New legislation taking effect January 1st, 2016 will affect the taxation of testamentary trusts and could eliminate any benefit to including one in your will; however, before you go out and re-write your Will let’s make sure that you actually need to.
In case you’re unfamiliar with a testamentary trust, it’s defined as a trust which arises upon the death of the testator (this is the person who’s will it is). The trust is outlined within the will and the will itself acts as the trust document for administrative purposes.
One of the more common types of testamentary trusts is a spousal trust.
Under the old rules, testamentary trusts had the benefit of their own set of graduated marginal tax rates. If the trustee decided to leave income generating assets in the trust, any income was taxed at the same marginal rates as an individual. Federal rates range from 16% to 29%. Under the new rules, all income left in the trust will be taxed at the highest marginal tax rate.
A very common estate planning maneuver was to leave part or all of ones’ estate to a spousal trust so that on the first death the income generated within the spousal trust could be split between the surviving spouse and the trust itself. What this effectively did was create an income splitting opportunity between the surviving spouse and the trust, ultimately reducing the overall tax liability on that income. This may be one reason why these changes are coming into effect.
Let’s look at an example of a couple that are both working and earning $100,000 each. If one spouse dies with an estate value of $1,000,000, under the old rules you could set up a spousal trust in their wills where the $1,000,000 would be held “in trust” for the benefit of the surviving spouse. If the $1,000,000 was invested and earned 5%, this $50,000 of trust income could be taxed in the trust (using marginal rates) instead of being added to the $100,000 the surviving spouse earns. If the spouse wasn’t working, or was earning less, the trustee could decide whether to leave the $50,000 to be taxed in the trust or to allocate any or all of the $50,000 out to the trust beneficiary (the surviving spouse). Under the old rules, you could adjust income allocation between the trust and the beneficiary depending on what was most effective in reducing taxes. Under the new rules, any income retained in the trust will be taxed at the highest marginal tax rate.
Over the last few weeks, many of our clients have received letters from various law firms recommending that they review, and in many cases re-write, their existing wills. Many of these letters have been misleading in the way they are worded. For example, a common misrepresentation is a statement like “Effective January 1, 2016, testamentary trusts will now be taxed at the highest marginal rate.” It’s also not unusual for this type of statement to be followed by something similar to “as a result, in almost all situations, we are now recommending that these types of trusts be removed from most of our clients’ wills before the end of 2015.”
To clarify this, the only income that will be taxed at the highest marginal rate will be income left inside trust. If all the income is distributed to the beneficiary in a specific year, the trust will earn no income and will not pay tax on the distributed income. Income will be taxed in the beneficiaries’ hands only.
Considering this, if you have a provision in your will leaving any part of your estate to your spouse or anyone else “in trust,” you may not have to change your will. The trustee has the option to pay out income to the beneficiary so that the trust avoids all income tax but still retains the capital. All income from the trust is paid out each year and is simply taxed in the recipients hands, not the trusts.
Testamentary trusts can still provide planning opportunities aside from these tax considerations. You may want to protect the estate assets from creditors (a spouse remarrying or a child of yours getting divorced). How about the thought of leaving an estate worth millions of dollars to a 19 year old? These are a few reasons to consider testamentary trusts and to not let these misleading letters from lawyers convince you it is necessary to change your wills.
There is one situation; however, that some of you should be aware of. If you (as an example) have a blended family and leave part or all of your estate in a spousal trust, you have to beware who the ultimate beneficiaries of that trust are.
Under the old rules, if you left your estate in a spousal trust and named your children as the ultimate beneficiaries, when the second spouse died the trust would pay any taxes owing and your children would receive the residual value. As of January 1st, 2016, this is not the case.
According to the new rule, if your will has a testamentary trust (for a spouse or anyone) and you predecease your spouse, when they die any tax owing by that trust is charged to their estate, not the trust. With a spousal trust, the tax bill goes to your spouse’s estate and the trust money all goes to your own children. Now imagine how this would work if you each have two children from a previous marriage. Again, you leave your entire estate to your spouse “in trust” and name your two children as the ultimate beneficiaries. On your spouse’s death, their estate receives the tax bill from the trust and your children get all the money that was left in the trust. Your spouse’s children are left with a reduced estate, and your children receive the net proceeds of your estate. Not a good way to leave the planet.
As outlined, there are a lot of changes coming into effect on January 1st, 2016 regarding testamentary trusts, which makes it an appropriate time to review your current wills to look for trouble spots. Our office can help to review your current wills to ensure your wishes are still being met in an efficient manner and you are not making any unnecessary changes to your wills unless overall functionality has been restricted.