Testamentary trusts are a common tool for estate planning in Canada. They help people manage how their assets are distributed to beneficiaries and can provide tax advantages through certain exceptions. These trusts can also offer protection for loved ones.
In this article, Lexpert will talk about what a testamentary trust is and how it works. We’ll explore who the beneficiaries might be as well as why one might choose to include this kind of trust in their will.
What is a testamentary trust?
A testamentary trust is a trust that is established by a will. It only takes effect after the person who created the will, known as the testator, passes away. The trust is managed by a trustee, who is responsible for holding and managing the assets according to the instructions in the will.
Choosing a trustee
Selecting the right trustee is one of the most important decisions when setting up a testamentary trust. The trustee must be trustworthy, organized, and able to manage financial matters.
The testator can choose a trustee who can be a family member or friend. They can also be a professional advisor or a trust company. The trustee’s duties include:
- filing tax returns for the trust
- managing the trust assets well
- following the instructions in the will
- acting in the best interests of the beneficiaries
- keeping accurate records and providing reports to beneficiaries
Who are the beneficiaries of a testamentary trust?
The individuals or entities who benefit from the trust are called beneficiaries. They are legally entitled to receive assets, income, or other benefits from the trust, as outlined in the deceased’s will.
Unlike an inter vivos trust, which is set up while a person is alive, a testamentary trust is only created after death. This makes it a useful tool for people who want to control how their assets are distributed over time, rather than giving everything to beneficiaries all at once.
Watch this video to better understand testamentary trusts in Canada:
To help you set up your testamentary trust, you might want to engage the services of a legal expert. Here are some of the best personal tax planning and estate lawyers in Canada.
Read next: Hiring an estate planning lawyer in Canada: What clients should know
What is the purpose of a testamentary trust?
When someone dies and their will is probated, the testamentary trust is created. The trustee then takes control of the assets that are placed in the trust.
The trust can last for a set period, such as until a beneficiary reaches a certain age, or for the lifetime of a beneficiary. Once the conditions in the will are met, the trust is wound up and any remaining assets are distributed.
Why use a testamentary trust?
There are several reasons why someone might choose to set up a testamentary trust in their will. For instance, it can provide for family members with disabilities or special needs. Using a testamentary trust in Canada can also:
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allow the testator to control how and when beneficiaries receive their inheritance
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offer tax planning opportunities, although recent changes to tax laws have affected the benefits
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protect assets for minor children or beneficiaries who might not be able to manage money on their own
How to set up a testamentary trust in Canada
Setting up a testamentary trust involves working with an estate lawyer to draft a will that includes clear instructions for the trust. Once the will is complete, it should be signed and witnessed according to provincial laws.
After the testator’s death, the executor of the estate will work with the trustee to set up and manage the trust.
The role of the executor and trustee
The executor and trustee might be the same person, but they have different roles. The executor is responsible for settling the estate, which includes:
- gathering assets
- paying debts
- distributing property according to the will
Once the estate is settled, the trustee takes over management of the trust. The trustee’s job is ongoing and might last for many years, depending on the terms of the trust.
How are testamentary trusts taxed in Canada?
Testamentary trusts in Canada are taxed as separate entities for tax purposes.
Before 2016, these trusts benefited from the same graduated tax rates as individuals. However, since January 1, 2016, most testamentary trusts are taxed at a flat top marginal tax rate like inter vivos trusts.
Are there exceptions?
Yes, there are two main exceptions. First, an estate that qualifies as a graduated rate estate (GRE) can use graduated tax rates for the first 36 months after the individual’s death.
Second, a testamentary trust set up for a beneficiary eligible for the federal disability tax credit can be a qualified disability trust (QDT). This allows it to use graduated tax rates if the trust and beneficiary jointly elect for QDT status for that year.
If a testamentary trust does not meet these exceptions, all its income and capital gains are taxed at the highest marginal rate. Trustees can reduce the tax burden by distributing income or capital gains to beneficiaries, who then pay tax at their own marginal rates.
This can lead to tax savings if the beneficiaries’ rates are lower than the trust’s rate. Trustees might also invest in tax-efficient investments to further manage taxes.
Recent changes
In 2024, the capital gains inclusion rate for trusts increased from 50 percent to 66.67 percent for gains realized on or after June 25, 2024. GREs and QDTs can still use the 50 percent rate for the first $250,000 of capital gains taxed in the trust.
If a capital gain is allocated to a beneficiary, they might also benefit from the 50 percent rate for up to $250,000 of gains in the year. All testamentary trusts except GREs must have a December 31 year-end and file a T3 return within 90 days of year-end.
Watch this clip to learn more:
Protecting assets with a testamentary trust
A testamentary trust might help protect assets from creditors, lawsuits, or relationship breakdowns. By keeping assets in a trust, rather than giving them directly to beneficiaries, the trust can provide a layer of protection.
This is especially important if a beneficiary is at risk of divorce, bankruptcy, or has difficulty managing money. The trustee has the discretion to manage and distribute assets in a way that protects the interests of the beneficiaries.
However, asset protection is not absolute. While testamentary trusts might provide some safeguarding, the courts might consider trust assets in family law or creditor claims. This depends on the circumstances and how much control the beneficiary has over the trust.
What are some disadvantages of testamentary trusts in Canada?
While testamentary trusts offer several benefits as mentioned above, there can also be some drawbacks to consider like:
- costs for legal advice and ongoing administration
- complexity in managing the testamentary trust
- changes in tax laws; these might reduce benefits
Testamentary trusts and probate
Assets placed in a testamentary trust must go through probate, which is the legal process of validating the will and settling the estate. Probate can take time and might involve fees.
The trust itself can help simplify the distribution of assets. This is especially true for complex estates or when beneficiaries are not ready to manage their inheritance.
Testamentary trusts and family law
In Canada, testamentary trusts can have a role in family law matters. For example, they can help protect inheritances from being considered family property in the event of a divorce. However, courts might look at how the trust is structured and how much control the beneficiary has over the assets.
You might also choose to create a family trust instead if you want to establish a trust while you’re still living.
Testamentary trusts and blended families
Blended families, where one or both spouses have children from previous relationships, often use testamentary trusts to make sure that all family members are provided for.
For example, a trust can provide income to a surviving spouse during their lifetime, with the remainder going to children from a previous marriage. This approach helps balance the interests of different family members and can reduce the risk of disputes.
Testamentary trusts and business succession
Business owners can use testamentary trusts to manage the transfer of a family business after their death. The trust can hold shares in the business and provide income to family members.
This can be so while making sure that the business is managed by someone with the right skills and experience. Setting up a testamentary trust can help preserve the value of the business and support a smooth transition to the next generation.
Ending a testamentary trust
A testamentary trust ends when the conditions set out in the will are met. This might be when a beneficiary reaches a certain age or after a set number of years. A testamentary trust can also end upon the death of a beneficiary.
Finally, when the trust ends, the trustee distributes any remaining assets to the beneficiaries as instructed in the will.
For related information about testamentary trusts in Canada, check out our Legal FAQs page.