The Tax Bill at Death in Canada and How to Fund It

Introduction

Canada does not levy an estate tax, which leads many people to assume that death carries no tax cost. For anyone holding appreciated assets, that assumption is wrong.

What Canada has instead is a deemed disposition. Immediately before death, a person is treated as having sold their capital property at fair market value. Gains accrued over a lifetime and never realized become taxable in the final return.

The result can be the largest single tax liability a person ever incurs, and it falls due on an estate that frequently holds no cash to pay it.

How the Liability Is Built

The final return brings together several components that did not previously appear in any single year.

Capital property is treated as sold at fair market value, so accrued gains on real estate other than a principal residence, on private company shares, and on non-registered investments all become taxable.

Registered plan balances are generally brought into income in full unless they pass to a surviving spouse or a qualifying dependant. A substantial registered balance can push the final return into the highest bracket on its own.

Depreciable property can produce recapture where its value exceeds its depreciated cost.

Probate or estate administration fees apply in most provinces, calculated on the value of assets passing through the estate.

Because these arrive together in a single taxation year, the effective rate on the final return is often far higher than the deceased ever paid during life.

The Spousal Rollover

Where assets pass to a surviving spouse, the liability is generally deferred rather than eliminated.

The surviving spouse takes over the deceased’s tax cost, and the gain is realized on their eventual death or disposition.

This matters for planning in a way that is frequently misunderstood. The liability has not gone away. It has moved to the second death, usually larger by then because the assets have continued to appreciate.

A plan that treats the rollover as having solved the problem has deferred it onto a generation that may be less prepared for it.

Why the Estate Often Cannot Pay

The difficulty is rarely the size of the estate. It is what the estate consists of.

An estate holding a private company, a rental property and a cottage can be substantial while containing almost no liquid assets.

The executor is obliged to settle the liability. Where there is no cash, the options are limited, and all of them are worse than having funds available.

The particular problem with private company shares is that they are frequently the largest asset and the hardest to convert. Selling a minority interest in a private company under time pressure is rarely possible at anything close to its assessed value.

The Options for Funding It

An estate facing a liability it cannot pay from existing cash has four routes:

• Sell assets, often under time pressure and at a discount
• Borrow, assuming a lender will advance against estate assets
• Seek an instalment arrangement where the circumstances permit
• Use life insurance proceeds arranged in advance

The first three are reactions to the problem. Only the fourth is a solution arranged before it arises.

Each of the first three also carries costs that are easy to underestimate. A forced sale realizes less than a considered one. Borrowing carries interest and requires a willing lender. Instalment arrangements carry interest and are not available in every circumstance.

Why Insurance Fits This Particular Problem

Life insurance is not the right answer to every funding question. It fits this one unusually well for three reasons.

The timing matches exactly. The proceeds arrive on death, which is when the liability crystallizes. No other funding source is triggered by the same event.

The amount is contractual. The estate receives what was arranged, regardless of market conditions at the time, which is not true of a portfolio that may have declined.

The form is cash. The estate does not need to convert anything or find a buyer.

Against that, the coverage must be arranged while the insured is insurable, which is the constraint that defeats plans left too late.

Sizing the Coverage

The coverage should be matched to an estimate of the liability, and that estimate needs maintenance.

The calculation requires current values for each asset, the tax cost of each, registered plan balances, and an assessment of what will pass to a spouse and what will not.

Both directions of error are common. Estates become underinsured as asset values grow beyond what the original calculation assumed. Others are overinsured because the plan assumed a liability that a subsequent sale or a spousal rollover removed.

Where the liability will largely crystallize on the second death because of a rollover, joint last-to-die coverage usually fits the need more precisely and costs less than individual coverage on either life.

Getting the Proceeds to the Right Place

Arranging the coverage is only part of it. The proceeds have to be available to whoever is settling the liability.

A policy paid directly to a named beneficiary goes to that person. It is efficient and avoids probate, but the executor cannot compel its use to pay the estate’s tax bill.

A policy payable to the estate is available to the executor but passes through the estate and may attract administration fees.

A corporately owned policy pays into the corporation, and the funds then have to move out to the estate, which is achievable largely without tax but requires steps to be taken.

For a business owner, this is the detail most often handled poorly, because the liability arises personally on the shares while the policy and the funding capacity sit in the corporation.

Reviewing the Plan

Coverage arranged for this purpose is typically set up carefully and then left untouched for decades.

Nothing about the policy signals that the plan around it has gone stale. Asset values change, businesses are sold, corporate structures are reorganized, and marital circumstances change in ways that affect both the rollover and the beneficiary designation.

A periodic review against the current position, rather than the position at the time of purchase, is the most useful habit available in this area and the one most often skipped.

Common Planning Mistakes

Several errors recur.

Assuming no tax arises at death because Canada has no estate tax.

Treating the spousal rollover as having eliminated the liability rather than deferred it, usually to a larger amount.

Sizing coverage against a calculation that is years out of date.

Naming a beneficiary directly where the funds were intended to be available to the executor.

Leaving the arrangement until the insured’s health makes coverage expensive or unavailable.

Conclusion

The deemed disposition on death can produce the largest tax liability a person ever incurs, assessed in a single year on gains accumulated over a lifetime, with registered balances and recapture arriving at the same time.

Where assets pass to a surviving spouse the liability is deferred rather than removed, and it generally arrives larger on the second death.

Estates holding private companies, real property or other illiquid assets frequently cannot pay it from existing cash, and the alternatives of selling, borrowing or seeking instalments all carry costs that funding arranged in advance avoids.

Life insurance fits this problem because the timing, the amount and the form all match what the estate needs.

The coverage must be arranged while the insured is insurable, sized against a current estimate, and directed to whoever will actually be settling the liability.

Tax Partners can assist you in structuring your affairs properly and ensuring full compliance while optimizing your tax position.

This article is written for educational purposes.
 

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