Mortality and Tax: The Full Accounting of Death

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All references to a spouse include common-law partners. All references to the ‘Act’ mean the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended. All references to the ‘Regulations’ mean the Income Tax Regulations. The following should not be construed as legal nor tax advice. Consultation with your usual tax/legal professional is advised. Please contact us to discuss the contents of the article herein.

Good morning Toronto! As is commonly said, there are two things that one cannot avoid in this life: death and taxes. In this article, we will explore what happens when someone dies in Canada, from an estate administration and a tax perspective.

First, the laws that govern the administration of wills and estates are set by each province or territory. Hence, while they are, in many regards, extremely similar, there are minute details which differ from jurisdiction to jurisdiction. In Ontario, the Acts that are of concern for this article are the Succession Law Reform Act (SLRA), the Estates Act, and the Trustee Act. Considering that the vast majority of the reader base is in Ontario, this article will focus on the regulstions in Ontario, although it can be expected that other jurisdictions are fairly similar in the below processes.

As with many other jurisdictions, wills generally need to undergo probate, the process where a will is validated by a court and when the estate trustee(s) (executor) is recognized. It is generally needed if the deceased owned real estate, other assets, and/or there are concerns/conflicts regarding the validity of the will/executor. If the deceased died intestate (without a will), an estate trustee(s) is appointed as part of the normal probate process. Should intestacy occur, assets are divided in accordance with SLRA provisions. To that end, Ontario also charges probate fees (Estate Administration Tax), equivalent to 1.5% of the portion of the estate valued above $50k.

One of the key duties of the estate trustee(s) is to ensure that any and all debts/liabilities are fully discharged (paid) before distributing any monies or assets to beneficiaries. Specifically, there is an order of priority for debts to be paid, as follows:

• Estate administration/probate fees
• Funeral Expenses
• Secured creditors (such as car loans and mortgages)
• Tax debts owed to the CRA/provinces
• Unsecured creditors (such as credit cards)
• Beneficiaries list in the will/according to law

While debts are not inheritable*, the trustee(s) can be held personally responsible for parts of the debt if they improperly distribute assets, up to the amount that was wrongly distributed. If the estate does not have the funds to discharge all its debts, then the estate is insolvent, and the beneficiaries receive nothing.

*If the debt was a joint debt, or if another person cosigned for the deceased's debt, that third party is still fully liable for the outstanding balance.

From a tax perspective, there are several tax liabilities that arise on the death of a taxpayer. Chiefly, the Act considers death to trigger a deemed disposition event. On the date of death, the capital property* of the deceased are considered to have been sold at Fair Market Value and immediately reacquired. This notional sale triggers a capital gains event which is reportable and taxable on the Final income tax return. Note that capital gains are included as income at 50% of the total applicable capital gain/loss.

*Capital property is ‘any property which, if sold, would result in a capital gain or a capital loss’. Common types of capital property include houses, securities, and land. The principle residence usually will qualify for the Principle Residence Exemption, amounting to no capital gains.

However, an exception to the deemed disposition rules are registered accounts. In particular, RRSPs and RRIFs are treated as deemed withdrawals, as if the entire value of the account was withdrawn on the date of death. Hence, on the final return, the full value of these accounts are included as ordinary income. For obvious reasons, if these portfolios have significant holdings, this event triggers significant tax liability for the estate.

Contrastingly, TFSAs retain their tax-free status to the date of the deceased's death, but any income or gains incurred after that date are taxable. In both cases, there are various provisions in the Act that allow for a continuation of the tax-advantaged status of these accounts. These special rollover rules are to be discussed in another article.

Finally, the estate trustee(s) is responsible for filing the Final income tax return, covering 1 January of the year of the death to the date of death. As with any other tax return, it must include all income during that time, as well as proceeds of the deemed disposition and/or withdrawal. The deadline for this return is:

• For deaths occuring between 1 January - 31 October, 30 April of the following year
• For deaths occuring between 1 January - 31 October AND the deceased had a business, June 15 of the following year
• For deaths between 1 November - 31 December, 6 months after the date of death

The trustee(s) also have a choice to include certain types of income on a separate 'optional' tax return, which may significantly reduce total taxes owed. When correctly used, certain types of income are reported separately, allowing the estate to use lower tax brackets and duplicate non-refundable tax credits (such as the Basic Personal Amount). Each optional return is effectively treated as a separate taxpayer for calculation purposes, which can significantly lower the overall tax payable. There are three optional returns:

*Sole proprietorships almost always have a fiscal-end of December 31, so most SPs likely do not qualify to file this optional return.

**GREs (Graduated Rate Estate) are trusts that that represents the estate of another deceased individual.

In the period that the estate winds down, it is possible for the estate to receive income that was earned and received after the date of death. In these cases, post-death funds are not included with the final return. Instead, estates are treated as testamentary trusts (even if the will does not explicitly create a trust) by operation of law. See §108(1) of the Act. As the estate is considered a trust, post-death income must be reported on a T3 Trust return, instead of the usual T1 Personal return.

In summary, this article has introduced a few key tax and estate implications of death:

• Probate fees
• Deemed disposition of capital property, triggering capital gains
• Deemed withdrawals of certain registered plans
• Income taxation of post-death income as a trust, which are subject to the highest marginal tax rates.

To that end, the next article will explore how each consequence can be minimized or deferred through strategic planning.

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