Canada doesn’t levy succession duties or gift, estate and death taxes, but income taxes in the year of death can be quite significant. Income taxes are inescapable, and should be factored into any financial or estate plan.
In order to assist clients with developing a comprehensive, tax-efficient estate plan, understand the basic rules applicable to deceased taxpayers, estates and trusts. It’s also important to appreciate the sometimes-onerous duties and responsibilities assumed by an executor and/or trustee—the person or entity ultimately responsible for executing the plan.
The death of a taxpayer
Let’s start with the period up to the date of death, including taxation in the year of death. Two rules govern taxation in the year of death. First, worldwide income earned and accrued from January 1 to the date of death is reportable on the final (terminal) T1 tax return. All income actually received by the taxpayer must also be reported in the terminal T1 return.
This includes standard items such as investment income and employment income. All accrued income amounts must also be included on a per-diem basis. In addition, the fair market value of all RRSPs/RRIFs must be included in the income of the deceased for the year of death.
Second, a deceased taxpayer is deemed to have disposed of capital property immediately prior to death for proceeds equal to its fair market value. Capital gains and losses must also be reported on the terminal T1.To determine the gain (or loss), the adjusted cost base and fair market value of each capital asset must be determined.
For many people, their final tax bill will be their highest by far. In essence, the deemed realization at death under the Income Tax Act is Canada’s death tax. The disposition rule provides the backdrop for most estate-tax planning. Luckily, these rules are subject to certain potentially ameliorating provisions: rollovers, exemptions and elections. Understanding these techniques is essential to tax-efficient planning and administration.
Rollovers, exemptions, elections
A common rollover involves transferring assets to a surviving spouse. The rollover is available for capital property and RRSPs/RRIFs.
It allows such assets to be transferred to a surviving spouse (via the will, joint ownership with right of survivorship, where applicable, or beneficiary designation) with no immediate tax consequences. Instead, the usual deemed disposition will be deferred until the death of the surviving spouse.
Note, the rollover can be made to a spouse or a qualifying spousal trust (criteria for establishing a “qualifying spousal trust” are set out in s70(6) of the Income Tax Act). Also note, for income-tax purposes, “spouse” may include legally married, common-law and same-sex couples. Other possible rollovers include family farms to a child or grandchild and RRSPs to a dependent minor child or grandchild.
The most significant exemption for most taxpayers is the one applicable to the principal residence. Possible elections include filing additional tax returns in the year of death and splitting certain types of income. If you use these techniques prudently, you can save taxes for the estate.
What happens to income earned and/or payable after the date of death? The tax rules require all income be captured somewhere. As a result, income earned after death must be reported in either a trust return or the beneficiary’s personal return.
Even if the deceased did not leave a will (or the will he left did not establish testamentary trusts), there is generally post-death income and,more often than not, the estate will need to prepare and file at least one T3 trust return. Post-death income may include investment income or income from rental properties.
Perhaps the most common example of post-death income is the CPP death benefit. The CPP death benefit, maximum $2,500, must be reported by the recipient. It cannot appear on the deceased’s terminal T1 return. In cases where the recipient is in a high tax bracket, it may make sense to report the death benefit on aT3 trust return in order to take advantage of the lowest graduated rate.
Taxation of trusts
Inter vivos (take effect during settlor’s lifetime) and/or testamentary trusts (established in will and come into effect after testator’s death) are very effective estate-planning tools and may be recommended for a variety of reasons, including:
- providing for family members with special needs;
- providing for a current spouse while ultimately benefiting children from a prior marriage;
- protecting special assets, such as a family cottage or business, from family law claims and other creditors; and
- minimizing tax or probate fees.
For both types of trusts, the trust is a separate taxpayer, though different tax rules apply to each type. This article focuses on testamentary trusts.When considering taxation of trusts, consider the rules for both the taxation of income and the treatment of capital property. Testamentary trusts are taxed at the same graduated rates as an individual taxpayer.
This rule affords the potential for tax-planning opportunities. The treatment of capital property—in particular the application of the deemed disposition rules—depends on the type of testamentary trust established.
For income-tax purposes, a trust is a conduit for income paid or payable to a beneficiary. All income (including capital gains) generated by the trust’s investments will be taxed in either the trust or the hands of the beneficiary.
Depending on the trust’s terms, the trustee may be empowered to allocate income to either the trust or beneficiary. As a result, tax efficiencies may be realized where the beneficiary and the trust are in different tax brackets.
Where multiple trusts are created, it may be possible to multiply the tax savings as each trust may qualify as a separate taxpayer. The ability to choose the taxation year-end for the trust may offer further benefit. In other words, from an income-tax perspective, testamentary trusts can be quite attractive.
As mentioned, the treatment of capital property varies depending on the type of trust. Where the trust is a qualifying spousal trust, capital property can be transferred to the trust on a rollover basis. The estate can defer the realization of capital gains until the capital property is sold; returns paid to the surviving spouse; and/or the death of the surviving spouse.
If the trust continues beyond the death of the surviving spouse, the 21-year rule will apply. In the case of a non-qualifying spousal trust (a trust for minor children or grandchildren, for example), the usual deemed disposition at death will occur. The adjusted cost base of the trust property will be its fair market value; capital distributions may be made to beneficiaries on a tax-free basis. The 21-year rule clock starts on the testator’s death.
How to implement
The job of implementing the plan established in the will—and addressing the tax consequences of the testator’s death—falls to the executor. In general, testators and executors are often surprised by the amount of tax work involved in settling an estate. In many cases, tax work accounts for a significant portion of the total time devoted to the administration.
Executors must complete and file the year-of-death return. They’re also responsible for any T3 and unfiled returns for prior years (depending on the citizenship of the deceased and the location of estate assets, an executor may also be responsible for filings in foreign jurisdictions). If executors don’t meet the filing deadlines, they risk interest and penalties.
In addition to these fundamental duties, executors are also expected to minimize the taxes payable, subject to the terms of the will and general anti-avoidance provisions. This means they should be aware of, and take advantage of, all available post-mortem planning opportunities. This may involve deciding to file certain optional year-of death returns and considering all available elections and exemptions, including the most judicious use of the principal-residence exemption.
Executors could incur personal liability if they fail to carry out these responsibilities. Lay executors should obtain professional advice and learn about the protection afforded by a Clearance Certificate.
Begin at the end
Once a testator has determined her intentions, she should work with a knowledgeable estate planner to determine the most effective way to transfer her legacy.
For advisors, understanding the principles at the planning stage can help ensure tax efficiencies are realized during the taxpayer’s lifetime. It also helps the estate—via a well planned will and appointment of a knowledgeable and experienced executor—to take advantage of the available date of death and post-mortem opportunities.
Elaine Blades is Director, Estate and Trust Products and Services at Scotia Private Client Group. Scott Cummings is National Director, Wealth Management Taxation, Scotia Private Client Group.