Tax-efficient will preparation

Leave more to beneficiaries, less to the taxman

The Covid-19 pandemic has caused much turmoil and disruption for most people, socially, financially, medically. And judging from how busy my Wills and Estates Group has been for the past year, it’s also started many thinking more seriously about estate planning, primarily the preparation of a will. When we think about planning our will, we think of priorities. For example, about who will take of our kids and provide for them. Or whether there will be enough of an estate left over for family members once the taxman gets his piece of the pie. With that in mind, here are a few tax-saving strategies to discuss with your legal advisor when preparing your will.

The spousal gift

Canadian tax rules provide that when you pass away, you are deemed to have sold all of your assets immediately prior to your death. To the extent that the dispostion of any of your assets results in a gain, then your estate will be subject to capital gains tax.

On the bright side, at least your beneficiaries get to inherit your assets with a bumped-up cost base and there is no tax to them. There is, however, one important exception to this deemed capital gain. You can defer your death tax exposure by making your spouse the beneficiary of your estate, or perhaps better still, you can leave your assets in a qualifying spousal trust. There is no election that your estate need make; it’s an automatic deferral to the extent you leave assets to your spouse or a spousal trust.

Specifically, the tax rules provide that bequests to a spousal trust (or to your spouse outright) will not trigger capital gains tax on your death so that assets transferred to the spousal trust will occur on a tax-deferred basis.

The bonus of a spousal trust is that you can choose trustees to protect the surviving spouse against poor financial decisions, or any undue influences. As well, you can ensure that the surviving spouse will not be able to transfer assets to undesired beneficiaries (for example, if he or she were to get remarried and decide to leave your assets to their new spouse).

But you must be certain that the spousal trust qualifies for the tax-deferred treatment; otherwise, no tax-deferred rollover upon your death will be available.

Specifically, the spousal trust must meet the following requirements:

The spouse is entitled to receive all of the income of the trust while he or she is alive (but this does not include capital gains).
No other person (including children) may receive or otherwise obtain the use of any income or capital of the trust.

Note that just because no one else is allowed to receive the capital of the trust does not mean that the spouse is automatically entitled to the capital. This means that you can provide that there is no power to encroach on capital so that the nest egg stays safe for your children while your spouse gets the benefit of the income during his or her lifetime.

In other words, as long as no other person received or obtains the use of the capital, the spousal trust will not be disqualified.

In order to make sure that you do not stray from these requirements, care should be taken when drafting your will and the clauses relating to the spousal trust.

For example, if the spousal trust allows for the trustees to lend funds on an interest-bearing basis to a relative, this could be interpreted as allowing someone other than the spouse to receive or obtain the use of the capital (it may be okay, however, to lend funds on commercial terms; however, you should check with your advisor).

Another advantage of a spousal trust is that it can provide for certain testamentary debts to be paid, i.e., funeral expenses and income taxes payable for the year of death and prior years.

Testamentary trusts

Before 2014, “testamentary trusts were deemed separate taxpayers, with access to the graduated rates, allowing for various income-splitting opportunities with children. However, as of 2016, testamentary trusts no longer benefit from graduated tax rates nor are they exempt from making tax installments or having an off-calendar year end. As a result, testamentary trusts are subject to a flat, top tax rate. The only exception to this rule is that the estate designate itself as a “graduated rate estate” (GRE) and thereby take advantage of the graduated tax rates for the first 36 months after death.

There are specific rules that relate to GREs, namely that there can be only one GRE per deceased person. It must meet the following criteria:

The estate must designate itself as a GRE on the first year’s tax return;
No other estate of the individual can be designated as a GRE; and
The estate must use the deceased’s Social Insurance Number on each tax return during the 36-month period following his or her death.

Another benefit is that GREs are also the only type of testamentary trust that can utilize capital loss carrybacks, which allows the GRE to carry capital losses back to the deceased’s terminal year under certain postmortem tax strategies (this is especially important if an estate owns shares in a private company, as such a strategy can help avoid double taxation). Additionally, GREs enjoy various administrative benefits, such as being entitled to refunds beyond the normal assessment period and an extended notice of objection deadline.

I would also note that if you are philanthropic, a GRE provides for more flexibility in claiming donation tax credits. Specifically, the tax credit can be claimed by the GRE in the year the donation is made (or any of the following five years), it can be carried back to previous year of the GRE, or even to the final tax return of the deceased (or a year prior to death).

Next time: Probate planning, RRSPs and RRIFs.

Samantha Prasad, LL.B., is a Partner with Toronto law firm Minden Gross LLP, a Meritas Law Firm Worldwide affiliate, and specializes in corporate, estate, and international tax planning. She writes frequently on tax issues, and is the co-author of Tax and Family Business Succession Planning, 3^rd Edition. She is also co-editor of various Wolters Kluwer Ltd. tax publications. This article first appeared in The TaxLetter, © 2021 by MPL Communications Ltd. Used with permission.

Disclaimer

The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.