Thinking about what to include in your will? If you are like most people, your thoughts are probably focused on who gets what, and who will take care of the kids.
It's also possible that you're worried about ensuring there is enough left over for your family members after the taxman gets his piece of the pie.
If so, then maybe you should also be thinking about how to keep that piece of the pie as small as possible by planning your will in the most tax-efficient manner possible.
The Spousal Trust
The Canadian tax rules provide that when you pass away, you are deemed to have sold all of your assets immediately prior to your death.
However, if your assets have increased in value, then your estate will be subject to capital gains tax.
Looking on the bright side, 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, by leaving 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 say that bequests to a spousal trust (or to your spouse outright) will not trigger capital gains tax on your death as assets transferred to such beneficiaries will occur on a tax- deferred basis. Upon the death of your spouse, however, the capital gains tax will then be triggered.
The bonus of a spousal trust over a gift outright to your spouse 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).
Once your spouse passes away, the spousal trust would then provide for the assets to pass to the residual beneficiaries (i.e. your children). 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 kids) may receive or other wise 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 it. In other words, as long as no other person received 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, care should be taken when drafting your will and the clauses relating to the spousal trust.
For example, if the spousal trust allows for the trustees to loan funds 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 loan funds on commercial terms – but you should first check with your advisor.
Happily (relatively speaking, of course), 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 tax-planning strategies for your will was the "testamentary trust." Such trusts were separate taxpayers, with access to the graduated tax rates.
You could leave assets in a testamentary trust for your kids, instead of giving them outright. This way, the kids 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.
That was then, and this is now. As I noted in my 2014 Federal Budget summary in The TaxLetter March/First Report, the government has proposed that beginning in 2016, testamentary trusts will no longer benefit from graduated tax rates.
This is 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, the opportunity to income split disappears (there will, however, 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. Here's one other 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.
In Ontario, tax of 1.5 per cent will be payable on the value of your assets that go through probate.
However, if you own shares of private companies, you should ensure that you have a secondary will that deals only with those shares. Why? Well, you may be surprised to know that, unlike bank accounts or real property, shares of private companies do not require a probated will in order to affect a transfer to the beneficiaries.
Accordingly, by segregating your private company shares in a separate secondary will, you can avoid probate tax on the value of your shares.
These savings can be substantial if the bulk of your wealth is tied up in private company shares. Therefore, if a secondary will is drafted to deal with your shares, then the application for probate will only be made in respect of the assets in your primary will.
I stated earlier that a probated will would be required in order to transfer real estate to your beneficiaries. However, it is possible to save on probate fees on your home or other personally owned real estate by having a bare trustee company on title, and the shares of such company be dealt with under the secondary will.
Since you won't need to change title to the property on your death (as it will continue on in the name of the bare trustee company), a probated will is no longer required for that purpose.
RRSPs and RRIFs
I recommend that you designate a beneficiary of a Registered Retirement Savings Plans (RRSP) or Registered Retirement Income Funds (RRIF) directly in the contract itself rather than in a will.
This will not only avoid probate fees; if you designate your spouse as a beneficiary (which I highly recommend), the value of your RRSP or RRIF will not be included as income in your final return as there is a deferral of tax for transfers to spouses.
If your spouse passes away before you, or you get divorced, you can designate a child or grandchild who is "financially dependent" on you. This means the RRSP will be taxed in the hands of the low tax rate of the child or grandchild.
The financially dependent child or grandchild can also specify a special annuity which will enable them to defer this tax while they are minors – or indefinitely, if they are mentally or physically disabled. ("Financially dependent" usually means that the child or grandchild's income does not exceed the basic personal amount.)
Your will can provide for gifts to registered charities, which, if done in the year of death, qualifies for tax credits of up to 100 per cent of your net income.
Although this sounds like a great tax planning opportunity, pitfalls abound in this area. Care must be taken when drafting your will.
I say this because CanRev used to be of the opinion that if the executors had discretion to choose between the value of the bequest and which charity would receive the gift, the donation would not qualify for the tax credit.
Although this position is no longer current, I would highly recommend that you speak with your advisor to ensure that an amount to be donated is determined (whether a specific amount or a percentage), and that it is clear from the terms of the will that the executor is required to make the donation to a qualified donee.
Another tax-saving strategy for your will: leave your residence to a beneficiary who will be able to claim the principal residence exemption. And if someone owes you money and you wish to forgive the debt, the best way to do this could be in your will so as to avoid certain debt forgiveness rules.
By properly planning your will using some of these tax-saving strategies, you can at least take comfort knowing that, upon your death, you are leaving a larger inheritance to your family – and not to the CRA.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.