Income solutions for trusts

Wealth Transfer Strategy 7

A trust provides a method for a person (the settlor) to give property to another person (the trustee) for the benefit of a third person (the beneficiary) while still maintaining some form of control over the property. If the intent is to provide a regular income to a beneficiary, a systematic withdrawal plan (SWP) or Series T option are worth considering.¹

The opportunity

Depending on the terms of the trust and the investment goals, establishing a SWP or Series T payment may be an appropriate option. This could be a case where the trustee would like a consistent income stream to flow through to the trust beneficiary to help fund various expenses (for example, a parent can set up a trust to provide an income stream to a spendthrift adult child).

A SWP is a fixed-dollar withdrawal that occurs on a regular basis (i.e., monthly). At the time of each withdrawal, there’s a sale of units to fund the withdrawal. This sale will trigger a capital gain or loss. A SWP is available for mutual funds and segregated fund contracts. For more information, see “Tax treatment of a systematic withdrawal plan (SWP).”

A Series T fund (also known as T-Class) can provide a regular stream of tax-efficient cash flow from monthly distributions. All or a significant portion of the distribution received is likely to be considered tax-free return of capital (ROC). The payment is based on a pre-selected percentage, up to 6%, that‘s paid monthly. This option is only available for mutual funds. For a tax comparison of these two payment options, see “Comparing SWPs to Series T funds—pay tax now or pay tax later?.”

What is a trust?

A trust isn’t a legal entity; however, it’s treated as an individual for income tax purposes and taxed separate from the settlor and the beneficiaries. Generally, both testamentary trusts and inter vivos (lifetime) trusts are taxed at the top marginal rate,² which can exceed 50% in most provinces. Generally, trusts report any income earned but are entitled to an offsetting deduction for amounts paid or made payable3 to the trust beneficiary in that year. The beneficiary would then report this income on their tax return.

If appropriately designated by the trustee, these amounts—including ROC, capital gains, taxable dividends, interest, and foreign source income—retain their character for tax purposes in the hands of the beneficiaries.

Does a systematic withdrawal plan or Series T option in a trust make sense?

Trust assets should be invested in something that’s consistent with the terms of the trust and that’ll fulfill its objectives. If one of the objectives is to provide a steady income stream to a beneficiary, then these options may be appropriate.

Can you do it?

Provided the trust document doesn’t prohibit an investment into a mutual fund or segregated fund contract, then these investments with a SWP or Series T option are generally permissible. The trustees are guided (or restricted) in their investment selection by the terms of the trust. If the trust is silent, or where no trust document exists,4 the applicable provincial trustee legislation applies. All provinces have adopted the prudent person rule, which provides wide discretion in investing, if certain tests are met.

How do you do it?

First, select a suitable investment. Then establish the appropriate income option. While a SWP is available for both mutual funds and segregated fund contracts, Series T is only available for mutual funds.

If a segregated fund contract is chosen, it’s important that the contract provisions are consistent with the terms of the trust. The trust should be entered as the owner. If the trust has been named (e.g., The Smith Family Trust), then that name should be used. If the estate, which is a testamentary trust itself, is purchasing the contract, then the estate should be identified as owner (e.g., The Estate of John Smith).

Given that the contract setup should correspond with the distribution under the trust, in most cases the annuitant under the contract would be the trust beneficiary.

The beneficiary under the contract shouldn’t be confused with the trust beneficiary. The beneficiary under the contract would typically be the trust, so that on the death of the annuitant, the funds would be paid back to the trust and would be distributed according to the terms of the trust. Where the trust document specifies who should receive the funds from the trust on the death of the annuitant, that person can be named as a beneficiary under the contract.

The complication

Beneficiaries under a trust are income beneficiaries (where they’re entitled to only the income of the trust), or capital beneficiaries (where they’d be eligible to receive the capital from the trust), or both.

The payment stream from a non-registered SWP is funded by redeeming units and will be comprised of a capital gain or loss and return of capital. While Series T isn’t funded by redeeming units, most or all of the payment is likely to be a return of capital.

It’s important to realize that what may be considered income for tax purposes may not be considered income for trust law purposes. From a trust law perspective, income normally includes interest, dividends, and foreign income but not capital gains, even though 50% of capital gains are included on a tax return. Capital gains and return of capital are considered capital and belong to the capital beneficiary. This divergence on what’s considered income between trust law principles and tax rules creates an additional complication that must be considered. If the definition of income is included in the trust agreement and aligns with taxable income from the Income Tax Act (ITA) then capital gains can be allocated to income beneficiaries.

If the income and capital beneficiaries are different individuals, or income is not defined as taxable income in the ITA, or the trustee doesn’t have a right to encroach on capital for the benefit of the income beneficiary, then the income beneficiary would only be entitled to any interest, dividends, or foreign income that the trust earns (e.g., distributions from a mutual fund reported on a tax slip). This amount may be small, resulting in the income beneficiary receiving little income. This may not be the desired outcome and may be inconsistent with the objectives of the trust. In such a situation, these options are probably not appropriate.

If the income beneficiary and the capital beneficiary are the same person, or the trustee can encroach on capital for the benefit of the income beneficiary, or the trust agreement allows income from the trust to be treated the same as taxable income in the ITA, then these options are still worthy of consideration. However, keep in mind that the trustee has a fiduciary duty to make sure that distributions from the trust are allocated fairly between the income and capital beneficiaries, unless the trust document dictates otherwise.

Ideal candidates

Trustees who are:

  • looking for a consistent income stream for trust beneficiaries
  • administering a trust where an investment into a mutual fund or segregated fund contract isn’t prohibited by the trust and is consistent with the trust objectives
  • administering a trust where the income and capital beneficiaries are the same person or where they can encroach on capital for the benefit of the income beneficiary

Take action

  • Determine the amount of regular income you’re looking for from these funds.
  • Consider using a Manulife mutual fund or segregated fund contract to provide part or all of the income needed.

A thorough review of all the issues relating to trusts is beyond the scope of this piece. For more information about trusts and their use, see “Understanding trusts.” You should speak to your tax and legal advisor about your specific situation. Qualified disability trusts (QDTs), which are testamentary trusts resident in Canada where the beneficiary is eligible for the disability tax credit, and graduated rate estates (GREs) continue to be taxed at graduated tax rates. 3 Legal entitlement is generally determined by the terms of the trust agreement. Legal entitlement of a beneficiary to enforce payment for amounts made payable in a particular year requires the trustee to exercise their discretion and the trustee giving notice of such exercise of discretion to that beneficiary. 4 In Quebec, only formal trusts are recognized, as the concept of an informal trust (e.g., an “in trust for” account) doesn’t exist.

The payment of distributions is not guaranteed and may fluctuate. If distributions paid by the fund are greater than the performance of the fund, then your original investment will shrink. Distributions should not be confused with a fund’s performance, rate of return, or yield. You may also receive return of capital distributions from a fund. Please consult with your tax advisor regarding the tax implications of receiving distributions. See the prospectus for more information on a fund’s distributions policy. Monthly distributions are based on a target distribution rate of the net asset value per security of the fund determined as of December 31 of the prior year.

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Tax, Retirement & Estate Planning Services Team

Tax, Retirement & Estate Planning Services Team

Manulife Investment Management

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