Marginal income tax rates
In Ontario personal income tax rates are graduated, which means that they increase as one’s income increases. For 2016 the top marginal rate on taxable income over $220,000 is 53.53% on normal income, 26.76% on taxable capital gains, 39.34% on “eligible” dividends and 45.30% on “ineligible” dividends. These rates vary by province and are one of the highest ever. Because of this, proper estate planning becomes ever more important.
Deemed disposition rules
Unlike the Unites States, Canada has no estate taxes. However, when an individual dies they are “deemed to sell” all of their assets (worldwide) at fair market value immediately before death. This gives rise to an income tax liability on the deceased’s final terminal income tax return based on the difference between the fair market value and cost.
The most common assets include domestic and foreign owned real estate, stocks in public and private companies, commodities, art, RRSPs and annuities. Real estate may also give rise to income tax on previous “deprecation claimed.” The Income Tax Act provides an exception to the fair market value rules on property left to a spouse (including common law spouse) or spousal trust, under the terms of a Will. Assets left to a spouse automatically transfer at original cost, unless one elects out of the income tax provisions and hence transfer at fair market value. This may be important if there are “accrued losses” in certain assets — as assets are transferred on an asset-by-asset basis. Taxes on accrued losses can be used to offset taxes on accrued gains.
Deemed disposition of capital assets normally give rise to capital gains rates while registered savings and annuities give rise to normal income tax rates. The tax on such RRSP and RRIFs and other annuities can be deferred if left to a spouse or, under a special election, your “financially dependent child.” For a spousal RRSP there is only a deemed disposition on the death of the plan holder and not contributor spouse.
Shares in Canadian Controlled Private Corporations (CCPC) have “enhanced capital gains” treatment if the shares have been owned for at least two years and if certain other conditions have been met for “two years prior” to the date and “immediately before” the date of the sale. The benefit is potentially upwards of $824,177 (indexed annually) lifetime tax free capital gains, assuming that the shareholder does not have certain other losses in his prior year tax returns. Planning should be done on a regular basis to ensure that the shareholders can avail themselves of this and ensure that the CCPC status continues. This is especially important for a family that may have a spouse and children.
Sales of “qualified farm property” also have an enhanced capital gains exemptions limit of $1,000,000 and specific rules that must be met.
Principal residences may be tax free. The exempt gain portion is determined by a specified formula and taxpayers are allowed to choose which residence qualifies as the principal residence. If two properties (home and cottage) were owned prior to 1981, spouses can potentially “double up” on the principal residence exemption.
If individual wants to fix the value of his estate and hence tax on death, they can implement an estate freeze. This allows any future growth to be taxed in the hands of other family members and generations. This is common for people that own either real estate that is capital property, shares in a family operating company or other assets that have or potentially will appreciate in value significantly.
In this instance, a new company would be set up and the assets of the original company transferred into it. Such transfers can be done on a tax-deferred basis, if properly elected.
The general rule is that Canadian citizens can transfer assets into the company from their original cost to their fair market value and not recognize an accrued gain on the transfer of the asset. The transferor would then take back a class of shares frozen in value at the fair market value of the asset. Other family members could then subscribe for and pay for “growth” shares.
A “family trust” could also be a consideration to better “control” the company and protect future shareholders from creditor and other claims. Over time these “freeze shares” could be bought back by the company, to further minimize taxes on death. Family law issues should be considered in such a freeze.
Charitable donations both during a lifetime and at the time of death (specified in a will) can go to reduce income taxes. Canada has very favourable rules for donation of publicly traded securities. A donor will save more taxes by donating publicly traded securities that have appreciated in value than donating the equivalent amount of cash. Gifts of “cultural property” (if certified to be of cultural significance to Canada) to certain public institutions also receive favourable tax treatment.
Life insurance can be used to minimize taxes on death and/or leave funds for heirs. There are different types of insurance, some of which may also allow one to accumulate funds on a tax-sheltered basis and hence save income taxes during a lifetime and at death. If one owns a company, corporate-owned life insurance could be an efficient and cost-effective way to hold and pay for a policy.
In this case, any life insurance proceeds will go into a special tax pool called the “capital dividend account” (CDA) which can be paid tax free to remaining shareholders, subject to certain rules. But effective Jan. 1, 2017, the CRA is dramatically changing the amounts that can be paid tax free from the CDA. New policies issued prior to year end will be grandfathered. This CDA account may exist for other reasons within a corporation and should be paid out (via a “CRA prescribed form”) on a regular basis, in order to minimize the company’s value and hence taxes on death.
Estate planning is an evolving process and should be revisited as one ages and family circumstances change. Every situation is different and the rules are constantly changing. People are allowed to arrange their affairs to minimize income taxes in a legitimate fashion. But professional advice should be sought to provide peace of mind and increased benefits for survivors.
(Cusimano, CA, CMA, CPA, is a chartered professional accountant serving entrepreneurial individuals, corporations, trusts and estates in the Greater Toronto Area.)