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Written by: Bryan Hubbell, CPA, CGA
The death of loved one is an emotional trauma for any family. But, as difficult as your loss may be to your family, you also have to think in practical terms – what happens to your estate after your death.
It’s important to recognize that death is an income-tax-triggering event. Without advance planning, the beneficiaries of your estate and trusts may be left dealing with a big tax bill.
In this blog article, our Manning Elliott wealth transition advisors review the common estate tax issues that may arise on death – along with some planning options to consider as part of your estate planning.
Upon death, you are deemed to have sold your assets at fair market value for tax purposes. This deemed disposition on death may result in triggering capital gains to be reported on your final income tax return. Assets that can often result in capital gains on death include:
This fair market value deemed disposition can be deferred if your assets pass to your surviving spouse or to a spousal trust. In these circumstances, the fair market value deemed disposition of the assets can be delayed until the death of the surviving spouse.
As no actual sale has occurred, the executor of the estate may have to liquidate or refinance assets in order to fund your final income tax liability arising from the deemed disposition of assets on death. If the assets are not liquid, such as real estate or private company shares, the time needed to complete a sale should be considered. If a quick sale is required, the executor may have to sell the assets at a discount in order to fund the tax liability.
On death, your estate is deemed to have acquired the assets at a cost equal to their fair market value. As a result, your estate will only be taxed on any increase in value realized after death.
Deferred income plans such as RRSPs and RRIFs are deemed to be collapsed on the death of the plan annuitant. The fair market value of the deferred income plan at death is included in the annuitant’s final income tax return.
Taxation of the fair market value of the deferred income plan can be deferred by designating a surviving spouse, or a financially dependent child or grandchild, as beneficiary of the RRSP or RRIF. In this case, the value of the RRSP or RRIF will be taxed in the hands of the surviving spouse, or of your dependent child or grandchild, as the funds are withdrawn.
There is an important issue to consider with direct designations. The tax liability associated with the RRSP or RRIF at death is usually funded by your estate, while the RRSP or RRIF assets pass directly to the named beneficiary. This can result in a financial cost being imposed on the beneficiaries of the estate, where the beneficiaries of the estate and the beneficiaries of the RRSP or RRIF are not the same.
So, when making RRSP or RRIF beneficiary designations, you should take care to ensure that the beneficiaries of your estate would not be unfairly burdened with the tax payable on the value of the RRSP or RRIF at death.
A private company can be a useful tool for the management and accumulation of wealth by the owner-managed business owner. On death, the shareholder is deemed to dispose of their shares in the company at fair market value. This may trigger a significant income tax liability to be funded by the individual’s estate.
The issue is that, while the estate is deemed to acquire the shares of the company at a cost equal to fair market value, there is no corresponding cost adjustment to the assets in the company. As a result, the company may have to pay tax when it liquidates its assets. And, the estate may have to pay tax when the company distributes the net after-tax funds as a dividend. It is possible that, without proper estate planning, tax may be paid on the value of the company’s assets up to three times.
If the company repurchases its shares from the estate, the estate will be deemed to have received a dividend from the company. But the estate will also realize a capital loss on the shares. If this capital loss is realized in the first taxation year of the estate, it may be possible to carry the capital loss back against the capital gain reported on the individual’s final tax return. This can eliminate tax being paid twice on the value of the company’s shares.
Alternatively, the estate might transfer the shares to a new company and create what’s called a “pipeline” to extract value equal to the cost base in the shares from the company as a tax-paid return of capital. This strategy avoids paying tax on a dividend from the company.
There are numerous technical requirements that have to be met for this area of estate planning to be effective. In either loss carry-back or post-mortem pipeline planning, it is essential to have the assistance of a knowledgeable tax advisor.
As you can see, income tax can have a significant impact on the value that will ultimately pass to the beneficiaries of your estate. The first step in planning for the tax liabilities is quantifying them. From there decisions can be made on how to fund the liability. This might include setting assets aside or purchasing life insurance that will fund the future tax liability.
Estate Freeze - Business owners might also consider an estate freeze. In an estate freeze the business owner exchanges their existing shares in their company for fixed-value preferred shares that have a redemption value equal to the current value of the business. The next generation of business owners can then acquire an ownership interest in the business at nominal cost, possibly through a family trust. A family trust can allow the business founder to continue to control the business and future equity distributions while providing benefits to family members. An estate freeze fixes the value that will be subject to tax on the death of the business owner.
Following an estate freeze, the future growth in the value of the business will accrue to the new equity shareholders. The business founder can reduce the value that will be subject to tax on their death by redeeming the preferred shares over time.
The cost of probate in BC is often a concern for high-net-worth families. Probate is a Court-authorized process of validating a Will and confirming the beneficiaries of an estate. To obtain a grant of probate, the executor of a Will must submit a detailed list of assets and liabilities of the estate to the Court. This information becomes public record and can be viewed by interested parties.
In British Columbia, the fee to probate a Will is 1.4% of the gross value of assets passing under the Will if the gross value of the estate is more than $50,000. For high-net-worth families, this probate fee can become a significant amount.
Options for managing probate exposure include joint ownership, multiple Wills and alter ego and joint partner trusts. There are pros and cons to these options. We encourage high-net-worth families to discuss estate planning options for managing their probate exposure with their tax and legal advisors.
Income taxes and probate fees can have a significant impact on the value of your estate and the transfer of family wealth to the next generation. Identifying these issues in advance, and planning to manage the future cost to your estate, is one step in ensuring the successful transition of wealth you envision.
The above content is believed to be accurate as of the date of posting. Tax laws are complex and are subject to frequent changes. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.