When Doing Estate Planning Remember the Taxes

Over the weekend the Globe and Mail published an excerpt from Douglas Gray and John Budd’s, the Canadian Guide to Will & Estate Planning.  In it, the authors discuss some of the main areas of tax liability that arise on an individual’s death and techniques to minimize taxes.  

On death, one of the biggest tax hits can come from the cash and investments sitting in an RRSP or RRIF. This is because the general rule is that the full value of an RRSP or RRIF must be included as income in the deceased’s final tax return (referred to as the “terminal return”).  Depending on the value of the registered plan and the deceased’s marginal tax rate, the taxes that come due can be significant.

Another area of considerable tax liability can come from assets that have appreciated significantly since being acquired by an individual.  This is frequently seen with vacation properties (that have not been designated as a principal residence) and marketable securities.  On an individual’s death, the deemed disposition of assets that occurs can trigger significant capital gains that must be included on the terminal return.

The authors provide a number of tax planning goals that should be considered when doing estate planning:

  • Minimize capital gains taxes arising on death by taking advantage of available exemptions;
  • Eliminate or reduce foreign estate taxes that might arise;
  • Take advantage of current income tax savings; and
  • Create a flexible tax plan that will be adaptable to changing personal circumstances or changes in the law.

When tax issues arise with estate planning, it is always a good idea to involve an accountant so that appropriate planning techniques can be employed.

How is an RRSP Taxed on an Annuitant's Death?

An advantage to contributing to RRSPs is the associated tax benefits.  However, the tax deferral doesn’t last forever – eventually the Canada Revenue Agency will come knocking.  While tax liability arises when funds are withdrawn from an RRSP, it will also arise when an RRSP annuitant dies. 

The tax treatment of an RRSP on an annuitant’s death will depend on who the beneficiary is.  Generally, the CRA will consider an annuitant to have received the proceeds of an RRSP at the time of death and the annuitant’s executors will need to report the amount, as well as any other amounts the annuitant withdrew during the year, in the annuitant’s tax return for his or her year of death (referred to as the “terminal return”).  As you can imagine, the taxes can be very high!  

However, there are some situations where a tax-deferred rollover will be available.  The first is where the beneficiary of the RRSP is the annuitant’s spouse.  The other is where the beneficiary is the annuitant’s child or grandchild (providing the child or grandchild is (1) a minor; or (2) mentally or physically infirm).

In situations where the beneficiary is a spouse or a physically or mentally infirm child or grandchild (who was also financially dependant on the annuitant) the RRSP can be rolled over (into an RRSP, RRIF, or annuity).  Where the beneficiary is a minor child or grandchild (who isn’t infirm), the proceeds can be rolled over into an annuity which can make payments until the child/grandchild turns eighteen – after this taxes will become payable. 

When an estate plan includes RRSPs careful consideration to the taxes is important. For more information, the CRA’s memorandum, “Death of an RRSP Annuitant” is a good one!

Some Taxing Issues Surrounding Executor's Compensation

The trusts and estates section of the Ontario Bar Association has a monthly “brown bag lunch” where estates and trusts lawyers in the province discuss various estate-related issues.  At yesterday’s lunch, a topic discussed was the tax rules relating to executor’s compensation. 

Most estates and trusts lawyers will be aware of the Canada Revenue Agency’s position that executor’s fees are to be treated as either income from office, employment, or business (depending on whether the executor acts in that capacity in the regular course of business).  In other words, the compensation received must be included in the executor’s income for the year and will be taxed accordingly. 

The issue of how the income is treated is of some importance – in situations where the income is from a business, the deductions allowable will be far more extensive than if the compensation is treated as income from employment or an office.

It is also important to consider the application of s. 153(1) of the Income Tax Act.  It provides that when a taxpayer’s income is from employment or an office, the person paying the income (in the context of an estate, this would be the executors) must withhold the amounts set out in the Income Tax Regulations.  When the executor is an employee the compensation received will be subject to CPP (and, in some circumstances, EI). 

It is important that any executor who wishes to receive compensation ensures that she is aware of the associated tax obligations and what amounts must be withheld.  It will often be prudent to seek advice from an accountant because confusion about tax liability is always best avoided - in situations where the appropriate amount is not withheld and remitted, the executors of an estate can become liable for interest, penalties, and the amount owing.  

Estate Tax Debate Continues in the United States

Back in September, I blogged about the uncertainty over the estate tax in the United States. The estate tax had lapsed this year and was set to return on January 1, 2011 with an exemption of $1 million per person and a maximum rate of 55%. 

Instead, as part of the tax plan approved by the US Senate on Wednesday (and which is awaiting approval by the House of Representatives) the exemption might be set at $5 million per person and at a maximum rate of 35%.  The Democrats have supported a $3.5 million exemption and a 45% maximum rate. 

For the last couple of days, the New York Times has featured an interesting debate about whether estate taxes really matter – are they really necessary or can the same policy goals be achieved with other forms of taxation? 

Robertson Williams, an economist and senior fellow at the Tax Policy Center, argues that the taxes have an important role to play: the country requires increased revenue and estate taxes affect the wealthy (who have benefitted the most from the economy and who have the greatest ability to pay).

Russell Roberts, an economist at George Mason University, argues that the estate tax is wrong because it amounts to double taxation – people are taxed once when the money is earned and again when it is given away on death. The main result, he says, is that people simply use various estate planning techniques to avoid it. 

Ian Shapiro, a political scientist at Yale University, argues that the Democrats’ focus is wrong – rather than worrying about the exemption rate, they should focus on the tax rate, because that’s where the revenue is generated.

Finally, Kevin Hassett, a senior fellow with the American Enterprise Institute, points to studies suggesting that most Americans (including those who would never be affected by the estate tax) don’t support it. He argues that despite the revenue generated by the tax, Americans value liberty more and this compels them to oppose the tax.   

If the bill passes, the tax is going to be effective for two years – which makes me think it won’t be long before we’re hearing this debate again.

As Income Trust Tax Changes Draw Near, Earth's Rotation Continues Uninterrupted

October 31, 2006, was a dark day for Canadian investors.  That was when our federal Finance Minister, Jim Flaherty, surprised everyone with the news that the government was introducing policy changes aimed at eliminating the tax benefits associated with income trusts and that those changes would be implemented January 1, 2011.  

The news promptly caused the business trust sector to tank.  In a two day period, the $200 billion sector lost $35.6 billion (a 16% decline).  

Prior to the tax changes being announced, income trusts were wildly popular in Canada.  First introduced in the mid-1980s, they are an ownership vehicle for businesses or assets that sell units to investors (who are the beneficiaries of the trust). The assets pay a return to the trust, which is then paid out to investors as either cash distributions or a return of capital. 

The tax benefits came because the trusts were able to “flow through” income to investors so that tax was not paid at the entity (i.e. asset/business) level, only by the unit holders.  This differs from a corporate structure where taxes are paid by the corporation and then again by the shareholders receiving dividends.  The other tax benefit came from the fact that income trusts could pay out as a return of capital, which is received by the unit holders on a tax deferred basis.   

With the proposed tax changes, most of the income trusts decided to convert back to a corporate structure.  This prompted fears that the payouts to investors would dry up. 

As it turns out, despite the catastrophic predictions, things have not been as bad as originally feared.  Of the 226 income trusts in existence in 2006, 60 have already converted to a corporate structure and 65 have announced they will be doing so.  Only 4 have stated they intend to remain as trusts. 

While many investors have seen a reduction in payouts (the average being 33%), approximately half the trusts plan to maintain dividends at the same level once the conversion to corporation has been completed. 

TFSAs - A Missed Opportunity for Most Canadians?

I was recently reading the Wealthy Boomer, Jon Chevreau’s blog in the Financial Post, and was surprised to learn that most Canadians still do not have a tax-free savings account (“TFSA”). 

A TFSA is a flexible savings vehicle which allows Canadians to earn investment income tax free.  Account holders can contribute up to $5000 per year to their TFSAs.  The interest earned is tax-free and there are no tax consequences to withdrawing funds.  However, contributions to the accounts are not tax deductible.  This is in contrast to RRSPs, where withdrawals are taxed but contributions are deductible.

Unused contribution room can be carried forward and the full amount of withdrawals can be repaid in future years. Re-contributing in the year of withdrawal is ill advised because the account holder runs the risk of over contributing, which can result in penalty tax. 

Funds can be transferred to a spouse or common law partner for the purpose of contributing to a TFSA and the assets of the account can be transferred to a spouse or common law partner on death.  For more information on designating beneficiaries on TFSAs read my blog on the topic here

Despite the many benefits of having a TFSA, not everyone seems convinced.  Chevreau cites a report by Angus Reid, commissioned by ING Direct, which found that 53% of Canadians don’t have an account. While a 1/3 of us have contributed, more than half of those who have not don’t intend to open an account in 2010 or 2011 – and 13% of us aren’t even aware that TFSAs exist.  All of which is unfortunate because the accounts are an excellent way of saving for retirement (or anything else for that matter) and carry with them distinct estate planning benefits. 

Another Billionaire Dies, Avoids U.S. Estate Tax

American broadcasting mogul and noted philanthropist John Kluge died a couple of weeks ago at age 96, leaving behind an estate worth approximately $7 billion.  

It’s not clear how his estate was to be divided on his death – and given the popularity of trusts amongst the wealthy (which, amongst other things, can keep the distribution of assets shielded from public view) we might never know. 

One thing we do know, however, is that his estate will avoid U.S. estate tax (at least for now – but more on that in a minute). 

While the estate planners down south probably can’t open a business section without reading about 2010 estate tax issues, I’ll briefly fill in those in the audience who aren’t familiar with the topic.

In the United States, the government imposes an estate tax.  Basically, when someone dies with assets valued over a fixed exclusion amount, a specified tax rate is applied to the value of their taxable estate (i.e. their gross estate, minus certain allowable deductions) – as you can probably guess, the specifics are more complicated than that, but you get the picture. 

From 2001 to 2009 the maximum tax rate declined from 55% to 45%, while the exclusion amount increased from $675k to $3.5 million.  However, for 2010, the US Congress let the estate tax lapse – meaning that this year there is no federal tax payable.  The exemption is for one year only – in 2011 the tax returns with a rate back at the 2001 level of 55% and an exclusion amount set at $1 million.

Above I noted that estate tax was being avoided “at least for now” – that’s because there has been a lot of talk that Congress may enact a law imposing a tax rate for 2010 and make it retroactive to the beginning of the year.    

Kluge isn’t the only billionaire whose estate will be able to avoid the tax: Texas oil tycoon Dan L. Duncan died in March leaving an estate worth approximately $9 billion and New York Yankees owner George Steinbrenner died in July leaving behind approximately $1.1 billion. 

I guess we’ll have to wait and see if, in the last 3 ½ months of the year, the estates of any other billionaires manage to dodge the estate tax – not to be morbid but David Rockefeller Sr. (son of oil baron John D.) is 95.

A Retiree Needs Money to Live, You Know!

On Wednesday, the New York Times published a special section on retirement.  The section is full of interesting articles (and, for my Yankee readers, there’s a good one on planning strategies for dealing with the estate tax uncertainty). 

An article I found particularly interesting was “Looking Ahead to the Spend-Down Years”, which explores the ways of enabling people to make better decisions about “decumulation” (the process of accumulating assets during working years and then drawing them down during retirement).

A shift in the certainty of retirement income has occurred over the past few decades – there has been a move from the defined-benefit plans (e.g. employer-funded pensions, where the amount the recipient will receive is certain), so popular twenty years ago, to the defined contribution plans (such as 401(k)s and RRSPs, where the value of account on retirement is unpredictable) so popular today.

Compounding this uncertainty is an increase in life expectancy - people can expect to spend more years in retirement than could generations past.  With this increased life expectancy they can also expect to incur higher medical and care expenses. 

All of this means seeking ways for retirees to create income from their accumulated savings - and ensure that the income combined with those accumulated savings will be enough sustain them for the rest of their lives. 

One of the issues raised in the article is the “annuity puzzle” – the conundrum that while annuities would appear to be the logical and safe way of ensuring a predictable income stream, they are not very popular with retirees.  One theory for this is that the trepidation associated with making a large, one-time payout of capital to purchase an annuity overrides the sense of security that would come from guaranteed annuity payments.

While the best way to ensure predictability in income stream while assets decumulate may be unclear, there appears to be one good way to persuade people to start saving more for retirement – show them a picture of what they will look like when they age.  A recently study found that people who were shown an aged image of themselves and then asked questions about retirement allocation, allocated twice as much as people who were shown a current image.  

Death of a TFSA Holder - How to Avoid the Taxes

The Globe and Mail has posted a great video about how to pass on your Tax Free Savings Account [“TFSA”] on death without triggering taxes. 

Depending on the intended beneficiary, there are two main ways to pass on your TFSA.  The first is by naming a successor account holder.  A successor account holder can be either your spouse or your common law partner.  Where a successor has been named, the effect is that when you die, he or she will be able to simply “take over” your TFSA – meaning the successor will be able to contribute to, administer, and withdraw from the account.  The transfer should be seamless and no taxes will be payable. 

The other option is to name a beneficiary on the account.  Possible designated beneficiaries include a spouse, former spouse, common law partner, child, or a “qualified donee” (such as a registered charity).  In this case, while a tax free transfer will still be available, there will be time limitations dictating by when the transfer must have been made.  Additionally, if the TFSA earns income subsequent to the account holder’s death (and prior to the account being transferred to the beneficiary), then that income will be taxed in the hands of the beneficiary.

An important distinction between naming a successor account holder and a designated beneficiary relates to what can be done with the proceeds of the account once they’ve been received.  When a successor holder is named, the TFSA will continue to exist, with the income earned sheltered from tax.  The successor’s contribution room for his or her own TFSA will remain unaffected.  When a designated beneficiary is named, that beneficiary will be able to withdraw any amounts up to the fair market value of the TFSA at the original account holder’s death on a tax-free basis.  However, the beneficiary will only be able to protect future growth in the TFSA from tax by contributing it to his or her own TFSA (and this will be subject to available room). 

If you are interested in learning more about the implications of the death of a TFSA holder, the website for the Canada Revenue Agency has useful information.