Testamentary vs Living Trusts

Introduction
Understanding testamentary vs living trusts is essential for families, business owners, investors, and anyone planning how to protect, distribute, and manage assets during life and after death. Trusts are some of the most powerful tax and estate-planning tools available. A living trust (inter vivos trust) is created while the person is alive, whereas a testamentary trust is created only upon death through a will. Each type of trust has distinct tax rules, filing requirements, benefits, restrictions, and strategies. CRA and Revenu Québec heavily regulate trusts, especially after recent rule changes requiring almost all trusts to file returns and disclose beneficiaries. This guide explains the key differences between testamentary vs living trusts so families can plan effectively and avoid costly mistakes.

Legal and Regulatory Framework
Testamentary vs living trusts are governed by the Income Tax Act, CRA T3 trust filing requirements, Québec’s Taxation Act, TP-646 trust return obligations, trust law under the Civil Code of Québec, attribution rules, TOSI legislation, and the 21-year deemed disposition rule. Both trust types are considered separate taxpayers and must comply with tax filing requirements, maintain detailed records, and follow trust deed or will instructions. CRA’s expanded trust disclosure rules require identifying all trustees, beneficiaries, settlors, and persons able to exert control.

What Is a Living Trust?
A living trust, also called an inter vivos trust, is created while the person is alive. The settlor transfers assets into the trust, and the trustee manages these assets for the benefit of beneficiaries. Living trusts are commonly used for income splitting, estate freezes, business ownership planning, creditor protection, and long-term asset control. Living trusts are taxed at the highest marginal rate unless income is allocated to beneficiaries. They must file a T3 return annually and, in Québec, TP-646. Attribution rules may apply depending on who transferred property into the trust.

What Is a Testamentary Trust?
A testamentary trust is created through a will and only becomes active upon the person’s death. It is funded with estate assets, not during the person’s lifetime. Testamentary trusts are used to protect minors, control how assets pass to beneficiaries, manage inheritances over time, provide income for spouses, and structure long-term care for disabled dependents. A testamentary trust provides the executor and trustee with instructions on distributing estate wealth while maintaining legal protection. Testamentary trusts also file annual T3 returns and TP-646 returns in Québec when the trust earns income.

Taxation of Living Trusts
Living trusts are taxed at the top marginal tax rate unless income is allocated to beneficiaries. They are subject to attribution rules when income can be attributed back to the settlor or spouse. They must comply with the 21-year deemed disposition rule, meaning capital property is deemed sold every 21 years at fair market value unless distributed earlier. Living trusts are ideal for long-term planning but require active administration, trustee decisions, legal compliance, and detailed tax filings.

Taxation of Testamentary Trusts
Testamentary trusts generally have different tax treatment than living trusts. Graduated Rate Estates (GREs) enjoy graduated tax rates similar to individuals for the first 36 months, after which they are taxed at the highest marginal rate. Testamentary trusts created for disabled beneficiaries may qualify as Qualified Disability Trusts (QDTs), allowing full access to graduated rates indefinitely. Like living trusts, testamentary trusts must follow the 21-year deemed disposition rule unless exempt. Income must be allocated or taxed within the trust annually.

Key Differences Between Testamentary vs Living Trusts
A living trust is created during life; a testamentary trust arises at death. A living trust is used to reduce probate exposure, control assets while alive, and manage family tax planning. A testamentary trust delays control until after death and provides legal protections for inheritances. Living trusts face attribution rules; testamentary trusts typically do not. Living trusts pay tax at the highest rate unless income flows out; testamentary trusts may qualify for graduated rates. Living trusts are commonly used with estate freezes and family trusts; testamentary trusts are used for minors, spouses, and dependents.

Use Cases for Living Trusts
Living trusts are used in estate freezes to multiply the Lifetime Capital Gains Exemption, to protect business assets from marital breakdown, to separate control from ownership, to hold real estate portfolios, to structure income allocation to adult children, and to maintain family wealth over multiple generations. They also help in situations involving complex corporate structures, succession planning, or high-value estates.

Use Cases for Testamentary Trusts
Testamentary trusts are especially effective for minors, beneficiaries with disabilities, blended families, spouses needing lifetime support, children needing structured inheritance, and special needs planning. They are also used in Québec to govern succession under civil law, to protect inheritances from family law claims, and to control how assets are distributed over decades.

Québec-Specific Considerations
Québec trust law is part of the Civil Code, not common law. Québec requires TP-646 trust returns for both living and testamentary trusts. Certain trust structures must comply with Québec succession rules, notarial requirements, and detailed trust deed formalities. Québec estates do not allow beneficiary designations on TFSAs and RRSPs unless insurance-based, meaning the estate may be the trust’s primary funding source. Disclosure obligations in Québec are stricter than in other provinces.

21-Year Deemed Disposition Rule
Both testamentary and living trusts are subject to the 21-year rule. Every 21 years, the trust is deemed to sell all capital property at fair market value, triggering capital gains. Planning must be done before the 21-year mark to distribute assets to beneficiaries, freeze values, or reorganize the trust to avoid unnecessary tax.

Documentation Requirements
Both trust types require a trust deed or will, annual trustee resolutions, minutes of meetings, detailed list of assets, beneficiary information, bank and investment records, T3 filings, TP-646 filings, and supporting documentation for distributions. CRA audits trust compliance rigorously, especially under expanded trust reporting rules.

Key Court Decisions
Courts confirm that living trusts must be administered independently and not manipulated by settlors. Courts emphasize that trust residency depends on where decision-making occurs. Testamentary trust interpretations rely on the wording of the will and trustee powers. Courts consistently uphold the 21-year deemed disposition rule and enforce trust documentation and filing requirements.

Why CRA and Revenu Québec Audit Trusts
CRA and ARQ audit trusts because trusts often hold real estate, business shares, or investments. Audits target missing T3 filings, incomplete TP-646 returns, undisclosed beneficiaries, improper income allocation, misuse of testamentary trust graduated rates, incorrect attribution rule applications, and non-compliance with the new beneficial ownership disclosure rules.

Mackisen Strategy
Mackisen CPA provides full trust planning, filing, and audit defense. We prepare T3 and TP-646 returns, determine trust residency, structure testamentary and living trusts, manage attribution and TOSI exposure, plan for 21-year rollovers, maintain trust documentation, and defend trusts during CRA and ARQ reviews. Whether setting up a family trust, managing an estate trust, or restructuring an existing trust, our expert team ensures full compliance and strategic tax optimization.

Real Client Experience
A Québec family used a living trust to protect real estate assets; CRA questioned the trust residency and allocation. Mackisen defended the trust successfully. A business owner passed away leaving a testamentary trust for minor children; we filed all trust returns and secured graduated rate status. Another client faced the 21-year deemed disposition deadline; we restructured assets to avoid capital gains. A family trust with multiple beneficiaries needed annual resolutions and T3 slips; Mackisen handled all administration.

Common Questions
Which trust is better for tax savings? Living trusts help with advanced planning; testamentary trusts help after death.
Do both trusts file T3 returns? Yes.
Do Québec trusts need TP-646? Yes—mandatory.
Do attribution rules apply? Yes for living trusts, not usually for testamentary trusts.
Can trusts reduce probate in Québec? Probate rules differ; trusts may reduce complexity.
Does the 21-year rule apply to all trusts? Yes, unless specifically exempt.

Why Mackisen
With more than 35 years of combined CPA experience, Mackisen CPA Montreal helps families, business owners, and investors choose between testamentary vs living trusts and manage both types effectively. Whether planning your estate, protecting your business, or complying with complex trust reporting rules, our expert team ensures precision, strategic planning, and complete protection from CRA and ARQ audits.