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Mar 2, 2015

Trusts, Taxes And Disability

by Ed Arbuckle

Ed ArbuckleMany families rely heavily on trusts in their financial planning because of the disability of a loved one. When it comes this kind of planning, most people automatically think of the Henson trust and believe it to be some unique arrangement that has legal characteristics different from all other trusts. But that is not the case.

What Is A Henson Trust

The Henson trust came into being when Leonard Henson set up a trust for his daughter Audrey so that she could receive small amounts of income from the trust that would not limit her ability to claim financial assistance under the Ontario Disability Support Program (ODSP). Since only the trustees had authority to provide Audrey with trust distributions, the assets and income of the trust were not part of Audrey’s assets or income to determine her entitlement to income assistance. The trust can be thought of as a kind of holding tank for capital to provide income to Audrey.

A Henson trust is a discretionary trust just like other discretionary trust used for other reasons. This means that the trustees have full discretion to control the trust assets and their distribution. Audrey had no rights in that regard. To repeat, a Henson trust is simply a discretionary trust utilized to maximize income assistance. Henson trusts (or special needs trusts, as they are sometimes called) can now be used in all provinces of Canada to maximize provincial income assistance.

Other Uses Of Trusts In Disability

Trusts are often implemented by families for reasons beyond the maximizing of income assistance. There are three main areas for trusts when it comes to disability and the related financial and tax planning and asset ownership issues. They are as follows:

  • Maximize income assistance (Henson trust)
  • As a vehicle to provide ongoing income to a person with disabilities, and to assist with the transfer of assets to other family members when the trust is no longer needed
  • Hold ownership of a property for a person with disabilities because they cannot or should not own property on their own.

The second and third points outlined above are important uses beyond the Henson trust use. They help families arrange their financial affairs over the long term despite the difficulties brought about by disability. The trust becomes the alter-ego of the owner of property when personal ownership is not a good choice or even a possibility. I might add that trusts can serve the same important function when it comes to managing the personal finances of vulnerable people who may not have disabilities as we understand the term but who nevertheless they cannot manage their personal finances.

Trusts And Income Tax

Without going into detail about the taxation of trusts, it can be simply said that trusts have many special rules in law and under the Income Tax Act which make them useful in handling the finances of people with disabilities and vulnerable people. In many cases, there is just no other way to do it.

Also, trusts provide a proper legal place for property ownership for these same individuals who can’t or shouldn’t own property because of their lack of legal competence or even the basic ability to make good judgments. Trusts also work well for tax purposes at the time of death of a person with disabilities to transfer the property of the trust to other family members. A trust allows decisions to be put in place far in advance of events so they can be carried out when the moment arrives.

Tax Rates For Trusts

Currently, the Income Tax Act allows two tax-rate structures for trusts. One is for trusts put in place during the lifetime of a person (inter vivos trust) and the other is for trusts set up in a will (testamentary trust) and acted on by the executors. The two tax rate structures are as follows:

  • Inter vivos trust - highest tax rate (one rate of 46%)
  • Testamentary trust - graduated tax rate (between 20% and -46%)

As you can see, an inter vivos trust is much less advantageous tax wise than a testamentary trust because of the much higher tax rate. It could easily be said that the maximum tax rate applicable to inter vivos trusts is punitive in most cases—especially when there is good reason to use them (when, for example, disability is involved). Consequently, families usually avoid inter vivos trusts and build their financial planning around the testamentary trust. However if the purpose of the trust is only to own non-income-producing property (such as a principal residence), then an inter vivos can be used because the high tax-rate issue is not relevant.

2016 Tax Rate Changes For Trusts

The federal government believes that the graduated rates for testamentary trusts are being used unfairly to create multiple uses for several taxpayers and consequently to reduce overall income tax unfairly. Accordingly, the government will abolish the graduated rates for virtually all testamentary trusts starting in 2016. However, they have agreed to continue the graduated rates for testamentary trusts established for a person with disabilities providing that the person qualifies for the disability tax credit. This new trust will be called a qualified disability trust (QDT). Here are the important qualifications that a QDT must meet:

  • At least one of the beneficiaries of the trust must qualify for the disability tax credit;
  • Only testamentary trusts will qualify as a QDT (no change here);
  • The trustee and the beneficiary with a disability (qualifying beneficiary) must jointly elect on an annual basis that the trust be a QDT;
  • There can only be one QDT for each person with a disability;
  • Existing testamentary trusts eligible for graduated tax rates will cease to be eligible for QDT status if they fail to qualify under the new rules outlined above.

QDT Problems

There are many problems with the new QDT rules for people with disabilities. The restrictions are too broad and will often make the QDT unusable. Most certainly, people who are vulnerable but don’t have a major disability that makes them eligible for the disability tax credit will not qualify for QDT use. Submissions were made to the federal government pointing out most of this but the government simply failed to listen. I know because I participated in one of the submissions.

The important limitations of QDTs (practical and legal) are as follows:

  • The QDT rules are complex and will likely be beyond the understanding and affordability of many families. Tax filings and compliance will be complicated;
  • Henson trusts that are in place now will not qualify as a QDT unless they are testamentary trusts and the qualifying beneficiary is eligible for the disability tax credit;
  • Where the person with a disability has a mental challenge there will likely be a need for guardianship so an election can be made on behalf of a qualifying individual;

  • If different family members (aunts, uncles,grandparents) wish to establish a QDT, only one will be able to do so because only one QDT is allowed for each person with a disability.

Conclusion

Writing on topics like this can be dangerous when you are dealing with such complex issues and new tax rules that have not even been introduced into law at the time of writing. Nevertheless, I felt that it was important to get the word out on these new and troubling tax changes affecting 500,000 or so Canadians with significant disabilities and 3,500,000 people who are vulnerable.

Ed Arbuckle, CA, FCA, TEP, Personal Wealth Strategies, Fee-Based Family Wealth Planners, Waterloo, ON (519) 884-7087 or (877) 883-3970, jea@finplans.net, www.finplans.net