Structuring your Child’s Legacy
In passing your estate to your children, we’ve explored this issue in part by examining specific assets and issues including:
- gifts to children while you’re alive and placing assets into joint tenancy with your child (like to avoid probate),
- registered accounts where there is a beneficiary designation (like RRSPs, RRIFs, TFSAs), and
- the transfer of your companies
In this article, we’ll look at the bigger picture where we’ll consider how the personal and financial situation of your children will impact your estate planning.
Deemed disposition and taxes payable at death
On the day you die, you are deemed to have sold all your property for proceeds equal to their fair market value as at the date of your death:
- For your capital property, the capital gain or loss is taxed in your final tax return and your estate acquires your property for an Adjusted Cost Base (ACB) equal to their fair market value as at the date of your death;
- For your RRSPs and RRIFs, they are deemed collapsed and their fair market value becomes ordinary income and taxed in your final tax return.
There may also be foreign inheritance and transfer taxes on foreign assets on top of the Canadian taxes.
Exceptions to the Deemed disposition rule
There are some exceptions to this deemed disposition rule:
(i) For capital property (other than your Principal Residence)
An exception to the deemed disposition rule applies where property passes to the deceased’s spouse, common-law partner or a “Spouse Trust”.
In this situation the proceeds are deemed to be equal to the Adjusted Cost Base (ACB) of the property resulting in the capital gain being deferred until the surviving spouse or common-law partner dies or the property is disposed of by the spouse, common-law partner or Spouse Trust.
The property must vest indefeasibly (this means the new owner has an absolute right of ownership of the property, and these rights cannot be pre-empted or superseded) with the spouse, common-law partner or Spouse Trust within 36 months of death.
The Spouse Trust is a Trust, normally created through your Will, where the Trust is resident in Canada immediately after the time the property vested indefeasibly in the Trust and under which:
(a) your spouse or common-law partner is entitled to receive all of the income of the Trust while your spouse or common-law partner is alive, and
(b) no person, except your spouse or common-law partner, may receive or otherwise obtain use of any of the income or capital of the trust, while your spouse or common-law partner is alive.
Through this rollover, the taxation is just simply postponed until the spouse or common-law partner dies or disposes of the shares. This rollover does not increase the tax cost of the company shares or company assets. Nor does it increase the paid-up capital of the shares.
A Spousal Trust might be of particular interest where it is likely that your spouse might remarry so as to avoid your children becoming disinherited. Here the Trust could be controlled by one or more children as Trustees with your children becoming beneficiaries on your spouse’s death. Such a Trust could also be used to avoid US Estate Taxes where your spouse is a US citizen or US resident.
(ii) For your Principal Residence
You and your spouse (or common-law partner) may only designate one property as Principal Residence for both of you in a tax year after 1981.
- For years prior to 1982, each individual taxpayer can designate a property each year as a Principal Residence. So if you and your spouse each separately owned two properties, the Principal Residence Exemption may be available for both homes for the years prior to 1982.
- For a home owned prior to 1972, only the increase in value since December 31, 1971 is used to calculate the gain before deducting the Principal Residence Exemption.
The increase in value of your home from the later of: the time of purchase or from January 1, 1972, is used to calculate the gain before deducting the Principal Residence Exemption.
The Principal Residence Exemption is calculated as follows:
(# of years home is principal residence + 1)
——————————————————— X capital gain
# of years home is owned
The extra year in the top of the equation means that when a person moves, both the old home and the new home will be treated as a Principal Residence in the year of the move, even though only one of them can actually be designated as such for that year.
(iii) For your RRSPs and RRIFs
For your RRSP/RRIF, the exception to the deemed disposition rule is where a qualified beneficiary[ii] of your RRSP/RRIF is designated as beneficiary where, on your death, he or she receives an amount from your RRSP/RRIF (called a refund of premium). In this case, the refund of premium paid to the qualified beneficiary is taxed in their hands. Furthermore, the qualified beneficiary may be able to transfer this income to their RRSP/RRIF where they obtain an offsetting deduction. The net effect of this is that your RRSP/RRIF is transferred to your qualified beneficiary without any tax consequence.
To summarize, when you name a qualified beneficiary as a beneficiary of your RRSP/RRIF, the date-of-death value of your RRSP/RRIF may be taxed in your hands in your final return, taxed in your child’s hands, or transferred to the beneficiary’s tax deferred plan.
So generally speaking, the taxman will collect the tax on your property either at your death, or through using these exceptions, on the death of your spouse or common-law partner. After taxes and final expenses are paid, the residue is what may be passed to your children. Some such assets might pass to them by way of beneficiary designation – in an insurance contract, RRSP, RRIF or TFSA beneficiary designation – or by operation of law where it is a jointly owned asset with right of survivorship. Whether that asset should pass directly in the name of your child or held for the benefit of your child will depend on their situation.
Your Children’s Situation
Where it is expected that a child is to receive a substantial inheritance, it will be important to consider that child’s:
- ability to handle the money wisely,
- potential liabilities – both business and personal – that can result in a loss of part or all of their inheritance, and
- opportunity to manage the taxation of income generated from inherited assets by having monies taxed in more than one person’s hands.
(i) Ability to Handle Money Wisely
Regardless of whether we are talking about a spendthrift, inexperience, or medical condition, it may make sense for a part of the inheritance to provide monthly receipts for the child over their lifetime. The type of investments and structure of ownership might be:
- an investment portfolio (which might include cash, stocks, bonds, real estate) owned by a Trust that’s managed by a trusted and responsible adult; or
- an insurance contract – like a non-commutable non-transferable life annuity, assuming a reasonable rate of return can be achieved. One might consider whether ownership might be in the child’s hands so that it might qualify as a tax-preferred Prescribed Annuity.
There are a few concerns in trying to control a child’s inheritance “from the grave” including:
- can you truly trust the “trusted adult” to always act in the best interests of your child and will that person be willing and able to carry out their duties throughout the lifetime of your child, and
- is it possible that your child’s situation could improve so that he or she could become a wise and responsible person able to manage their inheritance. In such a case, a triggering mechanism might be built in so that your child can take control over their inheritance. Funds might be spinkled on the child through time (say 25% at age 25, 25% at age 30 and the balance at age 35) so that they get some experience in handling money. Another possibility is where control is handed over on achieving some milestone, such as the time when the child graduates with a college or university degree.
(ii) Avoiding potential liabilities
Where a child has or may be subjected to significant liabilities, it would be painful to watch some or all of the inheritance disappear in dealing with these liabilities. It may instead be better for the inheritance to be settled into a Trust that’s managed by a trusted and responsible adult.
The nature of the Trust would have an impact on the level of control that the child could have over the Trust.
Where the potential liabilities are potential business liabilities and non-matrimonial personal liabilities, the child might be able to be a Trustee.
Where the child is in an unstable marriage or marriage-like relationship, provincial family law legislation is a significant risk. Although there is some exclusion of inherited assets, a family law lawyer will do their best to attack the assets and get them designated as “family assets” which may be subject to being split on a 50/50 basis. Even assets held in a Trust can be vulnerable where your child is a Trustee or has an ability to control the Trust. Consultation with a good family law and estate planning lawyer is suggested to ensure the Trust is appropriately structured.
(iii) Managing Taxation – income splitting
Where your child has children, it may be possible for a Trust to be established whereby your child is the Trustee and your child and his or her family members are also beneficiaries. In such a situation, where the inheritance is invested, it may be possible to significantly reduce income taxes on the inheritance.
Consider the following situation. If your child is working and is in the 40% tax bracket, had he or she received an inheritance of $1 Million that generates $50,000 of interest income, there would be $20,000 (= 40% x $50,000) of income tax payable each year.
Compare this to the case where the Trust receives the $1 million inheritance and makes the same investment. The Trust would have $50,000 of Taxable Income for which the Trust can then distribute income to beneficiaries. If your child has three young children with no income, each child can receive almost $12,000 a year with little or no tax due to their federal and provincial basic and personal amount tax credits. Assuming that your child’s spouse is not working, he or she might also receive $12,000. As a result, there is only $2,000 remaining to be taxed. While the Trust is considered a Testamentary Trust for the first 36 months, if taxed within the Trust, we would be looking at that $2,000 income taxed at the lowest marginal tax rate – let’s say at the 20% rate resulting in $400 income tax. If the $2,000 is distributed to you child and taxed at their 40% rate, we would be looking at $800 in total tax. So the value of the Trust can result in a tax saving of about $19,000 each year. That amount of tax saving might very well pay for most of your grandchildren’s college education.
The Next Step
This article has hopefully illustrated some of the planning opportunities to help defer tax on your death, protect assets from creditors and save taxes over the life of your child.
Adding a Trust in your Will and as beneficiary of your insurance policies and beneficiary of your tax deferred investment plans (like your RRSP, RRIF, TFSA) does add some extra complexity. This might not make sense for smaller inheritances, but is something to consider especially where a child might inherit $600,000 or more.
I can work with you to explore your estate planning options as well as refer you to a tax accountant and estate and family law lawyers to help custom design and implement your estate plan. Please call me at (604) 288-2083 or email me at email@example.com
Written by Steve Nyvik, BBA, MBA ,CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.
Your Principal Residence can be any of the following types of housing units:
- a house;
- a cottage;
- a condominium;
- an apartment in an apartment building;
- an apartment in a duplex; or
- a trailer, mobile home, or houseboat.
A property qualifies as your Principal Residence for any year if it meets all of the following conditions:
- It is a housing unit, a leasehold interest in a housing unit, or a share of the capital stock of a co-operative housing corporation you acquire only to get the right to inhabit a housing unit owned by that corporation.
- You own the property alone or jointly with another person.
- You, your current or former spouse or common-law partner, or any of your children lived in it at some time during the year.
- You designate the property as your principal residence.
Canada Revenue Agency (CRA) usually considers that if there is more than 1/2 hectare (1.25 acres) of property, only 1/2 hectare of the land can be considered part of the Principal Residence, and there would be a capital gain on the excess when the property is sold, even if the rest is the Principal Residence. However, they also consider whether the property is subdividable. Thus, if the property is 2 hectares, and is not subdividable, they may consider the whole amount of the land to be part of the Principal Residence.
If your home was not your Principal Residence for the whole time that you owned it, you will have to report the sale (and the resulting gain) on your tax return, and calculate the Principal Residence Exemption to deduct from your capital gain.
[ii] Who is a Qualified Beneficiary?
A qualified beneficiary is:
(i) your spouse or common-law partner, or
(ii) a financially dependent child or grandchild (we’ll refer to them both as a child). A child is considered to be financially dependent on you at the time of your death if the child ordinarily resided with you at that time and they meet one of the following conditions:
- the child is not mentally or physically impaired and their net income for the previous year (shown on line 236 of their tax return) was less than the basic personal amount (line 300 from Schedule 1) for that previous year; or
- the child or grandchild is impaired in physical or mental functions and their net income for the previous year was equal to or less than the basic personal amount plus the disability amount (line 316 from Schedule 1) for that previous year.