How are taxes paid between the time a person dies and the time the estate is distributed?

Have you ever wondered about the mechanics of filing tax returns for an estate? Who pays the tax on income that accrues between the date of death and the date the assets are distributed to the beneficiaries? A reader recently asked me about this, so I'm sharing his question and my response below:

"I know that income taxes must be paid on an estate to the time of a person's death, as part of the deceased income, but how are the taxes paid between the time the person dies and the estate is divided among those named in the will?"

As you know, in Canada we calculate our personal taxes on a yearly basis, with the year-end being December 31. When a person dies, his executor will file a tax return for the year of death. If a person dies on, say, February 14, the tax return is filed for the period of January 1 to February 14, a shortened tax year. The form used is a T1 return just as we all use every year, but because it's the last one for that person, it's called a terminal return.

Your question is about any taxes that are incurred after that terminal return is filed, but before the estate is paid out to the beneficiaries. Estates do have income for that period of time, and the longer the assets remain in the  name of the estate or the deceased, the more likely it is that there will be income. The income in question might be an increase in value of the asset (a capital gain), interest earned on funds, the taxable portion of proceeds of a registered asset, or other income.

The executor will file a tax return for the estate. The tax year for an estate begins the day after the death, and runs for a year. So in the example above, the estate tax year begins on February 15. The form used for an estate tax return is a T3 return. The tax is paid from funds held in the estate. If the estate isn't wound up a year after death, a new tax year begins. In complex estates, T3 returns are filed for several years in a row.

It's important to note that the tax rules for estates are complex, and no executor should be completing estate tax returns without the help of an accountant. In fact, I suggest you confirm the information I've provided here with an accountant, since I'm not one. Some estates require additional returns (such as a Rights and Things Return) to be filed as well as the T3, depending on the type of assets held by the estate. Also, an accountant will be able to advise an executor about filing deadlines, available deductions, rollovers, exemptions, and obtaining a Tax Clearance Certificate.

Sometimes, when an estate is wrapped up quickly, there is no need to file a tax return at all. This is not something an executor should assume. To avoid getting stuck with personal liability for not filing the proper returns, or filing them late, every executor should get an accountant's advice.

Something an executor might check with an accountant for any specific estate is whether or not estate income should be allocated to beneficiaries (and paid by the individual beneficiaries) rather than being paid by the estate itself. This would involve the individual beneficiaries each having to claim a portion of the estate income on their own personal returns, and paying their share of the tax. This is advantageous in some situations.

If you want to do some further reading about this, I suggest a paper that I wrote and presented a few years ago for the Legal Education Society of Alberta. The paper is called "Taxation of the Average Estate" and can be purchased as a download by clicking here. The site allows you to take a look at some sample pages before committing to it.