With the Canadian demographic aging and a health crisis sweeping the globe, many individuals are reflecting on their own mortality and have begun to review their estate plans and succession strategies.
In this issue of Canadian Tax Planner, we will discuss a selection of planning opportunities and pitfalls relating to life’s two certainties, death and taxes. While some should be considered prior to passing away, others may be considered in administering an individual’s estate. Regardless, all provide interesting opportunities and cautions which should not be missed.
While there are many estate planning strategies relevant to a wide range of individuals, in this article we will only highlight a select few that are either commonly overlooked, misinterpreted, or particularly problematic.
Specifically, we will discuss:
In some cases, individuals may wish to gift assets prior to their death, rather than distributing them as an inheritance. Some prefer to do this so they can see the beneficiaries enjoy the gifts provided. Others may prefer to retain full discretion over the gifts. Also, probate fees can be expensive in some jurisdictions and gifting assets prior to death can avoid these costs.
While Canada does not have a “gift tax”, there are tax issues that do arise on gifts of property. On a gift, both the giftor’s proceeds and the recipient’s cost are deemed to equal the fair market value (FMV) at the time of the gift. However, if something is received in exchange for that property, and the item received is not of the same FMV, a one-sided adjustment may apply:
In summary, unless the property is completely gifted, transfers for anything other than FMV will effectively result in double taxation on the spread between the FMV of the property and the FMV of what was received in exchange. In some situations, the FMV may be difficult to determine, and subject to later challenge, depending on the nature of the asset.
An additional benefit of gifting assets in advance over multiple years, is that taxable income resulting from the disposition is reported in the relevant year of disposition, allowing the income to be spread over numerous years. This may allow for more income to be taxed at lower marginal rates than what would occur if it were all taxed on the final tax return.
Donations of property, whether made during the individual’s lifetime or out of their estate, can lead to significant tax savings. Often, the contributions generate tax savings at, or near, the top marginal tax rates. Here are some interesting gifting possibilities.
Life insurance possibilities
Life insurance can be a very valuable gift and an interesting tool in one’s philanthropy plan.
One option is for a charity to be designated as the beneficiary of the life insurance policy. As such, it will receive the proceeds on death. Designating a charity will have no immediate tax consequences. While premiums will continue to be required, the donation credit available when the charity receives the death benefit can be of significant value. The donation credit can be claimed by the donor in the year of death, the year prior to death or by the estate. Designating the charity on the policy will avoid receipt by the estate, which may also avoid
probate fees in some provinces.
As another option, the policy could be directly donated to the charity. This would result in a disposition for proceeds equal to the cash surrender value (CSV), as if the policy had been cashed. The excess of CSV over the adjusted cost basis of the policy will be taxable income. The fair market value (FMV) of the policy is a donation eligible for a donation tax credit. An actuary will likely be required to determine the FMV. A policy held for less than three years, or acquired as part of a “gifting scheme”, will generate a donation equal to cost of the policy
instead of the FMV.
Gifting appreciated securities
Donating appreciated publicly traded securities (e.g. shares, bonds or mutual fund units) to a registered charity, rather than selling the securities and donating the proceeds, can provide additional tax benefits. While the full value of the securities will be a charitable donation either way and benefit from a donation tax credit, if the securities are donated directly to the charity, the taxable portion of the taxable gain is reduced to 0%. That is, there is no tax on the disposition. On the other hand if the security was sold and then the proceeds were donated, the usual 50% capital gain inclusion rate would apply on the disposition.
While this planning is typically considered by individuals, an estate can gift assets in this manner to maximize tax savings.
When an individual passes away, they are deemed to dispose of their assets at fair market value at the time of death. Any capital gain or loss is included in the deceased’s final tax return. For deceased individuals with a surviving spouse, assets can generally be transferred to the spouse on a tax-free basis. That said, there are a number of planning possibilities to legally manage the level of income included on the deceased’s final tax return, as appropriate. For example, where there is no or limited income on the final tax return, it may make sense to increase income to access marginal tax rates and credits that would otherwise be lost.
In this section we will discuss tools to manage income reported on the final tax return, as well as special cases for certain assets, such as RRSPs and RRIFs.
In addition, we will discuss other planning possibilities and additional administrative issues.
On an individual’s death, the default rule is that the value of an RRSP or RRIF is included in income on the final tax return of the deceased individual. The amounts included on the final return are not taxable to anyone else when the funds are removed from the RRSP/RRIF. However, there are possibilities to transfer some or all of the deceased’s RRSP/RRIF to another individual and avoid the immediate tax consequence on the individual’s passing.
Rollovers – surviving spouse
RRSPs and RRIFs can be transferred to a deceased’s surviving spouse without an immediate tax consequence. That is, there is neither a deemed withdrawal nor tax on the deceased’s final tax return. This results in the RRSP/RRIF funds not being taxable to the deceased and only being taxable to the beneficiary when funds are withdrawn, or deemed to be withdrawn, from the RRSP/RRIF. The transfer to the surviving spouse’s RRSP does not affect their available contribution room.
In some cases, it may be preferable to have only a portion of the deceased’s RRSP/RRIF rollover to the surviving spouse. In doing so, the fair market value of the deceased’s RRSP/RRIF that is not transferred is taxed on the deceased’s final tax return. This allows for the lower marginal tax rates and otherwise unused tax credits on the final return to be utilized.
Capital loss planning
Where an individual holds shares in a Canadian Controlled Private Corporation (CCPC), special possibilities exist. After the CCPC shares are deemed to be disposed at death, and a capital gain is reported on the final tax return, the estate would hold the shares. The CCPC can then redeem or repurchase its shares from the estate, resulting in a deemed dividend and a capital loss that is identical or close in value to the capital gain that was triggered on the death of the individual.
Where a graduated rate estate (GRE) realizes capital losses in its first taxation year, it can elect to have part or all of those losses be deemed to be capital losses of the deceased. The capital loss can then offset the capital gains reported in the final tax return. This results in the deemed dividend in the GRE being the only level of tax payable to extract the corporate equity.
This possibility for capital losses of the GRE to be deemed to be losses of the deceased on the final tax return is applicable beyond those capital losses realized in respect of CCPCs.
Post-Mortem pipeline planning
Where the transaction cannot be completed in the first year of the GRE, or where the taxpayer prefers capital gains rather than dividends, a post-mortem pipeline may be considered as an alternative. A pipeline converts the increased adjusted cost base (ACB) resulting from the deemed disposition of shares on the final personal tax return into a shareholder loan. This ensures that the tax on the capital gain on the final tax return is the only level of tax by avoiding the need to pay dividends later to extract corporate equity.
Conducting a post-mortem pipeline transaction is complicated. Assistance from a professional advisor should be sought.
The CGE allows individuals to, in effect, avoid paying tax on a prescribed amount of gains on the disposition of certain property. It can shield up to $883,384 (in 2020, indexed for inflation) of capital gains on qualified small business corporation shares and $1,000,000 for qualified farm and fishing property, in total during an individual’s lifetime.
Where a deceased individual holds assets that qualify for the CGE and they had unused CGE room at the time of death, and those assets would normally pass to their heirs on a rollover basis (such as a transfer to a spouse), they should consider electing out of the automatic rollovers in order to trigger gains that can be sheltered with the CGE. This will provide their heirs with a higher cost base on those assets, reducing the future tax on the disposition of these assets.
Specialist support should be sought when claiming this exemption as it can cause complications for non-arm’s length recipients. Also note that claiming the CGE should not be done in conjunction with a post-mortem pipeline transaction.
While the general rule is that assets roll over to the surviving spouse at cost, in some cases it may be more beneficial to not have this happen. In these cases, an election can be made to avoid the spousal rollover such that the deceased’s assets are deemed to be disposed of at fair market value on their death, and any associated gains or losses are reported on the final tax return. This may be beneficial if the deceased has unused capital losses, or is in a lower tax bracket than the surviving spouse.
The election to avoid the spousal rollover must be made on an “all or nothing” basis in respect of each individual asset. That is, while the executor can choose which assets they want to elect out of the rollover at cost, for the assets they do choose to elect out on, they must recognize a disposition at fair market value. They are not able to select a specific value between cost and fair market value.
Some flexibility can be garnered where the deceased holds multiple identical properties. For example, say the deceased held 100 common shares of Opco worth $100 in total (with no adjusted cost base). In the case that the executor wishes to trigger a $60 gain on the final tax return, they could choose to elect out of the spousal rollover on 60 of the common shares, while allowing the remaining 40 common shares to still pass on a rollover basis.
Special rules apply for farming and fishing properties.
Most individuals that have regularly contributed to the CPP are eligible for a $2,500 death benefit upon application (Form ISP1200). Specifically, the deceased person must have contributed for at least one-third of the years in the contributory period for the base CPP (but no less than 3 years), or 10 calendar years. If this test is not met, the years of participation in similar plans in other countries may count if the social security agreement between the other country and Canada permits it.
Payments are generally made within 12 weeks of application. Amounts are paid to the estate executor. If no estate exists or the executor does not apply, the person or institution responsible for paying the funeral costs may apply. If that party does not apply, the surviving spouse/common-law partner, may apply, followed by the deceased’s next-of-kin.
Although the payment and T4A is made out to the executor, it should be included in the income of the estate for the year the payment is received. Alternatively, if there is no other income in the estate, and no other reason to file an estate return, the amount can be reported in the hands of the beneficiary. If the payment is made directly to a beneficiary, the amount would be included in the beneficiary’s tax return.
Often, individuals that pass away in the later stages of life may have qualified for the disability tax credit for a few years prior to death. If a T2201 disability tax credit certificate can be obtained, up to ten of the deceased individual’s prior tax returns can be amended. The number of years that can be adjusted is limited by the number of years indicated on the T2201 for which the individual was eligible. Returns can be adjusted subsequent to the death of the individual. Adjustments can result in $20,000 or more in refunds.
Employers can pay a deductible benefit in respect of the death of an employee. Up to $10,000 of benefits paid by the employer can be excluded from taxable income. To qualify, the payment must be made in a taxation year on or after the death of an employee, in recognition of the employee’s service.
This provision is applicable even if the employee is also the owner of the corporation, or the sole employee. CRA has previously stated that the determination of whether an individual is an employee is a question of fact. The fact that an owner-manager who received salaries for several years but was only paid dividends in the two years prior to death does not automatically mean that no death benefit could be received. That said, it is more difficult to support an employment relationship where the individual never received employment income from the corporation.
The existence of a formal commitment, such as a contract or a Directors’ Resolution, prior to the date of death is not a requirement for an amount to be a death benefit. Finally, a death benefit could be paid out over time, but the $10,000 exclusion applies only once, not once for each year.
When an individual passes away, a final tax return up to the date of death should be filed. However, there are several optional returns that may also be filed, with the most common one being the “rights or things” return (ROT), and the other two being the “return for a partner or proprietor” and the “return for income from a graduated rate estate”.
There are several benefits of filling multiple returns. As income can be spread out between returns, more earnings can be taxed at lower marginal rates. For example, if $80,000 was included on one return, approximately $30,000 of it would be subject to tax rates in the second federal bracket, which is currently 5.5% higher than the lower bracket. However, if the income was split evenly between the two returns, none of it would be subject to the higher rates.
A second benefit is that certain credits can be claimed on each return. This means, for example, that credits can be claimed twice as opposed to once. Examples of credits that can be claimed on each return include items such as: the basic personal amount, the age amount and the Canada caregiver amount.
Only certain types of income can be reported on each return. While the executor can choose whether to file an optional return or not, only certain amounts can be included on the optional returns.
In general, the following should be reported on the final tax return:
The following types of income can be included on an optional rights or things tax return:
In respect of owner-managed corporations, there are often large amounts of time that pass between the declaration of dividends or bonuses, and the payment of them. As the amounts can be significant, a death that occurs between these two points in time can lead to large tax savings by having the income reported on a second return. Where the deceased held significant investments, it is also worthwhile to examine the transaction records from the financial advisor to identify declared but unpaid dividends.
T3 trust returns
In addition, T3 trust returns for the estate may be filed, with special characteristics available if it is a graduated rate estate (lasting up to 36 months after death). Examples of the special characteristics include the ability to use marginal tax rates, and the ability to carry back donations to the final tax return or the return immediately prior to the final tax return.
In some situations, an individual may pass away just before a regular personal tax return is due. For example, consider an individual who passes away on April 15, 2021, and had not filed their 2020 return yet. Is the surviving spouse or executor stuck with getting the 2020 return completed in 2 weeks (by April 30)? No. As long as the individual did not pass away on the due date, the final tax return and associated payment is due no sooner than six months after the date of death. The return for a co-habiting surviving spouse would be due at the same time, however, the payment would be due on April 30th. Payments after the due dates would be subject to interest.
When an individual dies, wrapping up their estate and administrative obligations can be very challenging. Often executors will be pressured by beneficiaries to distribute assets as quickly as possible. However, if the executor distributes assets without first obtaining a clearance certificate, they can be held personally liable for amounts owing by the estate to CRA if there are insufficient remaining assets to satisfy the obligation. A clearance certificate is basically a confirmation that all taxes, interest, and penalties owing at the time of issuance
have been paid.
While personal relationships between the executor and beneficiaries may offer a feeling of comfort, and while some beneficiaries may be in desperate need, the executor should be steadfast in first applying. Often, when emotions are high, especially after the death of a loved one, errors can be made, and relationships can sour quickly.
Preparing one’s affairs prior to death, and having them cleaned up afterwards, can be extremely taxing, both
emotionally and financially. These tips and traps can definitely reduce the negative impacts, allowing everyone
to better deal with the loss and continue on as peacefully and positively as possible.