For parents familiar with disability financial planning, the term disability trust, Henson trust or discretionary trust are terms you will be acquainted with. These are often complicated instruments to work with.
These trusts offer the ability to exclude valuable assets from “needs tests” that parents want to leave for their children to use to lead a more comfortable life than the poverty level lifestyle that the province provides. These trusts are powerful tools that, when used incorrectly, can lead to unintended effects like maximum taxation which in turn, can jeopardize the ability of the trust to last the lifetime of the beneficiary. However, used correctly, they exempt assets and reduce taxation of the earnings so that they may provide a lifetime of financial resources to the beneficiary.
Since trusts may be complicated and costly to set up, during educational workshops a common question parents ask me is “can anyone contribute to the trust I set up for my child.”
Invariably the answer is “no” from a taxation perspective if the trust was set up at the passing of the parents.
Trusts are seen by the government as a method to avoid taxation. As a result, the default tax rate is the maximum tax rate and not a marginal one. The latter tax is a sliding scale that increases significantly as the amount of income goes up hitting as high as 47.7% with the BC and federal tax rate combined as opposed to the lowest rate of 20.06%. That means that 48 cents of each dollar of income becomes tax if the default tax rate is used.
Set up correctly, a Henson Trust would be preferably set up on the passing of the parents and would therefore enjoy a marginal tax rate thereby offering tax relief in most cases. We must watch for anything that could jeopardize that status.
To remain in the marginal taxation state, all of the assets put into a trust must come from people who have passed away. Should any asset come from someone still living, the default maximum tax rate then will prevail. Such an event is typically not reversible and could seriously impact the ability of the trust to last the life of the child.
As a rule of thumb, to keep things simple and avoid complications and negative effects, trusts probably are best reserved for the assets of one individual who has passed away. Preventing others to contribute to it avoids invalidating the preferential tax treatment of the trusts income.
For more tips and advice on planning financially for your child, see a trusted advisor proficient with disability financial planning.
This article is written by David Chen, BSc, BA, CPCA, FPSC Level 1, Lead Advisor, DC Complete Financial