Person reviewing their tax planning strategies

Tax planning with the end in mind

July 12, 2022

Tax planning with the end in mind

Synopsis
5 Minute Read

There are several tax consequences that are triggered upon an individual’s death; planning in advance can help minimize tax liability for the deceased’s estate as well as minimize hassle for business partners, successors, and next of kin.

Although most people do not necessarily want to think ahead to their demise, the very certainty of the event makes it important to plan ahead, particularly to help manage the tax impact. In this article, let’s highlight some points to consider when discussing your estate plan with a trusted advisor.

At this point, no “inheritance taxes” or “estate taxes” exist in Canada, but this doesn’t mean that there is not a potentially significant tax impact arising from the death of an individual. The taxes are calculated and paid by the estate of the deceased individual (the Estate) before the assets are distributed.

In many provinces, the Estate may also be subject to probate fees, which vary considerably between jurisdictions.

Deemed Disposition – Double Tax

When an individual in Canada passes away, they are deemed to dispose of the assets they own at fair market value (FMV) immediately before death. The capital gain arising from the difference between FMV and the amount paid for the asset (adjusted cost base) is taxed on the individual’s T1 Terminal Personal Income Tax Return (the Terminal T1).

There are limited exceptions to the deemed disposition. When the deceased is survived by a spouse or common-law partner, the assets may be rolled to that individual at cost rather than FMV, deferring the tax until the surviving spouse disposes of the assets or upon their passing.

Of particular concern is the disposition of private corporation shares, such as the shares of a professional corporation. Without proper planning, the value of the corporation may be taxed twice! The first level of income tax arises from the deemed disposition on death and the second level arises on the distributions (taxable dividends) received by the Estate or beneficiaries on the ongoing operations or wind-down of the corporation.

Consider an example of an Alberta investment company holding cash or cash equivalents. Assume Dr. Smith owns an investment company at her passing. The current FMV of the shares is $500,000 and she purchased these shares for $1 when she incorporated the company. At her passing, the deemed disposition of the shares results in a capital gain of $499,999, and taxes of approximately $120,000 on her Terminal T1, assuming the income falls in the highest tax bracket. The shares of the company are transferred to her children, who immediately wind up the company. Her children will receive taxable dividends from the corporation in the amount of $499,999, which may result in taxes as high as $211,500. The total taxes without planning could be as high as 66 percent.

Wording your will to allow the Executor(s) the power to implement tax planning as needed, to reduce or eliminate double tax on private corporation shares, is crucial. The Executor you select must also be aware that some tax planning must be implemented within the first taxation year of the Estate, and they must meet with advisors as early as possible to set plans in action.

Lifetime Capital Gains Exemption

If the shares of a private corporation owned are qualified small business corporation (QSBC) shares, the lifetime capital gains exemption may be utilized in estate planning to reduce the impact of double taxation.

The private corporation must be a Canadian-controlled private corporation (CCPC), and all or substantially all of its assets must be used in an active Canadian business. “All or substantially all” is considered to be at least 90 percent of the FMV of all corporate assets being primarily used for business purposes in Canada at the date of disposition. The corporation must also have used more than half of its assets in active business primarily operating in Canada for the last 24 months and the deceased (or someone related to the deceased) must have been the owner of the shares for 24 months prior to the deemed disposition.1

We encourage clients to review QSBC eligibility regularly with their MNP advisors so planning opportunities are not inadvertently eliminated.

Registered Plans (Registered Retirement Savings Plans (RRSP), Registered Retirement Income Funds (RRIF), and Tax-Free Savings Accounts (TFSA))

Upon the death of an individual, registered accounts are treated as disposed of (withdrawn in full) and the FMV of the accounts are included in income on the deceased’s Terminal T1.

There is no immediate tax impact of the disposition of the TFSA on death; the account can generally be transferred to a successor beneficiary without triggering income tax liability. The account may also be transferred to a qualified donee such as a registered charity, resulting in a donation credit to offset taxes in the Estate.

The balance in an RRSP or RRIF at the date of death is fully taxed as regular income. Taxes may be deferred if the account is bequeathed to a qualifying survivor such as a spouse or common-law partner, or a financially dependent child or grandchild. If the accounts are left to an unqualified survivor such as an adult child, taxes are not withheld by the financial institution on the distribution of the account to the beneficiary so the Estate is responsible for the payment of taxes. This is an important consideration when determining the allocation of assets to beneficiaries.

For example, assume at Dr. Johnson’s passing, she had cash totaling $1.5 million and an RRSP worth the same amount. She had chosen to name her eldest adult child as the beneficiary of the residue of her Estate ($1.5 million cash), and her youngest adult child as the beneficiary of the RRSP. The financial institution will release the full RRSP amount to the named beneficiary without withholding taxes. The Estate will be responsible for the taxes on the income inclusion in respect of the registered account, which may be 50 percent or higher depending on the other income earned in the year of death and the province in which she lived. The taxes will be paid from the cash held in the Estate, reducing the bequest to her eldest child. If her intention had been an equal distribution of wealth to her children, the objective has not been met.

Income in the Year of Death

Income earned to the date of death is included on the Terminal T1; this includes items such as investment income, earned income, rental income, and pension income.

Certain items that have been earned but not yet received, for example dividends declared but not yet paid, may be reported on a second terminal personal tax return called a Return of Rights or Things.

Estate – Graduated Rate Estate

The assets owned at the date of death that do not pass outside of the Estate to named beneficiaries, or through rights as joint ownership, become assets of the Estate immediately after the passing of the individual.

For tax purposes, if certain criteria are met, the Estate will be designated as a Graduated Rate Estate. This designation is primarily beneficial for access to graduated or marginal tax rates. However, this status is also important to allow for tax planning when private corporation shares are owned, or donation planning is a component of the Estate planning. The Executor should meet with advisors as early as possible in the administration process to avoid tainting the Graduated Rate Estate status, which could impact available planning opportunities.

The Estate will be assigned a separate tax number by the Canada Revenue Agency and will be required to file its own tax return.

Planning

Perhaps you would like to consider gifting assets prior to your death, moving assets to a trust, using insurance as a method to equalize distributions, or including donations in your legacy planning. Your options for estate planning are numerous and should fit your individual and family goals, all while minimizing your tax burden.

We recommend that you review your estate plan regularly with your trusted advisors, and if possible, hold a joint meeting with legal counsel, financial advisors, insurance providers, and MNP team members so pieces of the planning puzzle interconnect seamlessly.

We would be happy to review your plans and documents including shareholder’s agreements, pre-marital agreements, Power of Attorney, and will, and follow up with suggestions to optimize your current and future planning. MNP offers a service called Lifebook, which includes a review of your documents, calculation of estimated taxes on your passing to allow for planning, consideration of your proposed distribution plans, and the creation of a digital filing cabinet to ease the estate planning process for you, your family, and your named Powers of Attorney or Executors. Please reach out to your MNP advisor for more information.

Contact us

To learn more about how MNP can help your organization, contact Michelle D. Coleman, CPA, CA, TEP, CEA, Partner. 

1. Some exception apply, please contact your advisor.

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