How to Leave a Bigger Legacy
When you are thinking about what to include in your will, your thoughts tend to focus on who gets what and who will take care of your kids. It’s also possible that you would tend to worry about ensuring there is enough left over for your family members once the taxman gets his piece of the pie. If so, then maybe you should also think about how to keep that piece as small as possible by properly planning your will in a tax-efficient manner. Here are some of my favorite strategies.
The Spousal Gift
When you pass away, the Canada Revenue Agency (CRA) deems you to have sold all of your assets immediately prior to your death. To the extent that any of your assets have a pregnant gain, then your estate will be subject to capital gains tax. On the bright side of things, at least your beneficiaries get to inherit your assets with a bumped-up cost base.
There is, however, one important exception to this deemed capital gain. You can defer your death tax exposure by making your spouse the beneficiary of your estate, or perhaps better still, you can leave your assets in a qualifying spousal trust. There is no election that your estate need make; it’s an automatic deferral to the extent you leave assets to your spouse or a spousal trust.
Specifically, the tax rules provide that bequests to a spousal trust (or to your spouse outright) will not trigger capital gains tax on your death, so that assets transferred to the spousal trust will occur on a tax-deferred basis.
The bonus of a spousal trust is that you can choose trustees to protect the surviving spouse against poor financial decisions.
As well, you can ensure that the surviving spouse will not be able to transfer assets to undesired beneficiaries (for example, if he or she were to get remarried and decide to leave your assets to their new spouse).
But you must be certain that the spousal trust qualifies for the tax-deferred treatment; otherwise, no tax-deferred rollover upon your death will be available. Specifically, the spousal trust must meet the following requirements:
* The spouse is entitled to receive all of the income of the trust while he or she is alive.
* No other person (including children) may receive or otherwise obtain the use of any income or capital of the trust.
Note: Just because no one else is allowed to receive the capital of the trust does not mean that the spouse is automatically entitled to the capital. Which means you can provide that there is no power to encroach on capital, so that the nest egg stays safe for your children, and your spouse gets the benefit of the income during his or her lifetime. In other words, as long as no other person receives or obtains the use of the capital, the spousal trust will not be disqualified.
In order to make sure that you do not stray from these requirements, take care when drafting your will and the clauses relating to the spousal trust.
For example, if the spousal trust allows for the trustees to lend funds on an interest-bearing basis to a relative, this could be interpreted as allowing someone other than the spouse to receive or obtain the use of the capital. It may be okay, however, to lend funds on commercial terms, but you should check with your advisor.
Fortunately, a spousal trust can provide for certain testamentary debts to be paid, i.e., funeral expenses and income taxes payable for the year of death and prior years.
Before 2014, one of the most important strategies when tax planning your will was the “testamentary trust,” as such trusts were treated as separate taxpayers, with access to the graduated rates.
By leaving assets in a testamentary trust for your kids instead of giving them the assets outright, the children could “income split” with the estate. This opportunity was even more lucrative because the estate could choose to declare and pay tax on its income, even though it is actually paid out to beneficiaries. And the more testamentary trusts you created in your will, the more you had access to the graduated tax rates. However, that was then, and this is now.
As of 2016, testamentary trusts no longer benefit from graduated tax rates (in addition to no longer being exempt from making tax installments or having an off-calendar year end). As a result, testamentary trusts will now be subject to a flat top tax rate.
The only exception to this new rule is that the estate can take advantage of the graduated tax rates for the first 36 months. But after that time period, there will be no longer any opportunity to income split. Note that there will continue to be access to graduated rates for testamentary trusts whose beneficiaries are individuals that are eligible for the federal Disability Tax Credit.
Income Earning Assets
There are many other tax-planning strategies that you should bear in mind when drafting your will. For example, if you own income and non-income-earning assets, it is possible to leave the income-earning assets to children with low income. This is because income from bequests to high-income children will, of course, be added to their other taxable income, thus resulting in a significant tax exposure.
Previously published in The Fund Library on February 22, 2018 by tax and estate planning lawyer, Samantha Prasad.