Who Is the Taxpayer – the Estate or the Beneficiary?
Executors and their accountants should be aware of issues raised as a result of relatively recent changes to the income tax rules relating to estates. Since 2016, most estates are subject to income tax at the highest marginal rate, instead of having access to the lower tax brackets under the previous rules. Under this new tax regime of graduated rate estates ("GRE"), issues that did not arise, or were previously not important, may affect the tax position of estates in unexpected ways, ultimately reducing the value of assets or cash available to distribute to beneficiaries.
To qualify as a GRE, various conditions must be satisfied and an election must be filed with the Canada Revenue Agency before the prescribed deadline. The GRE tax rates are also only available for a short period of time (36 months) from the date of death, so the expedient administration of the estate is also a factor to take advantage of the lower tax rates. After this period, the estate may be subject to the highest marginal rate that would apply to a trust.
One important question to consider is this: at what point does property of the estate vest in the beneficiary? In other words, who is the relevant taxpayer – the estate or the beneficiary? The answer to that question determines whether income from that property is subject to the highest marginal tax rate (in the estate) or potentially lower marginal tax rates (of the beneficiary). In the former situation, steps may need to be taken to access the beneficiary’s lower marginal tax rates. The default position at law is that the property transfers, or “vests”, in the beneficiary’s hands at the earliest opportunity after death. This default position may be reversed in certain circumstances.
To determine when this vesting can occur, it is also important to consider the type of gift that a beneficiary receives from the estate. A specific bequest, such as valuable piece of art that is designated to a certain beneficiary, or a piece of land that is directed to be transferred to a named beneficiary, are interests that are known at the time of administration. As such, recipients of these gifts have their interests "vest" at the earliest opportunity during administration and have a beneficial interest in the gift up until the gift is actually transferred to them. In comparison, a beneficiary who is entitled to a share of the residue of the estate (what is left over after all debts, taxes, specific bequests and expenses of the estate are paid) does not realize this interest until administration is nearly complete, as the value or property that forms the residue cannot be ascertained immediately. Residue, and income an estate earns off the residue, has a higher risk of being subject to the highest tax rates if the estate goes through a lengthy administration, as the estate may no longer qualify as a GRE.
Property of an estate cannot vest in a beneficiary until the administration of an estate is complete. “Complete” would typically mean that a final tax return has been filed, probate has been completed, and debts are satisfied. But, many things could cause the administration not to be complete. For example, if an estate has any outstanding debts the administration would not normally be complete. For example, if a beneficiary lends money to the estate to pay taxes or other expenses, which is not uncommon, the administration is not complete and any income from property in the estate would be taxed at the highest rate, unless the estate still qualifies as a GRE.
Tax elections or other planning opportunities may be available to mitigate the effects of an estate being subject to high tax rates under the GRE rules. Trustees and executors may find themselves in disputes with disgruntled beneficiaries, or even exposure to legal liabilities for failure to administer the estate in a timely and tax-efficient manner. When administering an estate, it is prudent for executors and trustees to seek professional advice at their earliest opportunity.
Invitation for Discussion:
If you would like to discuss this article in greater detail, or any other business law matter, please contact Marnie Lusis or any one of the lawyers in the Tax & Estate Planning group at Shea Nerland LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.