Brian Quinlan / Canadian MoneySaver
This is the final article in a series of four presenting the income tax implications of the death of a taxpayer.
- Part 1: The tax implications of death
- Part 2: Specific rules that can impact the filing of final personal tax returns
- Part 3: Mandatory and optional tax returns for a deceased taxpayer
- Part 4: Strategies to adopt while alive to minimize the income tax due on death
The less wealth an individual has at death, the fewer taxes they have to tax at death. If the plan is to pass assets to children, why not do it now? The kids may prefer the money now rather than later — especially if they have a mortgage. Where cash is given to an adult child, there are generally no tax implications, regardless how the money is used. (Canada does not have a gift tax.) If securities are sold to fund the gift, capital gains can result that are subject to tax in the year of sale. However, this tax may be less than the tax that would be due on the individual’s death.
If parents worry about how the adult child will use the money — or perhaps have family law concerns — they can make an interest-free loan to an adult child rather than an outright gift. This offers the parent the ability to “call” the loan if need be. The loan can be forgiven in the parent’s will with no tax implications to the parent or adult child.
An individual can negotiate with their employer to pay a $10,000 death benefit on passing (whether or not still employed). The surviving spouse (which, for tax purposes, includes a common-law spouse) can receive this tax-free. If the death benefit is paid to others, the $10,000 exempt portion is prorated among the recipients.
Pass assets to a surviving spouse — or a spousal testamentary trust
- Where non-RRSP/RRIF-held assets are passed on death to a surviving spouse — or to a spousal testamentary trust — the accrued gain (and/or recapture) is not triggered as a result of the deemed disposition rule.
- The use of a testamentary spousal trust can be advantageous because the trustees of the trust can assist the surviving spouse in managing the inherited assets.
Testamentary trusts — and the new tax rules effective for 2016 — are discussed at the end of this article.
RRSPs and RRIFs
When RRSPs and RRIFs are passed to a surviving spouse, no tax is payable on the death of the first spouse. The financial institutions holding the RRSPs and RRIFs require written documentation that the spouse is the beneficiary of these plans.
If, on death, the deceased has unused RRSP contribution room — and a spouse that is under 72 — the estate can make a post-death spousal RRSP contribution and claim a tax deduction on the final personal tax return. The contribution must be made no later than the 60th day of the year that follows the year of death.
If the estate is concerned about having a large tax liability on death, it can withdraw “extra” from the RRSP or RRIF to increase the annual taxable income and tax liability. This works only if the deceased is not currently subject to tax in the top bracket (taxable income over $138,586 for 2015 federal income tax). The extra tax paid may be less than the tax paid on death where a significant sum may be subject to tax in the top tax bracket.
Where a spouse is the successor holder of a TFSA, he or she will not be subject to tax on the income earned in the plan after the death of the first spouse.
Capital gains exemption
- Individuals owning shares in a qualifying small business or farm or fishing property can take advantage of the exemption now by locking in — or crystallizing — the accrued capital gain. As noted in Part 2 of this series, the maximum capital gain exemption is now $813,600 (2015) for shares of a qualifying small business and $1,000,000 for qualified farm or fishing property.
- Once this is undertaken the individual no longer needs to worry about maintaining the investment so that it continues to qualify for the exemption or the tax rules being changed.
- If an individual does not make use of the capital gains exemption before or on death, it is lost. It cannot be passed to a beneficiary.
Locking in death tax liability
As an asset grows in value, so too does the accruing tax liability associated with the asset. If an individual exchanges a growth asset (an investment or real estate portfolio, shares of a family business, etc.) for a non-growth asset (such as a preferred share of a holding corporation), the tax faced by that individual on that asset will stop increasing.
The individual needs to transfer their growth asset to a corporation in exchange for fixed-value preferred shares. With a tax election, no tax on the accrued gain is triggered on the exchange, and the payment of the tax can be deferred until the death of the individual. This is referred to anestate freeze as the tax liability is frozen at the time of the exchange.
The growth of the asset, after the exchange — or freeze — will accrue to the common shares of the holding corporation, which will be owned by the individual’s heirs (e.g., children) and not the individual.
As the individual does not own the common shares, those shares are not part of the assets exposed to the deemed disposition rule on death. Therefore, the individual faces no tax liability on death on the post-freeze growth of the asset.
It is usually preferable to donate publicly traded securities to a charity rather than selling the securities and donating the cash. This applies to whether the donor is alive or deceased. Donating the securities ensures that the accrued capital gain is not subject to tax. The donor receives an official charitable receipt for the value of the securities donated.
Donations made post-death by virtue of a will can qualify for a tax credit on the deceased’s final personal tax return. Refer to Part 2 of this series for more details on this. Part 2 also included comments on the tax changes coming in 2016 to provide executors of estates with greater flexibility in terms of tax saving when charitable donations are made after the death of a taxpayer.
When publicly traded securities of the deceased are donated to a charity after death, the securities are not subject to the deemed disposition rule at death. Where an individual wishes to donate to a charity after death, the will needs to be drafted to allow the executor flexibility in donating securities rather than cash or other assets.
The death benefit of a life insurance policy is received tax-free. Life insurance does not decrease tax due at death but provides a way to fund the tax payment. This strategy is particularly attractive in cases where a family cottage would need to be sold to obtain cash to pay the income tax on the cottage’s accrued capital gain.
You might want to consider having the beneficiaries pay the premiums, as they are the ones that ultimately benefit.
An estate will incur a loss on an asset it sells where there is a decrease in value since the deceased’s death. Where the loss is incurred in the first taxation year of an estate, a tax election can be made to claim the loss on the final personal tax return of the deceased.
This election can be made on losses resulting from both assets that are capital property (e.g., shares of public and private corporations, mutual funds) and assets that are depreciable property used for rental or business purposes (e.g., rental building). To maximize the availability of this election, it is best that the first taxation year-end of the estate be a full 365 days after the death.
When there is a post-death decrease in value of an RRSP or RRIF before the plan is wound-up and distributed to the estate, the loss can be deducted on the final personal tax return of the deceased. To make use of this tax rule, the RRSP or RRIF must be wound up by December 31 of the year following the death.
Taxing income in the estate — changes coming in 2016!
Currently, a deceased taxpayer’s estate exists from the time of death to the time the deceased’s assets are distributed in one of two ways:
- to the beneficiaries
- to testamentary trusts created for the beneficiaries
A testamentary trust is a trust created as a result of an individual’s death. An estate can earn income while it is holding assets. This income is subject to tax.
An estate is taxed in the same manner as a testamentary trust. The benefit of being taxed as a testamentary trust is that the trust is considered a separate taxpayer and its income tax is calculated using graduated income tax rates. This is particularly attractive where the ultimate beneficiaries of the estate are subject to the highest personal income tax rate.
Beginning in 2016, an estate will be able to make use of the graduated tax rates only for the first 36 months after the death of the taxpayer. If an estate still exists after 36 months — perhaps because of litigation — all of its income will be subject to tax at the highest tax rate.
Use of testamentary trusts in estate planning — changes also coming in 2016!
Common estate planning often includes drafting a will such that the estate isnot passed directly to the desired individual beneficiaries but to testamentary trusts created for the beneficiaries. There are two reasons for this:
- to permit control/management of the inherited assets by someone other than the ultimate beneficiary (see comments above in respect of a spousal testamentary trust)
- to allow for a potential income tax savings on the investment income earned on the inherited property. Put another way, this allows for a greater after-tax return than if a testamentary trust had not been used.
As noted above, testamentary trusts can make use of graduated tax rates, which can result in income tax savings where the desired individual beneficiaries are subject to tax at a higher tax rate. The tax saving could be multiplied when a will provides for multiple testamentary trusts to be created on death. An example would be a spousal testamentary trust and a testamentary trust for each adult child beneficiary of the deceased.
Beginning in 2016, the potential tax savings available by making use of these testamentary trusts will cease. All the income from these trusts will be subject to tax at the highest tax rate. These trusts will no longer be able to make use of the graduated tax rates in calculating their income tax liability.