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By Julie Cazzin with Allan Norman

Q: My two sisters and I are in the process of doing some estate planning for my mother, who is 80 years old, has Alzheimer’s and doesn’t have long to live. We are trying to understand how a testamentary trust works as well as the 21-year deemed disposition rule. My mother’s estate will be worth about $4 million (a split of 50 per cent in rental real estate and 50 per cent in a dividend stock portfolio). Her principal residence is worth $1.5 million and is over and above the $4 million in investments. We are all in our 50s, very comfortable financially and would like to leave the estate to my mom’s four grandchildren, the youngest of whom will turn 18 this year. Is this something we should consider? If so, would it be of benefit in our circumstances? — Maritia

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FP Answers: Maritia, I’m curious to know why you believe a testamentary trust may be a good idea. It might be, but not without some work and responsibilities for the trustees. Plus, with your mom having Alzheimer’s, you may not be able to change the will. Start by asking yourself what you want to achieve. Is there an alternative to a trust? As I discuss testamentary trusts below, consider if that is what you want to get into and if there is an alternative.

A testamentary trust is established by a person at their death, and they are the settlor, that is, the person who puts property into the trust. They can establish one trust, or a testamentary trust for each grandchild.

There is also a trustee, who is the legal owner of the property, as well as a beneficiary, who is the beneficial owner of the property. The trustee and the beneficiary can be one and the same, but you have options.

For example, you (or you and your siblings) could be trustees, the grandchildren could be trustees, you can have a professional trustee or any combination of these. It will depend in part on the purpose of the trust and the capacity of the trustees to fulfil their responsibilities.

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Trustee responsibilities include observing the terms of the trust, acting in good faith, dealing with an “even hand” for all beneficiaries, unless permitted not to (say, for tax reasons). The trustee can’t delegate their responsibilities to someone else, and they have to keep records, file the tax returns and make everything available to the beneficiaries.

Trustees are entitled to payment for their work and reimbursement for expenses, but they can’t secretly take money for themselves. Being a trustee is not a short-term job; it requires work and a trustee can be held accountable.

The two main reasons for setting up a testamentary trust are to exert control over the assets as well as to income split. Exerting control isn’t just about restricting access to the property in the trust. It can also be about encouraging grandchildren to accomplish certain things.

For example, until they reach, say, 25, they can only access the trust for educational purposes, or withdraw $10,000 a year to be spent on travel, or benefits will only be paid to them once they have established their ability to hold a regular job, and so forth.

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Although a trust is not a legal entity and can’t own property, the trustees do. It is taxed as if it is a legal entity at the highest provincial tax rate where it conducts its business. The exception for a testamentary trust is made in the first three years, when you can elect to have graduated estate and marginal tax rates apply, although there isn’t the $15,000 basic personal tax exemption.

A trust pays tax on the annual income, dividends and capital gains it retains in the trust. If the income, dividends and/or capital gains are paid out to the beneficiaries, it is optionally deducted from the trust income, so effectively no tax is paid.

If some grandchildren are earning income above the lowest tax bracket, there may be an income-splitting opportunity in the first three years. In Ontario, the top of the lowest tax bracket is $51,466 and the tax rate is 20.05 per cent. The trust could elect to pay the tax on the $51,466 and then give the money to the grandchild with no tax consequences for them. There may also be income-splitting benefits if the grandchildren have dependent children.

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The 21-year deemed disposition rule you asked about is designed to prevent the long-term deferral of capital gains. Every 21 years, the trust assets are deemed to be sold and the capital gains tax is applied.

What you might do is transfer the property out of the trust to the grandchildren before the 21 years are up; the transfer will not trigger capital gains. I should note that when or if the rental properties and dividend stocks are initially transferred into the testamentary trust, there is a deemed disposition and tax will apply.

What are your thoughts, Maritia? Rather than a trust, what if the money went to you and your siblings, and you then gave the money to the grandchildren as you saw fit? I know, you would be responsible for the tax, but you have the assets to cover the tax.

What if you instead gave them the money with instructions? They would be responsible for the tax at their marginal tax rates. If you are concerned they may take the money and run, you could have a contract drawn up for them to sign agreeing to your conditions.

Before you do anything, have a good discussion with your lawyer and the financial professionals in your life.

Allan Norman, M.Sc., CFP, CIM, provides fee-only certified financial planning services through Atlantis Financial Inc. and provides investment advisory services through Aligned Capital Partners Inc., which is regulated by the Canadian Investment Regulatory Organization. Allan can be reached at alnorman@atlantisfinancial.ca.

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