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Friday, February 4, 2011

How does forgetting about tax upset an equal distribution?

Whenever you meet with an estate planning lawyer, part of your discussion should be about taxation. You need to have a pretty good idea of what tax liabilities are going to rear their ugly heads once you pass away. If you don't, your assets might not end up the distribution you hoped for.

One of the main reasons that problems arise when tax must be paid on death is that people don't understand where the tax payment is going to come from. As always, making assumptions about what you think the law might be is dangerous and you should consult an accountant or estate planning lawyer.

Taxes and expenses are paid from the residue of the estate. If you simply leave the residue of the estate to be divided equally, you may not have a tax issue. Taxes will be paid before the beneficiaries are paid, with the resulting effect that all of the beneficiaries are treated equally.

But many people who make their own wills tend to list individual assets that they want to leave to their children. This often leads to tax trouble. For example, let's say that George makes a will with the idea in mind that he will treat his three children equally. He has a cottage worth $350,000 that he leaves to his daughter, Eleanor. He has about $350,000 in his RRIF, which he leaves to his daughter, Fran. His cash, his home and the rest of his assets are worth about $350,000, so he leaves the residue to his son, Gavin.

George may think he has treated the kids equally but in reality, he has not.

The cottage that Eleanor inherited is subject to capital gains tax. For the sake of this example, let's say that the amount payable is $75,000. Since taxes are paid out of the residue, the $75,000 comes out of  Gavin's share.

The RRIF that Fran inherits cannot be rolled over to her as she is not George's spouse. Therefore the tax has to be paid on that when George dies. Let's say the tax owing is $125,000. Again, this comes out of Gavin's share of the estate.

This means that Gavin's share pays Eleanor's tax ($75,000), Fran's tax ($125,000), the cost of the funeral ($10,000), all of George's outstanding bills ($10,000) and all expenses relating to probate and administration of the estate ($10,000). He is left with $120,000. This is hardly the equal distribution George had intended.

This is only one example. There are several other scenarios in which the testator's plans could be disrupted.

This is not to say that wills made by lawyers don't include gifts of certain assets, because they often do. However, if a lawyer helped you make a will like this, he or she should be offering you ideas on how to avoid the disruption of the equal distribution (if an equal distribution is what you want).

One way of avoiding this lopsided distribution is to state in the will that taxes are to be paid from some other source than the residue, or that each beneficiary must pay the tax arising from his or her inheritance. Another idea is to buy life insurance that will top up the residue, making extra cash available for payment of the taxes. Your estate planning lawyer will work with you to discuss options.

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