Lesson Six - Estate Planning Tools

WILLS
Your will is the basic document in estate planning. The will determines how the estate will be distributed. In it, you can direct that a specific property (including a woodlot, a favorite fishing rod or a specific amount of cash) go to a certain person. The will also determines the distribution of the rest of your estate - the residue that is left after specific bequests have been dealt with.

More complex wills can provide for the establishment of various trusts and may give very specific direction as to the disposition of assets. That is, your will may specify exactly how and when your assets will be disposed of, who gets them, and under what conditions.

In your will you appoint an executor to manage your estate. You can have co-executors if you feel more than one person is required to carry out your wishes. An executor is generally a family member, but can be a friend, a lawyer or a trust company. Being an executor is a serious responsibility so you should choose yours carefully, and you must be sure they are willing to accept the appointment. The will should give the executor the power to make any income tax elections (choices) that they deem advisable.

Your spouse has an interest in all of the family’s assets under the Matrimonial Property Act. She or he is entitled to enforce the scheme of distribution of property under the Act rather than following the terms of the will. In other words, what you put in your will may be over-ridden by the rules of this Act, unless a marriage contract is in place. So it is important to involve your spouse in the whole estate planning process.

If you die without a will, or intestate, your estate will be distributed according to a statutory plan. If you are survived by a spouse, the first $50,000 of your estate goes to the spouse. If your spouse and one child survive you, the spouse and child would share equally in any part of the estate over $50,000. If two or more children and a spouse survive you, one-third of the assets over $50,000 go to the spouse and two-thirds to the children. If there is no spouse the estate is split equally among the children. This may not be what you wish; the cost of administration of the estate increases; and it may cost more in income tax in the event of death without a will. As such planning should include everyone who might be affected by the provisions of your will.

You can write a will on a piece of paper or you can buy a kit that shows you what to do. However most lawyers charge fairly modest fees for a simple will, and it is probably worth the cost to be sure it is done right.

Trusts
A trust is a relationship where one person (the trustee) holds property for the benefit of another person (the beneficiary). There can be more than one trustee and/or more than one beneficiary.

A trust is created by a person called the settlor. The settlor transfers property to the trust by means of a trust agreement. The trust agreement governs how the trust will operate, including how income and capital will be distributed. Each trust agreement is unique and this provides quite a bit of flexibility. The beneficiary of a trust owns the trust but does not manage it.

A testamentary trust is one that arises on and as a consequence of a person’s death. These trusts receive special tax treatment including a non-calendar year end, no installments, and graduated tax rates. Testamentary trusts are generally created under the terms of a person’s will.

A discretionary family trust is an “inter vivos” trust, which means it is created during the lifetime of the person who contributes property to the trust. This form of trust is generally used in effecting an estate freeze. The beneficiaries are primarily the members of one family (including by marriage), the distribution of trust income and/or capital is within the complete discretion of the trustees, and the trust property often consists of shares of one or more private companies.

The benefits of a trust can include income splitting with family members, access to multiple capital gains exemptions, deferring capital gains (otherwise resulting from deemed disposition) until death of spouse, access to multiple marginal taxation rates (testamentary trusts only), creditor protection, and separate control from beneficial owners.

Trusts are used in specific situations, such as when transferring property to a minor child. A trust is often used to manage an investment portfolio for the benefit of a spouse or child who lacks financial skills or responsibility. Another use of a trust would be to transfer a woodlot to children who are not yet ready to manage it.

The drawback of using a trust is that the transfer of property to the trust is a disposition of property and may create some immediate tax liability. This is something you can discuss further with your professional advisor.

Another particular type of trust is referred to in the Income Tax Act as a spousal trust. A spousal trust is one where no one but your spouse may benefit from the income or capital of the trust during the spouse’s lifetime. When the spouse dies, the remaining capital of the trust is distributed to the other beneficiaries, usually your children.

A spousal trust is used to provide income for the spouse to live on, while passing the capital (the original money or other assets in the trust) on to the next generation.

The Taxation of Capital Gains
A capital gain (or loss) occurs when a taxpayer disposes of a capital property. A disposition includes a sale, a gift or any other transaction where the “beneficial ownership” of the property changes. If you give your son your house, he takes on the beneficial ownership of the house, for example.

There are also a number of situations where the Income Tax Act deems that a disposition has taken place. That is, there are times when it is assumed, or deemed, you have disposed of your property. For estate planning purposes, the most important of these is that you are deemed to have disposed of all of your property when you die.

All disposals have proceeds of disposition or deemed proceeds of disposition. Generally, this is the money that was received for the property disposed of, usually simply the sale price of a property that has been sold. The proceeds can be zero, as when a property is destroyed or a debt goes bad.

Exchanges of property will produce proceeds of disposition. If you exchange properties with another person you will have proceeds of disposition equal to the fair market value of the property you receive. That is, if you exchange your woodlot for your friend’s house, which is worth $80,000, you will have proceeds of disposition of $80,000.

To determine the amount of a capital gain or loss, you take the proceeds of disposition and subtract from it the adjusted cost base of the property and any costs of disposition (legal fees, real estate commissions, and so on). There can be a number of complex technical adjustments, but in most cases the adjusted cost base of a property is simply its original purchase price.

There are two important exceptions to this rule. The first is a property that has been inherited. As we noted above, if a parent has left you a property in their will, they are deemed to have disposed of that property for proceeds equal to the fair market value of the property at the time. Their deemed proceeds become your deemed cost.

The other exception is a property that you owned on December 31, 1971. This was the day before capital gains became taxable in Canada and is referred to as Valuation Day or V-Day. There are two ways to calculate the adjusted cost base of a property owned on V-Day.

The basic way is by using the median rule. Using this method you find the adjusted cost base by working out which of these three amounts – the cost, the proceeds of disposition, or the fair market value on Valuation Day – has a value that falls in between the other two – this is the median. Usually this will work out to be the V-Day value. The other method (which most people use) is to elect (choose) to use the V-Day value – that is, the value from December 31, 1971.

Only one-half of a capital gain is taxable (for gains acquired after October 18, 2000). This taxable capital gain is included with your other income and taxed at your marginal tax rate. There is no specific “Capital Gains Tax.”

If the adjusted cost base plus the costs of disposition exceed the proceeds of disposition, then there is a capital loss. The allowable capital loss is one-half of the loss. Gains and losses are netted - or offset - against each other for the year. If there is a net loss, it can be carried back one year and forward indefinitely. A capital loss can only be deducted against capital gains.

Your principal residence is a special type of capital property. It includes your house plus one acre, unless you can demonstrate that more land is required for the use and enjoyment of the property. An example of a need for more land would be a zoning by-law that requires a minimum lot size. A gain on the disposition of your principal residence is not taxable. This is true even for any gain that might result from a deemed disposition on death.

Here are two examples of how the capital gains rules work.

Example 1
Assume that you purchased a woodlot in 1965 for $3,000. At December 31, 1971, it was worth $5,000. In 2008 you sold it for $75,000 and paid a real estate commission of $4,000 on the sale.

Your proceeds of disposition would be the sale price of $75,000. There are two ways to arrive at your adjusted costs base.

By the median rule method, the adjusted cost base would be the median (middle) amount of the cost of $3,000, the V-Day value of $5,000, and the proceeds of disposition of $75,000 (in this case it is the V-Day value of $5,000).

By the V-Day value method the adjusted cost base would simply be the V-Day value of $5,000.

In our example, the two methods produce the same result; an adjusted cost base of $5,000 and a gain of $70,000. From the above result, we subtract our cost if disposition, the commission of $4,000. This leaves us with a capital gain of $71,000. The taxable capital gain included in your income is 50% of this or $35,500.

Example 2
Assume a woodlot was purchased in 1980 for $10,000 and today is worth $80,000. You decide to give the woodlot to one of your children. Your proceeds of disposition will be the fair market value of $80,000. Your adjusted cost base is the original purchase price of $10,000. As there are no costs of disposition on the transaction, your capital gain is $70,000. And your taxable capital gain is 50% of that or $35,000.

Dealing at Arm’s Length
The Income Tax Act refers many times to dealing at arm’s length. People deal at arm’s length when they have separate and opposing economic interests. The Income Tax Act deems (assumes) that related persons do not deal at arm’s length. Related persons are your parents, children, spouse, in-laws and any corporation that you or they control. Unrelated persons may not be dealing at arm’s length, but this is dependent on the facts of the situation.

The importance of the concept of arm’s length is that transactions between persons not dealing at arm’s length are deemed to take place at fair market value rather than the notional transaction price. The effect of this is that if you leave your woodlot to your children, you will be deemed to have disposed of it for its fair market value.

Spousal Rollovers
The general rule is that, when you die, you are deemed to have disposed of all of your property at its fair market value – except for property that passes to your spouse or to a spousal trust. This property is deemed to be disposed of at your adjusted cost base. You should note that this transaction is not tax-free, but rather tax-deferred, as tax will be payable when the property is later disposed of by your spouse.

If you transferred property to your spouse during your lifetime, it is treated the same way. It is deemed to be disposed of at your adjusted cost base. Complex rules known as attribution rules prevent the transfer of income and capital gains between spouses. These are best explained by a tax specialist, but here is a simple example.

If your woodlot cost $7,000, for example, and is now worth $55,000 you could transfer it to your spouse with no immediate tax cost. You would be deemed to have disposed of the woodlot for $7,000 so you would have no gain or loss. Your spouse would be deemed to have a cost of $7,000. If your spouse then sold the woodlot for $55,000, there would be a $48,000 capital gain of which one-half ($24,000) would be taxable.

If you had transferred the woodlot to your spouse during your lifetime, the taxable capital gain would be included in your income. If the actual sale takes place after your death, the gain will be included in your spouse’s income – regardless of whether the property passed to your spouse during your lifetime or on your death.

Your executor can elect out of the adjusted cost base rule and have property deemed to be disposed of at fair market value. This can be useful in some situations – for example, when there are unused capital losses.

Unused capital losses can only be applied against capital gains. If the property passes to your spouse under the normal adjusted cost base rule, there will be no capital gain and your spouse will be subject to a larger capital gain when he or she disposes of the property.

Life Insurance
Life insurance can serve a number of purposes in estate planning. When you pass on, it can provide cash flow to allow your spouse and dependents to maintain their lifestyle while they are still young. It can provide ready cash to pay estate liabilities – you may have significant liabilities that will need to be met from estate funds. Later on, it can provide the cash to pay taxes rather than forcing your survivors to sell a property you wish to remain in the family.

Finally, many people simply want to leave something to their children. Life insurance is a way for you to save up this inheritance and be sure that it will be paid if you die prematurely.

All life insurance policies have a beneficiary or beneficiaries. Usually the beneficiary is a specific person or persons, but it can also be your estate. If it is your estate, control of the proceeds of the policy is dealt with by your executor.