What do I need to know about tax on my estate?

Some of you may already know that I write a quarterly column for News & Views, the magazine published by the Alberta Retired Teachers' Association. I'm attaching a link here to the winter 2012 issue, in which my column was called "What Do I Need to Know About Tax on my Estate?". Click here and scroll down to page 12.

Who should help an executor with estate tax returns?

A reader recently sent me the following question about who should be hired to prepare tax returns for an estate. It's a great question really, since we lawyer are always saying that executors should "hire an accountant" but not everyone knows where to turn.

Here's the question:

"What type of person should I be looking for to help me prepare terminal (and other tax returns) for my father who died last year? CA vs CGA vs CMA? I'm so confused."

I posted this question to my LinkedIn group called "Canadian Will and Estate Professionals" to see what the accountants in the group (and the other estate lawyers) would say about this. The general answer seems to be that an executor should look for a CA (Chartered Accountant).

However, every person who answered the post commented that the individual accountant's experience with estates and trusts is far more important than the letters after his or her name. I would agree with that.

In larger cities, you can get in touch with large accounting firms who have accountants working exclusively in different areas of tax, such as personal income tax, corporate tax, or estates/trusts. However, not everyone has access to a firm like that. When shopping for an accountant to help you with estate returns, ask how much experience the accountant has with estates. (Note that this is a different question than "do you do estate tax returns?")

You can also ask your estate lawyer for some names, as all of us work with accountants on our files on a regular basis.

One of the people who replied to my post suggested that executors avoid tax preparers, as opposed to accountants. This of course brought a reply from a tax preparer to counter that warning. My experience using tax preparers to work on estate returns hasn't been good. One of my clients who went to a tax preparer to have the deceased's terminal return prepared was told to "go away. You can't do a tax return for a dead person".

That of course was completely wrong; you can and should do tax returns for dead persons and their estates. This is why I agree with my colleagues' advice that the individual's experience is most important. Not all tax preparers are as poorly trained as the one that my client was unfortunate enough to encounter, by any means. Make sure you're comfortable with the expertise of the person to whom you trust your estate returns.

Passing the torch to the next generation

There's a good article in www.globeadvisor.com that talks about several issues relating to passing your estate on to your children. It covers a bit of everything, from choice of executor to life insurance, but the main topic is saving on taxes when passing on property. I wish more people would read articles like this one before going ahead with steps like putting their children's names on the cottage.  Click here to read the article.

RRSP/RRIF spousal transfers on death - not so automatic

Warning! This post talks about tax. I realize that not everyone finds tax information as interesting as I do, but it's important stuff for all of us.

I'm attaching a link to a blog post by accountant Mark Goodfield, better known as The Blunt Bean Counter. In this post he talks about the transfer of an RRSP or a RRIF from a deceased spouse to a surviving spouse. You might be surprised to find that a spouse can choose simply to take the funds outright rather than receive the funds into his or her own RRSP or RRIF. If that happens, the estate may end up paying the tax.

Click here to read the article, which is very readable and contains tons of good information.

If I leave money to my executor, is it taxable?

If you leave money to your executor in your will, does your executor have to pay tax on it? Well, that depends on what your will says about it.

Let's say you want to leave your executor, Jack, a gift of $100,000. You can leave a gift of money to anyone you want to in your will, whether or not he is the executor. You would simply say "I leave $100,000 to Jack". If it's a gift, the recipient of the money doesn't have to pay income tax on it. Inheritances are not taxed in the hands of beneficiaries in Canada. That seems pretty straightforward, doesn't it? But unfortunately, some people accidentally make it more complicated.

The problem is that money earned by an executor for doing the executor's work is considered by Canada Revenue Agency to be earned income. Jack did work for the estate and was paid. Therefore, it's subject to income tax. When the will says to give Jack $100,000 for acting as the executor, Jack must add the amount of the fee he receives to his income for the year.

Again, this rule is pretty clear. Based on this rule, the solution arrived at by those people who hope to avoid the need for the executor to pay tax is to call the money going to the executor a gift, even though it's really only being given to them because they are executors. They believe that throwing the word "gift" in there will keep the executor's fee away from the tax man. I've seen many wills over the years, drawn by lawyers and non-lawyers alike, that say to give $100,000 to Jack as a gift to thank him for all his hard work on the estate.

As it happens, leaving this money to Jack to thank him for his work on the estate indicates that Jack is receiving the money for acting as executor. The fact that he worked for the money will override the word "gift". Jack would be obligated to pay tax on the $100,000 even though the will says to give it to him as a gift.

You may decide to leave your executor a gift without mentioning the work on the estate to avoid Jack having to pay tax on the money. That may or may not work out for your estate, though it is the best thing for Jack. The downside for not mentioning an executor's fee is that Jack would be entitled to claim an executor fee in addition to the "gift" because it will look as if you simply neglected to talk about Jack's fee. As I said, good for Jack, not so great for the estate.

As a general rule, if you're congratulating yourself on finding an easy way to get around a tax or estate-planning rule, you're probably just walking right into a problem you don't see coming. Just ask yourself why, if it's that easy, everyone isn't doing it. Professional advice is worth the money.

How to reduce taxes on your final tax return

Dealing with tax is often one of the most mysterious and challenging aspects of an estate. I'm always on the lookout for good information and articles that help executors with this area. The following article was recently published in the Vancouver Sun. It talks the reader through an example of reducing capital gains tax on a typical estate. Click here to read the article by John Pin.

Income tax on inheritance

Are you wondering about a potential tax hit if you inherit money or property? If so, you're not alone. This remains one of the consistently asked questions here on this blog. Today I'm linking you to a blog post by Mark Goodfield, a Toronto accountant also known as The Blunt Bean Counter. To read his post about income tax on inheritances in Canada, click here.

Probate fee planning - income tax, estate & legal issues to consider

This excellent article comes from Mark Goodfield, an experienced accountant who blogs at www.thebluntbeancounter.com. It goes into tax and legal consequences of the various ways that people try to avoid probate fees. It's a really good read if you are wondering about how probate fees might affect your plans. Click here to read it.

Probate fees vs. income tax

Tax is one of the trickiest parts of estate planning, so when I see good information about it, I can't wait to share it with you. Here is a link to an article by Canadian Tax Resource Blog. It compares and contrasts probate fees and income tax with respect to certain assets. In particular, it talks about the effects of naming a beneficiary on an RRSP or RRIF. To add to the advice given in this article, I suggest that you check the tax effects of your beneficiary designation with your accountant or estate planning lawyer.

Avoid RRSP tax with a proper beneficiary

This article from the Globe and Mail does a particularly good job of explaining the error that many parents make when leaving their estates among their children. The mistake I'm referring to is forgetting or not understanding who is paying the tax on their RRSP or RRIF when they pass away. Click here to read the article.

Is my willed RRSP taxed?

This short question, asked by a reader, has a complicated answer.

First of all, let's look at the fact that the reader is asking about a "willed" RRSP. When you set up an RRSP, you have the opportunity to name a beneficiary. If you have done so, and most people do, the RRSP is not controlled by your will. It's controlled by the beneficiary designation you made when you set it up. This means that the RRSP goes to whoever was named at the time, regardless of what it says in the will.

So why would an RRSP be covered in the reader's will?

It's not impossible. It could be that the beneficiary the reader named is his estate. It could also be that the beneficiary named in the RRSP has already passed away. In a case like this, the RRSP proceeds are paid into the estate and, like everything else in the estate, are distributed according to the will.

It could also be that when the reader was making his will, he changed his mind about who should be the beneficiary of his RRSP. He could be using his will to change the named beneficiary. This is possible, but I generally advise clients who want to make a change like this to go right to the bank or financial advisor and have the change made on the RRSP itself. There is always a chance that a change made in a will is not specific enough to be effective, particularly in home-made wills. There is also a significant risk that the financial institution is never advised of the change and pays out the proceeds to the person who was named in the first place.

In any event, let's assume that the RRSP is properly governed by the will. I would make a further assumption that the person named in the will to receive the RRSP is not the reader's spouse. After all, since the reader could roll the RRSP to his spouse on a tax-deferred basis by naming her on the RRSP itself, it would make absolutely no sense for him to have the RRSP paid to the estate, have the tax paid and then have his spouse receive the net amount through the will.

If the reader's RRSP is paid to his estate, then yes it will be taxed. Taxation will be based on the idea that the reader cashed out his RRSP one minute before he died, and all the money cashed out is taxable.

Keep in mind that the tax hit doesn't happen just because the RRSP goes into the estate. It's the choice of beneficiary that is important. For example, if the same reader changed his beneficiaries on his RRSP to his two children and the proceeds were paid to them directly, there would still be tax payable. And the tax would be payable by the estate, not the children. As many of my clients grumble to me on occasion, the tax man gets you one way or another. However, that's the nature of RRSPs and the reason that TFSAs are becoming so popular.

A person can roll over his or her RRSP on a tax-deferred basis to his or her spouse. He or she can't roll it over tax-deferred to his or her children except in very limited circumstances where the child is financially dependent.

It's always a good idea to talk over the tax implications of your RRSP beneficiary designations with your estate planning lawyer or your accountant. At that point you get to move past the general tax information that's available, and find out about your own specific situation.

Retire early, it's cheaper

This article from the Financial Post discusses a couple of strategies for maximizing money available at retirement and reducing your tax hit. Click here to read it and see if one or both of these strategies might work for you.

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.

Some Taxing Issues Surrounding Executor's Compensation

Are executor's fees received when an executor works on an estate taxable? Generally, yes, but that's not the whole story. To find out more about this, click the link below, which goes to Megan Connelly's blog, the Toronto Estates and Trusts Monitor.

Some Taxing Issues Surrounding Executor's Compensation

I echo Ms. Connelly's advice to check with an accountant before deciding to accept executor's pay.

Charitable donation tax credit

This article from Canadian Tax Resource Blog describes how to apply a charitable donation to your tax return. It talks about giving through assets other than cash, and how much of a deduction applies (including in the year of death where 100% is deductible). You can see by reading this article some of the ways in which charitable giving ties in with estate planning. And even though this is a tax article, it's easy to read! Click here to read it.

RRSP contributions in the year of death

This article from tax advisor Derek de Gannes reveals how the executor can reduce tax in the year of death by contributing one last time to the deceased's RRSP. Tax savings ideas are always welcome! Click here to read the article.

Basics of RRSPs

This link goes to an article from Canadian Tax Resource  Blog that gives the ABCs of an RRSP. Something the article doesn't cover that I believe is extremely important is the choice of beneficiary of your RRSP. I'd like to talk about that here as a supplement to the attached article.

When you set up your RRSP, you may name someone to receive the proceeds of your RRSP on your death. The choice of beneficiary affects the tax your estate will pay. As described in the attached article, you don't pay tax on your RRSP until you take the money out. Canadian law says that on your death, your RRSP (and all other assets) are deemed to be cashed out immediately before your death. Therefore the money has been taken out of the RRSP and your estate will have to pay tax on it.

This is where the choice of beneficiary comes in. If you name your spouse as the beneficiary of your estate, on your death your RRSP can roll over to your spouse's RRSP. This means that no tax is payable at the time of your death; the tax is deferred until your spouse dies or takes out the money. This is a popular arrangement for married and common law couples as it provides the best tax advantage.

If you name someone else as the beneficiary, or you name your estate, on your death, your estate will have to pay the tax on your RRSP.

When choosing your beneficiary, remember to keep the big picture of your estate in mind. It can be a mistake to take individual asset - RRSP, house, bank accounts - and deal with each separately. Try to envision your estate as a whole so that you can see the effect of how everything works together. This is something an estate planning lawyer can help you do.

Why does a trust have to file a tax return?

Some time ago I posted about the tax returns that an executor must file, including both the final return for the deceased and the trust returns on behalf of the estate. Click here to read that post. I've been asked a follow-up question, that is "why does a trust have to file a tax return?"

The simple answer is that when a person passes away, Canadian law states that a new taxpayer is created. That new taxpayer is the estate. Because the assets in an estate are temporarily held on behalf of the beneficiaries, the estate is a form of trust. A trust exists whenever one person or entity holds property or funds on behalf of another person.

Most estates are completed within a year of the deceased's passing away, unless of course there is a lawsuit to be settled or complicated business affairs to be wound down. For that year, the assets in the estate may earn income in the form of interest, dividends or capital gains. The new taxpayer - the estate - will report that income on a return just as individuals do, and pay tax on it if applicable.

In many estates, money is paid into a trust account for a minor or handicapped adult. Once the money has been paid into this trust specifically for that person, the taxpayer is this new trust, not the estate. If there are no trusts set up in a Will and the executor immediately pays out all assets to the beneficiaries, the executor may not have to file any tax returns for the estate.

My suggestion to all executors would be that you check with an accountant about whether or not you have to file a tax return for the estate. I can give you general information here, but if you consult an accountant you will have the chance to crunch the actual estate numbers and get individualized advice.

Tax deductible legal fees on an estate?

The legal fees paid to settle an estate are usually not tax-deductible, but read this article from All About Estates to find out when they might be tax-deductible. For a tax article, it's very readable!

Multiply the tax savings with multiple trusts

This article by Derek de Gannes is required reading for anyone interested in taxation issues regarding inheritance. Mr. deGannes does a really good job of describing both the situation and the solution in a reader-friendly way. Click here to read the article.