Disability Trusts: Income Tax Issues

Besides PWD issues, you’ll spend a fair amount of time on tax-related trust issues. Fortunately, there are a number of disability and disability-trust rules that aren’t available to other folks. As trusts are often needed for PWD and for over-coming capacity issues, factoring tax-efficiency is crucial.

Disability Tax Credit

• Crucial tool for accessing disability-related tax benefits

• Issued by the CRA by filing a Form T2201

• Permits the recipient to receive the annual DTC grant ($8K annually), qualify for an RDSP ($90K in free grants/bonds), be eligible for a Qualified Disability Trust (21.2% base tax rate), and qualify to use the Preferred Beneficiary Election (transferring inter vivos trust income to the beneficiary’s tax return – saves more than 27% annually in taxes)

• Typically issued for five years at a time, but for obviously incapacitating disabilities (permanent), issued for lifetime.

• Based on a functionality test – ie. what the person CAN’T do. (CRA doesn’t care about a diagnosis – which many doctors like giving)

• Biggest problem is that the doctor is the gatekeeper. If the doctor won’t answer the questions properly, doesn’t have sufficient knowledge of their patient’s lifestyle, or doesn’t believe the patient “deserves it”, they’ll never qualify. You may need to coach the doctor on how to prepare the form. (Plan Institute has published three resource guides on preparing T2201s for physicians.)

Qualified Disability Trust

• Key estate planning tool – introduced in 2016.

• Testamentary trust created by the parent, grandparent, or spouse for the benefit of a person with a DTC. Can only have one settlor.

• Gets graduated tax rate

• Homes held by a QDT, where the beneficiary resides, qualify for the Principal Residence Capital Gains Exemption.

• Beneficiary can only have one QDT per year, but can elect a different QDT each year – problem when disabled beneficiary’s parents are separated – each will likely create a separate QDT in their respective wills..

• Came into effect January 1, 2016. Prior to this, person could benefit from multiple testamentary trusts, all of which had graduated rates. Crucial to review ANY estate plan made before 2016, as multiple testamentary trusts are no longer tax efficient.

Insurance/Additional Testamentary Trusts

• I used to do a significant number of testamentary insurance trusts, where a life insurance policy was made payable to a separate, testamentary, discretionary trust. As long as it had either a different trustee, or a different residual beneficiary from the disability trust in the Deceased’s will, it often provided for substantial tax savings by creating several taxpayers.

• Since the 2016 ITA changes, permitting only one QDT, this technique is no longer tax efficient. Unless there are concerns about a possible wills variation claim, I encourage people, wherever possible, to merge all assets through their estate to get into one QDT.

Tainting a QDT

• Be careful about tainting a QDT. If this happens, the graduated tax rate ceases to apply and the base tax rate on retained income jumps from 22.1% to 49% (or higher, changes every year).

• QDT is valid ONLY if it receives all of its capital from one deceased parent/grandparent. The moment it receives settled assets from a second source, QDT status goes “poof”.

• Untainting MAY be possible, but above my paygrade. Time to call the tax guys at Thorsteinssons or similar tax experts.

Preferred Beneficiary Election

• Available where the beneficiary of the trust has the DTC, and the Settlor is the Beneficiary, the Beneficiary’s spouse, former spouse, parent, or grandparent.

• The Election must be made annually, within 90 days of the year end, jointly by the trustee and beneficiary.

• It causes the trust’s income to be taxed in the beneficiary’s hands, without actually being paid from the trust.

• In a nutshell, it typically causes trust income, which is normally taxed at around 49%, to be attributed to the beneficiary and taxed in his/her hands – typically at around 22%.

• NOTE: attributed income, as it’s not actually paid out, does not count as “income” for PWD purposes. (This confuses the heck out of most people.) BUT – it might affect eligibility for other benefits, like reduced home care costs.

Attribution Rule – Income Tax Act, Section 75(2)

• NOTE – Needs to be considered for EVERY inter vivos trust

• In a nutshell, when the Settlor has a continued or contingent interest in a trust’s income, the income is automatically taxed in the Settlor’s hands

• This can be a two edged sword, so you must understand the trust creator’s situation.

• Typical example A: parent sets up an inter vivos trust for their son/daughter, but as the kid may die, they want to be the residual beneficiary. If they’re named in the trust as the residual beneficiary, it will trigger s. 75(2) and the trust’s income will be attributed back to the parent (and parent gets VERY ticked off). Two easy solutions:

1. If the son/daughter is not married/no kids, name the residual beneficiary as: “divide and distribute the remaining assets of the trust among those persons who would inherit the beneficiary’s estate if he died intestate, without any creditors, and in the proportions set out in the intestacy legislation applicable to the beneficiary’s estate”. As the trust doesn’t explicitly name the settlor, it doesn’t trigger 75(2), however by default, it reverts to the parent upon their kid’s demise.

2. Name the parent as the residual beneficiary, settle the trust for $5, and then have the parent loan the funds to the trust. As long as the parent/settlor is paid an annual nominal interest rate, there’s no deemed gift, and 75(2) doesn’t apply.

• Typical example B: person on PWD sets up an inter vivos trust for themselves. Whether they’re the trustee or not, s. 75(2) applies, as they’re both the settlor and the beneficiary. Not a problem, because PWD rules only care about actual money paid from the trust. Attributed income doesn’t count.

• Typical example C: person with subsidized housing or home care support sets up an inter vivos trust for themselves. Whether they’re the trustee or not, s. 75(2) applies, as they’re both the settlor and the beneficiary. Might be a problem, because rent subsidies and home care per diem rates look at TAXABLE income – which includes attributed income under s. 75(2). If it’s a large settlement, consider a loan to the trust as opposed to a gift.

Lifetime Benefit Trust – s. 60.011 ITA

• Not used too often. A parent/grandparent via their will can have their RRSP converted to an annuity which is payable to a discretionary trust for a child/grandchild with the DTC. The trust must be fully discretionary, and used for the “comfort, care, and maintenance of the disabled son/daughter”.

Registered Disability Savings Plan (“RDSP”)

• RDSP is a program introduced by the Feds in 2010 to assist folks with disabilities with long term savings.

• Must have the DTC to open one, offered by major banks, some credit unions.

• Can contribute upto $200K over lifetime, but until age 49, Feds will match annual contributions up to 3X, for an annual $3500 grant and $1000 bond. (Ie., person contributes $1500, and gets $4500 in free grants and bonds.)

• Can make catch-up contributions for up to 10 previous years.

• Can get a maximum of $70K in grants, and $20K in bonds.

• Grants/bonds are clawed back if withdrawn within 10 years of the last grant/bond payment.

• Must start withdrawing at age 60. If (at age 60), government contributions are higher, must withdraw according to a set formula. If individual contributions are higher, can withdraw as much as is desired.

• Funds in RDSP and income from RDSP is exempt for PWD purposes – EAAPD Regs, s. 10(1)(jj)

• Important to understand rules around RDSPs. See: https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/registered-disability-savings-plan-rdsp.html

Registered Disability Savings Plan – Probate

Because of the clawback rules, it seems unfair to pay probate fees on the pre-clawback value of the RDSP. The probate registry permitted us to reduce the value of the estate by the amount of the likely clawback, AFTER I provided the registry with a sworn affidavit outlining the law on the formula for revoking RDSP contributions.

Using a trust to leverage an RDSP

• If person on PWD needs to shelter funds, is under 49, and has the DTC, they won’t be able to max-out the RDSP grants/bonds if they do a lump sum deposit. As well, if they do a lump sum deposit, they can’t withdraw funds from the RDSP for 10 years without losing grants/bonds. Hence, it’s often economically wiser to use a trust the leverage the RDSP.

• To do so, the PWD beneficiary sticks their inheritance/settlement into a trust. The trust does the ten year back contribution, and makes $1500/yr ongoing contributions to the RDSP, until age 49, maxing out the grants/bonds. Then, when the PWD recipient turns 58, the trust makes a further contribution to ensure that their personal contributions are at least $1 greater than the Fed’s contributions. This will enable them to withdraw whatever amounts they want at age 60.