- Charles Rotenberg
THE WILL AND TAX PLANNING
The Will is the most common and most important document in the estate planning process. Without a Will, the assets in one's estate will go to beneficiaries determined by statute rather than by the deceased. It is also impossible to accomplish any meaningful planning after death without a Will.
When an individual dies intestate (that is, without a Will), under the laws of intestate succession the person’s estate is divided among that person’s relatives (sometimes regardless of how remote), and where there are no relatives, the entire estate can fall to the government.
Where there is a Will, all authority and property rights are governed by that Will and it takes effect upon the moment of death. Technically, a properly drawn Will requires no further act to justify its legal existence. However, largely as a result of the often secretive nature of Wills, and the fact that the deceased is no longer available to verify the terms of his or her Will, third parties will often require a higher level of certainty when dealing with the property of a deceased person. This certainty is provided through a processed traditionally referred to as “probate”, now called a “certificate of appointment of estate trustee”. The process involves submitting the Will to the courts for verification.
If there is no Will, the courts must appoint an individual once referred to as an “administrator”, now called an “estate trustee without a will”.
With applications to the courts, both with or without a Will, it is necessary to pay the required court fees (commonly known as “probate fees”). With the exception of assets that were held jointly with a right of survivorship, and life insurance, RRSPs, RRIFs and TFSAs that have named beneficiaries, probate fees are calculated on the value of all personal property owned by a deceased anywhere in the world and all real property situated within the province of Ontario . With the exception of a mortgage on real property, debts are not deductible from the gross value.
The basis for calculating the fees varies from province to province. In Ontario the rate is1.5% of the value of the estate in excess of $50,000. There are no probate fees on the first $50,000 of value.
Simple Probate Planning:
There are a wide variety of options available to individuals for reducing the exposure to their estates from probate fees. The more popular options include gifting of assets prior to death, settling assets in inter vivos trusts, ensuring that separate beneficiary designations are in place for such things as insurance policies, RRSPs, RRIFs and TFSAs, and holding property jointly with others.
All of these methods are designed to keep the assets out of the estate, allowing them to pass “outside” of the Will upon death. To the extent that a deceased’s assets pass outside of his or her Will, the residue is reduced as are the probate fees that would otherwise be payable.
Although these methods will lower the “probate value” of an estate, they can also reduce a person’s control over his or her own assets prior to death. Holding property jointly with spouses and/or children, will also expose those assets to the claims of divorcing children-in-law and creditors who would not otherwise have claims against such property.
Between spouses, holding the family residence as joint tenants generally makes good sense. But holding the same property jointly with children could cause problems. Not only will a parent have lost the opportunity to redirect a child’s share of the property to his or her own children should such a child die before the parent, but that parent will also be exposed to the potential matrimonial and creditor claims of his or her children. Even more significant is the fact that the exemption from capital gains tax liability available on the family residence is compromised when the property is owned by those who do not live in it. In addition, upon the transfer of assets to joint ownership with a child, in most cases, there is a deemed realization of any capital gains in the transferred property…meaning that there may be a high “up-front” cost in using this technique.
One method of avoiding some of the pitfalls associated with the “simple probate planning” techniques is to draft dual Wills, one to cover assets that require probate and the other to cover all assets that do not need a probated Will to complete their transfer.
For probate purposes, a person’s assets may be categorized into three different groups: (1) those that have a title document evidencing their ownership and require a probated Will to effect their transfer, such as shares in a publicly traded company and real property; (2) those that have a title document evidencing their ownership but which do not need a probated Will to effect their transfer, such as shares in a privately held corporation and debts owed to the deceased; and (3) those that have no title document evidencing their ownership, such as personal effects, artwork, clothing, etc.
Dual Wills anticipate the drafting of a “Primary Will” to deal with the assets of the first category, thus being the Will that is submitted for probate, and a “Secondary Will” to deal with the assets of the second and third category, such Will not being submitted for probate. Where there is only one Will, the value of all assets dealt with by that Will must be included in the calculation for probate fees, even though only some of the assets may require a probated Will to complete their transfer.
Consider the following example: Assume that a person dies with a private company worth $14,000,000.00, and real property with a net value of $300,000.00. If such person dies having drafted only one Will, the probate fees will amount to $213,750.00. If, however, dual Wills were prepared with the second Will dealing with the private company, the probate cost would be $3,750.00.00 instead. How would you like to be the financial planner that neglected to suggest Dual Wills?
Alter Ego and Joint Partner Trusts
In December, 1999, the Department of Finance introduced legislation which opened up a number of planning opportunities, primarily the avoidance of probate. The legislation introduced two new forms of inter vivos trust – the alter ego trust and the joint partner trust. For more detail, see my Memo entitled Alter Ego and Joint Partner Trusts.
As discussed above, a testamentary trust is one that is established pursuant to a Will, rather than a trust agreement.
Assets that pass to one's spouse, either during lifetime or at the time of death can pass free of any capital gain. Similarly, assets transferred to a qualifying spouse trust will pass free of tax. A qualifying spouse trust is, basically, a trust under which only the spouse, during his or her lifetime can be paid income or capital.
There is a tax rate advantage of testamentary trust for up to three years, from the time of death. The Estate may, and probably will, qualify as a “Graduated Rate Estate”, which will be taxed as an individual with graduated tax rates. Otherwise, and after the three years, the Estate will be taxed as an ordinary trust, at the top personal marginal rate. Income tax considerations aside, spousal trusts also provide an often overlooked opportunity for a Wills drafter to overcome dicey succession issues such as the complications that may arise when planning for spouses of second or third marriages. However, under the new rules, great care must be taken when a trust is set up for a second spouse, as discussed below.
As a matter of tax rate and income splitting planning, there is little reason to keep assets in a spousal trust after the first three years, unless the trust is being set up to look after a second spouse for his or her lifetime and then to distribute the assets to the children of the deceased.
Testamentary Trusts for Adult Children
Notwithstanding the change to require testamentary trusts to pay tax at top personal rates, there is still a tremendous advantage to setting up “adult children’s trusts”. Some children may be put off by the prospect of receiving their inheritance in the form of a trust for life rather than a direct distribution, especially if such children are older, well established individuals. But like many issues in life, things aren’t always what they seem. It would probably help such children to know that testamentary trusts set up in their parents’ Wills may be the greatest opportunity available to legitimately save on income taxes.
Consider the conventional “Ma-Pa” type Wills, which routinely give the estate to the surviving parent with that survivor then gifting over the balance of the estate equally among their adult children. On the death of both parents each adult child will be entitled to do as he or she pleases with his or her gift. Some will pay off debt, such as mortgages on their homes. Others will invest it, perhaps as a cushion for the education of their own children.
For those who choose to invest their inheritance the income earned will be added to their own. If they are already at or near the highest marginal tax rate, this additional income will be taxed at the highest rate, which, in Ontario, is currently 53.53%. And when it comes time to pay for the education of their children it will be done with after-tax dollars.
This tax consequence could be completely different if the parents’ Wills directed instead that the inheritance of each adult child be held in trust for the rest of that child’s life, if the trust extends to the benefit of the adult child’s own children and spouse. When such children are young and their incomes low or non-existent (such as while they are going to university or college) the income from the trust can be paid directly to them and taxed in their hands, often resulting in the payment of no or very little income tax. In effect, their education will be paid with “before-tax” dollars. In other words, $1.00 of trust income will get $2.00 of education. This trust will allow each child to split income on an annual basis among himself or herself, and his or her spouse and children, even minor children.
These testamentary trusts for life can be drafted with considerable flexibility to suit the unique needs of each beneficiary. Control of the adult child’s trust can be put in his or her own hands by appointing him or her the trustee. Moreover, each child (as trustee) can be given unqualified power to encroach on the capital of his or her trust should such child require some or all of the assets of the trust in future.
Of course, if a Will is not drafted to accommodate testamentary trusts no such opportunity will ever exist for the surviving beneficiaries. Provided the intended beneficiary is made to appreciate and understands fully the income tax purpose behind such trusts, there appears to be no downside in leaving large gifts in Wills as trusts for life rather than as direct distributions. With a beneficiary’s ability to encroach on capital, at least that beneficiary is given the opportunity to avail him or herself of this very valuable income tax planning technique for as long (or as little) as he or she deems necessary.
Wills drafted to contemplate this sort of planning will be more costly than the standard Ma-Pa variety, but the cost will pay itself back many times over if the planning potential envisioned by the creation of testamentary trusts is brought to ultimate fruition in the hands of the beneficiaries.
Deemed Disposition on Death
At the time of death, an individual is treated as having sold all of his or her property at fair market value, and any taxable gains are taxed at that time. if assets are transferred to one’s spouse, or to a Qualifying Spouse Trust, the deemed disposition is delayed until the spouse’s death. In the year of the spouse’s death, he or she will be liable, for the tax on any income that received in the year of death.
Clearly, drafting a Will is not as simple an exercise as one might think – at least not if one considers it to be the last chance to do some significant, including post-mortem, tax planning. Given the changes in the rules, clients, especially those in second or third marriages, should be encouraged to review their Wills before the rules change in January 2016.
I would be happy to help you work through the various estate and tax planning issues in
order to carry out your wishes in the most tax efficient manner.
- Chuck Rotenberg