Table of Contents
- Key Responsibilities of an Executor
- The Three Layers of Taxation
- Strategies to Reduce Postmortem Tax Liabilities
- The Graduated Rate Estate
- The Loss Carry Back Method
- The Postmortem Pipeline Method
- Tax-free Rollovers
- Estate Freeze
- Foreign Assets
- Pitfalls for the Executor to Avoid
- Late Filing Penalties
- 21 Year Rule for Trusts
- Bottomline
The information contained herein is for educational purposes only and should not be taken as legal advice, as tax laws and regulations can change within weeks and render some tax strategies void. For tax advice, consult our professionals by logging on to our website: www.FaberLLP.ca.
Postmortem tax planning is as essential as estate planning during the taxpayer’s life. It is not all “postmortem”; it is equally relevant during the taxpayer’s lifetime, as their choices will impact the options available to the executors after their death. In this regard, an important agent is the executor.
Without effective postmortem planning, a large chunk of the Estate can go to taxes, owing to possible double taxation and the absence of effective tax management. On the other hand, appropriate postmortem planning can save as much as half of the taxes and benefit the successors.
Key Responsibilities of an Executor
An executor must undertake multiple practical measures to ensure that the Estate is distributed to the beneficiaries in the best possible manner with as few tax liabilities as possible:
- Settle all outstanding debts of the deceased.
- Notify and communicate with beneficiaries.
- Maintain transparency throughout the process.
- Act with diligence and integrity.
- Seek professional advice for optimal tax strategies.
- Navigate business structures and mediate disputes among beneficiaries.
- Ensure business continuity, including the maintenance of licenses and permits.
The Three Layers of Taxation
- Corporate-Level Tax on Asset Sale
- Dividend Tax
- Capital Gains Tax at Death
The “triple taxation” at death refers to a worst-case scenario where the same underlying value of assets is taxed three separate times-typically in context of privately held corporations. The first becomes liable when the deceased dies, and all their capital property, such as in a private company’s shares are subjected to deemed disposition. The second time, when the company disposes of its assets, it may incur a further corporate tax on capital gains or recapture inside the company. Once the company sells its assets and pays corporate tax, it distributes the after-tax cash to shareholders (the estate or beneficiaries). This is often treated as a taxable dividend in the recipient’s hands. So, the same value is taxed again at the personal level as dividend income.
For example, if person X owns shares in a private company with a value at $5 million, with a nominal cost base. Upon death, a deemed disposition occurs, triggering a capital gain of approximately $5 million- only half is taxable. The top marginal rate in Alberta is 48% resulting in personal tax owed of around $1.2M.
If the estate lacks sufficient liquid assets to cover this tax, it may need to sell the assets within the company to settle the debt. A sale within the corporation could trigger corporate-level tax. Assuming the corporation realizes the $5 million gain and is subject to Alberta’s investment income tax rate of 46.67%, the corporate tax would amount to approximately $1.17million (again assuming a nominal cost base and the 50% capital gains inclusion rate).
Now let’s say that funds need to be extracted for personal use. If this is done through eligible dividends, the shareholder may face additional personal tax of approximately $1.72 million, based on current top personal dividend tax rates in Alberta of 34.31%.
Alternatively, if the corporation is wound up, a deemed dividend arises equal to the value of the net assets distributed in excess of the paid-up capital (“PUC”), which is also subject to personal tax.
In total, the combined tax burden on the same $5 million value can reach approximately $4.082,250 million, representing about 82% in total tax.
Strategies to Reduce Postmortem Tax Liabilities
- 1. The Graduated Rate Estate
For up to 36 months after death, an estate may qualify as a Graduate Rate Estate (“GRE”) and be taxed at individual graduated rates rather than the highest trust rate, offering meaningful tax savings.
- 2. The Loss Carry Back Method
Using this method, if these shares have a low PUC when they are redeemed, a deemed dividend will result, and there will be a corresponding capital loss. The resulting capital loss can be carried back to the first taxation year of the GRE.
If the double tax is eliminated, tax is ultimately paid on dividends rather than on capital gains- thus, this will be most effective where the corporation has tax attribute and tax rates on eligible dividends are lower than capital gains tax rates.
- 3. The Postmortem Pipeline Method
The postmortem pipeline strategy is a tax planning method used to avoid double or triple taxation when a private corporation owner dies. Instead of paying dividend tax to extract corporate value, the estate reorganizes the shares into a new corporation and receives a promissory note equal to the fair market value of the shares at death.
After that, the private company repays the note tax-free, allowing the estate to extract funds without triggering dividend tax rate.
- Tax-free Rollovers
The executor should be aware of assets that may qualify under a rollover provision (e.g., RRSPs to a spouse or private corporation shares to a child involved in the business) are transferred appropriately to defer taxes.
- Estate Freeze
An estate freeze locks the current value of a property deferring future tax liability and passing future growth to beneficiaries. In this way, tax deferral takes place beyond the taxpayer’s death. If done properly, it can be beneficial to ensure that an estate does not have to be liquidated, or assets sold, to pay the taxes due, so that the beneficiaries get settled before the tax liability arises.
- 4. Foreign Assets
Executor should determine what jurisdictions’ laws apply to foreign assets. Fortunately, Canada has tax treaties with many countries to avoid double taxation. In this regard, the executor should explore all available exemptions and credits.
Pitfalls for the Executor to Avoid
- Late Filing Penalties
The deceased’s final tax return must be filed on time, as late filing can result in penalties- 5% of the balance owing, plus 1% for each full month the return is late, up to a maximum of 12 months. While penalties are applied to the estate, the executor could be held personally liable in certain situations. The executor is responsible for ensuring compliance with all relevant tax regulations to avoid unnecessary costs and delays for the beneficiaries.
- Accuracy of Calculations
The executor should calculate the deceased’s returns vigilantly because they can be conflex, mainly because regulations change over time. Moreover, multiple factors like tax deductions, rollback of assets, tax credits, and individual waivers can make filing returns an intricate task. As important as it is, the executor should pay attention to this task.
- 21 Year Rule for Trusts
Under Canadian tax law, most trusts are subject to the 21-year deemed disposition rule, which means that every 21 years, the trust is considered to have sold all of its capital property at fair market value, even if no actual sale has occurred. This can trigger significant capital gains taxes within the trust. To avoid or minimize this tax burden, trustees should plan ahead- either by transferring assets to beneficiaries before the 21st anniversary or by restructuring the trust as needed. The executor should seek professional advice so not to run into any concerns with anti-avoidance rules.
Bottomline
Postmortem tax planning involves a wide range of complex rules and considerations. The above discussion highlights key strategies and risks; it is just the tip of the iceberg. Executors play a crucial role in protecting beneficiaries’ interests through timely action, careful planning, and professional guidance.