Toronto Estates and Trusts Monitor

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.

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.  

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. 

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.

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.