.”

That’s not to say that testamentary trusts will die, says Richard Niedermayer, estate and tax lawyer with Stewart McKelvey LLP in Halifax. There still are many instances in which clients will want to use a testamentary trust, he adds, which is created in a will and takes effect when the person creating the will dies.

Before the recent changes, the assets held in these trusts were subject to a graduated tax rate as long as the trust existed. However, changes in the 2014 federal budget, which come into effect in 2016, will limit the period of graduated rates to three years after death. At that point, a flat, top-rate tax will be imposed. This makes testamentary trusts much less attractive as a tax-planning vehicle for some affluent clients who could afford to leave the assets in their trust for extended periods.

Hines notes that there may still be tax benefits to maintaining a testamentary trust past the three-year period. For example, he says, “[These trusts] still can provide income-splitting opportunities by sprinkling the trust’s income among beneficiaries that are taxed at lower marginal rates.”

Testamentary trusts also may be useful in cases in which the beneficiaries are minors or when an adult beneficiary has demonstrated difficulty in handling money. Providing for a surviving spouse until that person’s death while preserving assets for the next generation also may justify the use of a long-term testamentary trust.

The proposed changes carve out an exception for beneficiaries who are eligible for the federal disability tax credit and so-called “Henson” trusts, another vehicle for providing for the disabled. The graduated rate still will apply to these situations.

There also are some housekeeping amendments that you should know about. Among them, testamentary trusts will have to start paying taxes on a quarterly basis and no longer will be able to use a non- calendar yearend.

For other situations, tax experts are developing alternative solutions to long-term testamentary trusts.

One of the main alternative vehicles under consideration are inter vivos trusts, which are created during the lifetime of the person creating the trust (the settlor). The rules for two of these types of trusts – alter ego trusts and their cousin, joint partner trusts for couples – are contained in the Income Tax Act.

Niedermayer, for one, says his practice used to have about a 75%/25% split between testamentary trusts and alter ego trusts. “I think that has switched,” he says. “I am doing many more alter ego and joint partner trusts than I did before.”

One of the drawbacks to alter ego and joint partner trusts is that the settlor must be at least 65 years old when they are created.

However, there are several benefits. Assets may be transferred into these trusts without triggering capital gains taxes. Such gains are deferred until the death of the settlor, or the surviving spouse in the case of joint partner trusts.

Alter ego and joint partner trusts also avoid the legal fees and probate fees that accompany the settling of an estate; the assets are disposed of upon death according to the terms of the trust.

There are other, less obvious benefits, Niedermayer adds. For example, alter ego and joint partner trusts provide more privacy than does a will, which must be filed with a court. These trusts also allow the settlor to appoint a trustee to manage the trust’s assets if the settlor becomes incapacitated – an alternative to using a power of attorney.

So, while the income left in the alter ego trust is taxed at the highest marginal rate, the advantages may make such trusts worth revisiting, given the changes to the rules for testamentary trusts. Notes Niedermayer: “Advisors may find these alternatives more appealing, depending upon the clients’ specific circumstances.”

Finally, if you have clients who are subject to an existing testamentary trust, the changes could see more taxes being paid once graduated rates are eliminated. That, notes Niedermayer, may prompt discussions about collapsing or varying existing trusts, which requires court approval.

© 2014 Investment Executive. All rights reserved.