Estate taxes?

At this time neither Canada nor its provinces levy estate or inheritance taxes on the death of an individual and the distribution of assets to beneficiaries. However, under the Canadian tax system, income tax is payable at death on accrued gains on shares and property as well as the value of certain assets such as RRSP'S. This works as follows:

Capital gains tax

When someone dies they are considered to have sold all of their capital property at fair market value. This includes real estate, shares in private and public companies, and other capital assets. There is an exception where the property passes to a spouse or a spousal trust. In that case the spouse or spousal trust is considered to have acquired the properties at the same tax cost as the deceased and tax on any gains is deferred until an actual sale or until the death of the spouse. Your principal residence is an exception and is not taxed.

Unless there is a transfer to a spouse or spousal trust, the properties are considered to have been sold at fair market value for tax purposes. This means that under current rules 75% of the accrued gain is included in the final tax return of the individual who has died.

Other taxes

In addition to the capital gains, there may be other assets that can give rise to a tax liability at death. Individual owned real estate, amount of any depreciation on buildings and equipment that have been claimed in previous tax returns is included as income in the final return. Also the value of RRSP's or RRIF's that do not transfer to a spouse are included as income.

Many individuals are not aware of these taxes and how they work and even more individuals have not planned to provide the cash for their executor to pay the taxes that occur on death.

Options to pay the tax

There are only four basic methods of providing the cash so that an executor can satisfy the obligation to pay your "joint debts and taxes". These are as follows:

1. Maintain sufficient liquidity to cover off the tax liability.
2. Sell assets.
3. Borrow.
4. Purchase life insurance.

Maintain Sufficient Liquidity

Liquid cash assets such as cash term deposits, T-Bills etc. are put aside and maintained at a level sufficient to pay expected taxes at death. This method assures the executor of the necessary funding but is it an effective use of capital? Typically the income earned on the funds set aside is taxable and the after tax return is minimal.

Sell Assets

Under this method assets are sold to generate cash. Typically the assets to be sold are private or public company shares or real estate. Is the requirement to raise cash for taxes an impediment to the executor realizing the highest value for the assets? Will the best assets be sold leaving the less productive assets to the heirs?

Borrowing

Borrowing entails either spreading the payment to Revenue Canada or obtaining a loan from a lender. The payment to Revenue Canada can be spread over ten years with interest and by providing security. The interest is not tax deductible.

The terms of borrowing from other lenders are negotiable but there can be other concerns. They are:

• The interest will usually be non-deductible.
• If the primary asset is a business, will the lender be comfortable lending when the leadership of the business is in transition?
• Will borrowing hold up the distribution of other assets?

Use of Life Insurance

Maintaining cash reserves, selling assets, and borrowing are all forms of self insuring. The use of life insurance is transferring responsibility to provide cash for taxes at death to a life insurance company. The Life Insurance Company charges a standby fee for receiving the cash. This is known as the premium.

The company accommodates the premium and investment returns like a sinking fund to pay its obligations.

What are economies?

The purest form of self insurance is maintaining cash reserves. The first columns in Graph A shows a $1,000,000 tax liability for a couple both aged 55 due in 30 years. We have used a couple because in most cases individuals leave their significant property to their spouse or a spousal trust and defer the tax.

The second column is the present value of the $1,000,000 tax liability assuming a rate of 3.5% after tax. In other words if this amount was invested at age 55 and the after tax (at 50%) income was reinvested it would grow to $1,000,000 in 30 years.

The third column shows the present value of life insurance premium at the same interest rate to fund a $1,000,000 life insurance policy. The insurance would be payable when the tax is due, i.e., on the death of the second to die. The annual premium is $5,816 and the net present value at 3.5% after tax is $111,000.

What if the Insurance is Corporate owned?

The tax liability on private company shares can be significantly reduced through a strategy of corporate owned life insurance and the repurchase of shares from the estate. If shares of the company are "grandfathered" the tax reduction can be up 40% of the insurance amount. If the shares are not grandfathered the reduction can not be more than 25% of the tax that would have been payable without using the strategy. Shares may be grandfathered if the company owned life insurance on the deceased or spouse at April 26, 1995.

The fourth column of the graph shows the present value of the tax saving at 3.5% after tax. This assumes that the savings is limited to 25% because the shares are not grandfathered.

The fifth column at the right shows the net present cash value at 3.5% of the cost (column 3) less the tax reduction column 4). In other words, this is the net cost in today's dollars of the life insurance if corporate owned.

Other Scenarios

The graph uses a simple form of life insurance to compare the economic results of using life insurance with self insurance. The comparison usually results in an economic advantage to using life insurance. The results are even more striking if the shares are grandfathered and/or if insurance is prepaid.

Liquidity

These economic comparisons are based on the assumption that liquid assets are otherwise available to pay the tax. Of course, this is not always the case. The use of life insurance to deal with liquidity short falls is more a necessity than an alternative.