When a testator is considering leaving assets to a beneficiary who has a disability, there are important factors that the testator needs to examine to ensure that the disabled beneficiary is appropriately protected. With new and proposed tax laws, the process of estate planning to accommodate beneficiaries with disabilities is becoming more complex; it is increasingly important to consider the personal circumstances of the disabled beneficiary when structuring an estate plan.
When a lawyer is apprised by a testator that a beneficiary has medical issues, whether they be physical or psychological, the lawyer’s first question will typically be whether that individual is receiving government assistance. In Ontario, support for people who are mentally or physically disabled is provided through the Ontario Disability Support Program (“ODSP”). ODSP often provides a limited living allowance, but it does provide a drug plan that can be invaluable for certain individuals with high medical or care costs who would otherwise likely not be insurable. To qualify for ODSP, the disabled individual must meet the stringent assets and income threshold. Currently, the disabled individual is limited to having $5,000 worth of assets and receiving $6,000 worth of income and discretionary payments, such as gifts or windfalls, per year. There are some exceptions to the strict thresholds. For example, there are a number of exempt assets that a disabled individual can own, including a house, a therapeutic recreational property, a car, and a Registered Disability Savings Plan, and still qualify for ODSP. Disabled individuals can also receive unlimited gifts or payments for disability-related expenses over and above the yearly $6,000 income limit so long as the expense is pre-approved by ODSP. Perhaps most importantly for estate planning purposes, the disabled individual can also be the beneficiary of a fully discretionary trust.
Discretionary Trust Basics
A trust is a relationship whereby an individual, known as a trustee, manages assets for the benefit of an individual, known as a beneficiary. For the purposes of this discussion, the beneficiary is the disabled individual. In a formal trust, the management of the trust, including how the funds are to be managed by the trustee, the distribution of the funds and the use of the funds can be recorded in a document known as a trust settlement or trust instrument. In the case of a trust under a will, the will itself becomes the trust instrument. Trusts are flexible tools because the level of discretion given to the trustees can vary regarding distributions of income or capital from the trust. For example, a trustee can be required to make payments of a particular amount or the amount of the payment can be left to the trustee’s discretion. A fully discretionary trust, or “Henson Trust” as it is popularly referred to, is one of the most common planning tools for protecting assets for disabled individuals. A fully discretionary trust is a trust in which the trustee has complete discretion on how, when and if to make payments to or for the benefit of the disabled individual. Because the disabled individual has no legal right to require the trustee to make a payment to them, assets held in a fully discretionary trust are not considered to be assets of the disabled individual for the purpose of determining ODSP eligibility.
Discretionary Trust Considerations
While establishing a fully discretionary trust under a will does ensure, in Ontario, that a disabled individual’s inheritance will not interfere with his or her ODSP benefits, the following drawbacks need to be considered when contemplating establishing a fully discretionary trust:
- Payments out of the trust are still limited to the $6,000 income threshold unless the payments are for disability-related expenses. A fully discretionary trust can be of great benefit to an individual who has high disability-related expenses but of limited benefit to an individual who does not have significant disability-related expenses.
- All control for the distribution of trust funds is in the hands of the trustees of the trust. If a trustee elects not to make payments for the benefit of the disabled individual, the disabled individual has little legal recourse to demand payment. If the trustee is also the residual beneficiary of the trust (inherits the remainder of the trust funds after the death of the disabled individual), this can put the interest of the trustee in conflict with the interest of the disabled individual who may have little ability to advocate for themselves.
- Testators often do not consider the amount of the assets going into trust when deciding to establish a fully discretionary trust. The amount placed in trust has a large impact on whether a fully discretionary trust will be appropriate for a particular individual because of the asset limitations required to qualify for ODSP and the impact those restrictions have on the disabled individual’s lifestyle. If the amount to be placed in trust for the disabled individual will be sufficient to support the disabled individual for the remainder of his or her life, the testator, in conjunction with the disabled individual or their substitute decision makers, should consider whether it is important for the disabled individual to continue to receive ODSP. Then, if the disabled individual does not need to qualify for ODSP, it may also be more appropriate instead of a fully discretionary trust to structure a trust that gives the trustee less discretionary power thereby providing more security for the disabled individual in the administration of the trust.
Testators need to consider the personal circumstances of the particular disabled individual who they are contemplating making a beneficiary and consider whether alternatives to a fully discretionary trust might be more suitable for the disabled individual. If a testator questions whether to establish a fully discretionary trust for a disabled beneficiary, or if there is a question as to whether the funds going into trust will support that disabled individual for their lifetime, the testator should always opt to set up a fully discretionary trust in his or her will. It is difficult to remedy a gift to a disabled individual after the fact as a disabled individual can only establish a disability trust for himself or herself in an amount not exceeding $100,000 at any given time. This means that if the disabled individual cumulatively receives any amount from inheritances over the $100,000 threshold, they may lose their ODSP benefits if they cannot purchase an exempt asset such as a house, recreational property or car or contribute the funds to a Registered Disability Savings Plan (for which they have to qualify for the Disability Tax Credit). Moreoever, if a trust does not have enough assets to support the disabled individual over the course of their lifetime, re-qualifying for ODSP can be a difficult process, especially for the incapable or those with mood or anxiety disorders.
Unsurprisingly, the Canadian tax landscape also plays a role when a testator is planning for a disabled individual.
Qualified Disability Trusts
Beginning in 2016, the federal government significantly restricted the beneficial tax treatment of testamentary trust income. Income earned in testamentary trusts is no longer taxed at marginal tax rates and instead is taxed at the highest marginal tax rate with a few limited exceptions. One of those exceptions is known as the Qualified Disability Trust (“QDT”). In order to qualify as a QDT, a trust has to meet the following requirements:
- At the end of the taxation year for which it is to qualify as a QDT, the trust must be a testamentary trust that arose on and as a consequence of a particular individual’s death;
- The trust must be resident in Canada for its tax year;
- The trust must make a joint income tax election with a “qualifying beneficiary” to be a QDT;
- Electing beneficiaries must be “named” beneficiaries under the will or other instrument that created the trust;
- Electing beneficiaries must qualify for the disability tax credit under sections 118.3(1)(a) and (b) of the Income Tax Act (the “Tax Act”); and
- Each electing beneficiary may only make one QDT election.
While the QDT is intended to provide some income tax relief for individuals, the application of the provisions may not be helpful for some ODSP recipients. The QDT definition specifically requires that electing disabled beneficiaries be named beneficiaries in the instrument under which the trust was created; therefore, references to “children” or “issue” will not qualify. If a disabled individual does not qualify for the disability tax credit under sections 118.3(1)(a) and (b) of the Tax Act, they will not be eligible to elect for the QDT. Under subsection 122(2) of the Tax Act, if at any time income taxed at a marginal rate as a result of the QDT election is paid out to a non-electing beneficiary, the trust can be subject to an additional amount of tax to gross up the amount paid at the marginal rate to the amount that should have been paid at the top rate. This means that the income that was taxed at the marginal rate will be reassessed at the highest marginal rate. Most fully discretionary trusts for disabled individuals allow for payment to non-disabled beneficiaries in the event that the Accumulations Act is engaged or in the event of the death of the disabled individual, so it is likely the QDT will merely become a tax deferral method rather than a tax savings method for fully discretionary trusts. Additionally, an electing disabled individual can only have one QDT election, so if the electing individual is the recipient of multiple trusts, only one of those trusts is allowed to be a QDT. If an electing disabled individual is the recipient of multiple trusts, the trustees of those trusts will have to coordinate to ensure that the QDT election is filed where it can provide the most benefit to the electing disabled individual. For further detail regarding the QDT, please see our Wealth Matters article, A Review of Qualified Disability Trusts.
Changes to the Principal Residence Exemption
Changes proposed on October 3, 2016 by the Department of Finance would, if enacted, limit the ability of a trust to claim the principal residence exemption. There are three major exceptions to the proposed rules, one of which allows a trust for the benefit of a disabled individual to claim the principal residence exemption, provided it meets the following qualifications:
- The trust must be a qualified disability trust;
- The beneficiary of the trust must be a spouse, common law partner, former spouse or common law partner or child of the testator;
- The beneficiary must be a resident of Canada in each year for which the exemption is claimed; and
- The beneficiary must have a right to the use and enjoyment of the property as a residence under the terms of the trust.
These requirements present issues for fully discretionary trusts established for disabled individuals as follows:
- As the trust must be a QDT, the beneficiary must qualify for the disability tax credit under sections 118.3(1)(a) and (b) of the Tax Act. Disabled individuals may qualify for government benefits but may not qualify for the disability tax credit thereby excluding them from benefitting from the principal residence exemption.
- For a trust to be able to claim the principal residence exemption, the beneficiary of the QDT must be closely related to the testator. This restriction on trusts prevents more remote relatives from establishing trusts holding property for the benefit of a disabled individual if the relative wants the property to qualify for the principal residence exemption on sale.
- For a trust to be fully discretionary, the beneficiary must not be entitled to receive an absolute right under the trust. However, in order to qualify for the principal residence exemption, the beneficiary must also have a right under the terms of the trust to the use and enjoyment of the property as a residence. This may result in the trust offending ODSP requirements that the trust be fully discretionary and may result in a loss of ODSP benefits.
As a result of proposed changes, and their potential consequences, testators will have to carefully consider the nature of the assets that they are placing in trust and the ability of the trust to be able to benefit from the principal residence exemption. For further details regarding the proposed changes, please see our Wealth Matters article, Department of Finance Announces Proposed Changes to the Use of the Principal Residence Exemption.
In conclusion, there are many considerations that have to be taken into account when planning for a disabled individual, including the particular needs of the disabled individual, the amount of money in the estate and the tax implications of the proposed structure. The decisions regarding these considerations are not always simple. A comprehensive plan for a disabled individual may require coordination between different family members to ensure efficiency in the administration of assets held in trust for a disabled individual. To ensure that the beneficiary’s interests are protected and to avoid a loss of benefits or adverse tax consequences, competent professionals should be retained to assist in careful planning for the disabled individual. The lawyers in the Miller Thomson Private Client Services Group can assist.