Tag: Tax rates

Estate as the designated beneficiary – An estate-planning lawyer’s perspective

“Make sure to designate a beneficiary on RRSPs, RRIFs and TFSAs so the money doesn’t fall into the estate.”

It’s such familiar guidance in investment and financial planning that it would be foolish to suggest otherwise. Or would it?

I recently had an exchange with a financial advisor whose client’s lawyer recommended the estate as the named beneficiary. It was a young family with a single child and nothing else remarkable.

Unusual though that recommendation may appear, I myself offered the same advice to some of my clients in my past estate-planning law practice. Then as now, beneficiary designations help bypass probate tax and estate creditors, but may be cast in a different light when considering the following countervailing points. [See Callout Box on Quebec below]

Tax onus on registered retirement savings plans (RRSPs)/registered retirement income funds (RRIFs)

A person named directly as beneficiary is entitled to the gross value of an RRSP/RRIF, with the tax liability falling to the estate. Though the named beneficiary has a joint liability under the Income Tax Act (Canada) for the proportionate amount of the estate’s tax, the Canada Revenue Agency would likely only bother pursuing such a course if the estate is insolvent. There is no provision for the estate itself to claim contribution from the RRSP/RRIF beneficiary.

This would not be an issue where the beneficiary/ies of the RRSP/RRIF and the estate are identical, but could be a serious concern in a situation such as a second marriage, whether on first or second death of spouses.

Flexible spousal rollovers

It may be desirable to have RRSP/RRIF proceeds come into an estate in order to take advantage of a deceased’s graduated tax brackets, rather than have an immediate rollover to a spouse. This could be particularly effective if the death occurs early in the year (i.e., there is little other income). Otherwise, the RRSP/RRIF simply adds on to the surviving spouse’s own registered funds, with potentially higher future tax cost to fully deplete (whether in life or at death).

Generally, the estate and surviving spouse can still elect to roll the excess (not included in the estate) to the spouse.

Amending and revoking

The Will gathers all beneficiary designations together in one place, centralizing control through that one instrument. Otherwise, the person would have to deal with the administrative rules, paperwork and potential delays in dealing with each financial institution. It remains that person’s prerogative to amend/revoke the Will, with the requirements of testamentary capacity being the same for a Will as for beneficiary designations.

On divorce (though not necessarily on separation), spouse entitlements in a Will are generally revoked (although this may vary by province) without having to execute a new Will. On the other hand, designations with financial institutions are not automatically revoked, even in the face of apparent explicit terms in an executed separation agreement. In fact, there is plenty of case law where this has been fought. (Even so, one should be tactful if raising this point with spouse-clients who are otherwise presently in wedded bliss.)

Inheritance contingencies

Trust terms in a Will can be tailored for later issue/grandchildren, whether as additions to the distribution or as stand-ins for one or more predeceasing directly named beneficiaries. For beneficiary designations, the default is generally that if AB, CD and EF are RRSP/RRIF beneficiaries and AB predeceases, CD and EF share equally under survivorship. That may not be the satisfactory expected result if AB has children whom the deceased would have wished to include.

If a target beneficiary has creditor and or matrimonial concerns (presently or as caution against future developments), trust terms may be attached to insulate against that exposure.

For spendthrift concerns (e.g., gambling, drinking, profligate), trust terms could be laid out, maybe to establish a short- or long-term allowance rather than a lump sum.

Transfers to minor beneficiaries or disabled beneficiaries will likely not be adequate as direct beneficiary entitlements, and may be detrimental in terms of impairing provincial support amounts (for the disabled), limiting investment options (requiring an annuity to age 18 for minors), losing control of distributed monies, and likely requiring consultation/approval of government authorities.

Estate liquidity

Absent cash in the estate (e.g., it consists solely of a house and other non-monetary assets), it may require someone to post the funds for the probate tax (to be eventually reimbursed) in order for the executor to take control of the estate assets and begin realizing on them.

Inter vivos or testamentary trust?

As a final thought, an estate is a testamentary trust that is taxed using graduated brackets. Assuming a principal beneficiary (e.g., a surviving spouse) is at a higher bracket than the estate, the cost of probate may be effectively negated by lower taxes on income generated from estate investments. In the past, this could potentially be carried on for many years, but after 2015 will generally only be available for the first 36 months of the estate.

Another alternative may be to have designations directed to a trust that is separate from the estate, with the result that probate and creditor concerns may be circumvented. The lost use of the estate’s graduated brackets should be factored into this latter approach, perhaps by directing some of the RRSP/RRIF proceeds to the estate or by providing the trustee with power to disclaim entitlement to some extent, in order to allow such RRSP/RRIF funds to fall into the estate.

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Callout Box – Quebec residents

Based on a Supreme Court of Canada ruling in 2004, financial institutions generally will not accept beneficiary designations by Quebec resident annuitants, forcing such registered plan proceeds to fall into the deceased’s estate.  While a Will is a key planning tool for all Canadians, the mandatory involvement of the estate for registered plans in Quebec reinforces this need, and underlines the considerations expressed in this article.

Trust issues – The end of testamentary trusts?

There was an collective, almost-audible gasp from the estate-planning community when Finance Minister Jim Flaherty announced in the 2013 Federal Budget that testamentary trusts would be placed under the tax microscope. While not technically “the end” for such trusts, the budget brought into question whether the key benefit of graduated tax bracket treatment would remain available to them and to grandfathered pre-1971 inter vivos trusts.

 In June 2013, the government published a consultation paper on the issue (the consultation period closed December 2, 2013), soliciting input from all interested individuals and organizations. As proposed, these changes have the potential to:

  • fundamentally change future estate-planning processes and decisions,
  • force existing plans to be reconsidered and possibly reconstructed, and
  • disrupt existing trusts that may have been in place for years or even decades.

Key benefit: Graduated tax brackets

A testamentary trust comes into being on a person’s death, with the trust terms generally provided for in the person’s Will. In fact, an estate itself is a testamentary trust, irrespective of whether a Will exists or what may be stated in it. There’s more on estates below within the summary of proposed changes (see “Challenged to respond”).

A trust is subject to the combined federal-provincial tax rates where it’s determined to be resident. As compared with an inter vivos trust (one created during one’s lifetime) that is taxed at the top marginal tax rate, a testamentary trust is entitled to use graduated tax brackets. Though it cannot claim tax credits available to an actual human being, a testamentary trust can thus experience a tax-rate reduction of 20% or more in some cases.

Proposed changes

Put simply, the proposals would subject these trusts to flat top-rate taxation. In the case of estates, graduated treatment would be allowed for up to 36 months, after which flat top-rate taxation would apply. The measures would apply to existing and new arrangements for the 2016 and later taxation years.

A number of further implications flow from this change:

  • Tax instalments – Instead of being allowed to pay taxes at year-end, quarterly tax instalments would be required
  • Alternative minimum tax calculation – As is the case for existing inter vivos trusts, the $40,000 exemption would no longer apply
  • Year-end – Rather than being able to choose its year-end, such trusts would be subject to a calendar year-end
  • Distributions to non-residents – The exemption from part XII-2 distribution tax would no longer apply
  • Tax-deferred distributions – Rather than being automatically a “personal trust” that may transfer assets at cost base to beneficiaries, conditions would attach to such characterization
  • Investment tax credits – These credits would no longer be allowed to be transferred to beneficiaries, and therefore could only be used to calculate the trust’s own income
  • Tax administration – Extended time periods for certain refunds, assessments and filings would no longer be available

The proposals would not affect capital property rollover rules for spousal and common-law partner trusts, but otherwise the changes would apply to the operation of these trusts.

For disabled and minor-age beneficiaries, income would still be able to be taxed to qualified beneficiaries while being retained in the trust, though the trust itself would be subject to flat top-rate taxation.

The fallout

The government’s stated concern is that beneficiaries of these impugned trusts may access more than one set of graduated tax rates, raising questions of “tax fairness and neutrality.” With respect to grandfathered pre-1971 inter vivos trusts, I agree that tax planning undertaken almost half a century ago should not continue to provide tax benefits indefinitely. However, in the case of testamentary trusts – where you must die for the wheels to be set in motion – we need to tread far more carefully.

Accepting that the system may be open to abuse by some, there is a much broader swath of the population who, by no fault of their own, find themselves in a vulnerable position due to the death of a key household provider. Juxtaposed with “tax fairness,” life itself has not been fair to these widows or widowers, orphans and other dependants. There are valid personal and public policy reasons for the “neutrality” of the tax system to give way in such circumstances.

Challenged to respond

Wills prepared under the prevailing rules may need to be redrafted, and other planning avenues may need to be considered.  Apart from the confusion and complication this could introduce, there is also a cost.  Practically, inaction may be the default result; or if a testator is now incapable, no corrective action would be possible anyway.

Surrounding estate-planning measures would also be affected.  For example, the quantum of life insurance may now be out  of sync — whether those proceeds are intended to flow through a testamentary trust or directly to a beneficiary — on the assumption of existing tax treatment applying to other assets flowing through a testamentary trust.  As with wills, there is the potential for confusion and complication, and a very real possibility that insurability would limit or eliminate manoeuvring options.

The Ontario 2% super tax: Pushing the 50% threshold

What is a “super tax”? It’s the term that has emerged in the media after the Ontario government introduced a new 2% tax bracket for income earned in excess of $500,000.

Quite obviously, this will affect a very small percentage of the population – less than 1%. For those affected, however, it places them within a hair’s breadth of a 50% marginal tax bracket. For some, it could be the proverbial straw that breaks the camel’s back in terms of undertaking strategic tax planning, particularly owners of small-business corporations.

So what does the arithmetic look like?

Approaching a 50% tax bracket

The new tax has been promoted as 2%, but that’s not the whole story. Ontario has a two-stage surtax that kicks in well before reaching top tax-bracket levels. A surtax is a tax on a tax. In 2012, a 20% surtax applies once provincial tax tops $4,213, with a further 36% surtax on provincial tax over $5,392. This works out to a combined 56% surtax on income in excess of $80,963.

For the top federal tax bracket on income over $132,406, the federal rate is 29%, the basic Ontario rate is 11.16% and the provincial surtax is 6.25%, for a total of 46.41%. If you multiply the new 2% tax by 1.56 for the surtaxes, it adds 3.12%, for a total of 49.53% on income over $500,000.

To ease the transition, the new tax will apply for only half the year in 2012, beginning on July 1. Breaking it down by income type, here are the marginal tax rates for Ontarions with incomes over half a million dollars:

Shareholders of business corporations

While this new tax applies to individuals, it could have implications for an owner-shareholder earning income through a small-business corporation.

Once one applies the gross-up and tax-credit procedure, the impact on Canadian dividend income is about 50% higher compared to salaried income. Looking at the table, after 2012 the top rate on salary will increase by 3.12% as detailed above, versus 3.90% and 4.30% for eligible and ineligible dividends, respectively. (For 2012, halve all those figures.)

Remembering that the new tax is only applicable to personal income over $500,000, it’s difficult to say whether this will be sufficient to motivate a business owner to adjust compensation structure, but it remains food for thought.

Note: A detailed rundown of corporate–personal tax integration in all provinces is available through our InfoCard of the same name, which is updated in August each year. Despite this Ontario development, our model will continue to reflect income at the top federal tax-bracket level as it is applicable to the bulk of business owners.

Ontarions not alone

In the fall of 2010, Nova Scotia introduced a 21% provincial tax rate on income in excess of $150,000. Combined with the 29% top federal rate, that makes for an official top tax bracket of 50%. Concurrently, the province suspended its 10% surtax. Ironically, this has meant lower net taxes for those with incomes up to about $170,000.

For Ontarions, this new tax has a political sunset once the province returns to a balanced budget, projected to occur about 2017. In the meanwhile, the simplest of tax planning may be to simply defer income recognition, which in the investment-income space would mean a preference toward holdings that generate unrealized capital gains.