Death and taxes

Last week I presented a webinar called "Taxation of the Average Estate" through  www.seminarpartners.ca. About 100 lawyers across the country tuned in, which was great. Taxation of estates is one of those things that I feel I never know enough about, and I keep learning all that I can so that I can properly advise my clients.

I thought it would be worthwhile for all readers of this blog to have a brief overview of what tax comes out of an estate and who pays it, so here goes:

Despite the rumours you've heard, the federal government of Canada does not take a percentage or a cut off the top of estates. What they DO take is capital gains tax and income tax. The amount depends on the type and value of the assets; some estates will pay no federal tax at all.

Capital gains tax is assessed against certain assets of the deceased, such as real estate and shares of private companies (among others). The tax is assessed if the asset is worth more at the time of the owner's death than it was when the owner acquired it. There are some exemptions, meaning there are some assets that can be passed on or sold without giving rise to tax. An exemption that affects many people is the principal residence exemption that allows a person to pass on their home to their estate without tax.

Income tax is assessed against some assets of the deceased. This is because financial instruments such as RRSPs and RRIFs are deemed by law to be cashed in when the owner dies. This means the tax has to be paid when the owner passes on. As with capital gains tax, there are ways to plan in advance to defer or even avoid paying the tax by rolling over the RRSP or RRIF to the owner's spouse.

So who pays this tax? I am frequently asked by clients if their children have to pay the capital gains tax and the income tax. The answer is that no, they do not. The deceased person's estate pays these taxes. If there is not enough cash in the estate, the assets may have to be sold to pay for the taxes. In a roundabout way it seems as though the children are paying the tax simply because they may not inherit a thing if there are a lot of taxes and expenses in the estate.

Having said that, I should point out that if a person (a non-spouse) is named the beneficiary of an RRSP, that beneficiary gets the full RRSP amount and the tax on it is paid from the estate. However, if there is not enough in the estate to pay the tax, CRA will go after the recipient of the RRSP to collect the tax. Sometimes these situations take people by surprise.

On the provincial level, to my knowledge it is only Ontario that has what is called an estate administration tax. All provinces and territories have a fee that is payable to the probate court if someone applies for probate or estate administration. In some places, the fee is a percentage of the estate and in other places, flat rates are used. It varies from province to province. Again, these taxes are paid from a deceased person's general estate.

If you receive proceeds of a life insurance policy, the proceeds are not taxable.

When you inherit from an estate, you do not pay tax on your inheritance (just a note here: I don't know what other countries do about taxing estates, so please consider my remarks to be restricted to Canada). As I mentioned above, if there are taxes on an asset you are supposed to receive, those taxes have to be paid before you can receive the asset. Sometimes this means the asset has to be sold and you won't receive it. For example, families often don't realize that there may be significant capital gains tax on a cottage or cabin that is being handed down to the next generation.

Planning ahead of time can certainly make a difference in how much tax is paid after your death. Planning can also help ensure that things run smoothly for the beneficiaries by avoiding tax surprises.