In my last blog post, I discussed that for tax and estate planning purposes, you should estimate your current estate tax liability and then plan how your estate will cover off this liability (which in many cases is an ever growing tax liability). Today, I want to discuss what income tax rate(s) you may wish to use in estimating your estate tax liability.
For clarity, this exercise to estimate your estate tax liability is not meant to be definitive calculation (if you wish a definitive calculation, you will need to engage your accountant and possibly a business evaluator). This exercise is intended to provide you with a starting point, so that you have a number to plan with, whether your intention is for your estate to cover off this potential tax liability by a sinking fund, cash on hand, liquidation of your assets, insurance or some combination of all of the above.
One would think the income tax rate(s) to be used in estimating your estate tax liability would be a straightforward calculation, but there is a little more than meets the eye. Please keep in mind, that I am assuming you are the last spouse to pass-away for this estimated calculation, as if you are the first spouse to die and transfer your assets to your surviving spouse, there is no tax at that point in time.
For RRSPs, RRIFs or any other income related items taxable on death, I usually use the highest current marginal rate of 53.53% (in Ontario). This assumes your estate’s income tax rate is mostly high rate in the year of death. While that is typically the case with most of the people I work with, that may not be your case and you may be able to utilize a lower marginal tax rate, but if you want to be conservative, the highest marginal rate builds in a buffer.
As most people like to think/hope personal marginal rates will not increase much in the future (although many of us thought the same when rates were 45%), they are comfortable using the current 53.53% rate for a future rate on income type items.
Things become trickier when determining the appropriate tax rate to use on capital items. The highest current marginal capital gains rate is 26.76% (in Ontario). However, many people assume capital gains rates are going to increase in the future, so the rate to use is not entirely clear. Thus, I typically provide an alternative estimate using 26.76% and another using 40% assuming a higher future capital gains inclusion rate of 3/4 of the capital gain (as opposed to the current inclusion rate of 1/2 of the capital gain) for capital gains rates on personally held assets. If you do not expect your estate to be at the highest marginal rate on your death, you can use the lower marginal rates; but remember, the inclusion of your RRSP/RRIF value on your death will in many cases move you into a much higher income tax bracket.
The future capital gains rate is even more complicated for shareholders of private corporations, since their shares are potentially subject to double taxation if proper steps are not undertaken to alleviate this liability. Double taxation can occur where the estate pays tax on the deemed disposition reported on the owner’s terminal tax return, and then the estate pays further tax when it removes the assets from the corporation in the form of dividends to the estate.
There are two tax planning strategies that can generally eliminate any double tax; however, both techniques have some potential restrictions:
(1) The first is known as a subsection 164(6) loss carryback. In simple terms a loss is created on a share redemption by the estate that reduces or eliminates the capital gain that arose as result of the deemed disposition on death.
(2) The second, known as the pipeline strategy allows the estate to remove the corporate funds generally tax-free. This is achieved by transferring the deceased owner’s shares to a new corporation and using share redemptions and a netting of promissory notes to remove those funds tax-free.
However, a pipeline strategy can be problematic in certain circumstances and the strategy relies upon the CRA allowing such a strategy in the future. This makes determining a future capital gains rate potentially problematic. So, when I prepare my estate tax liability, for private corporations I use a 30% rate as a low-end and a 40% rate as a high-end estimate (Note: unlike above, I am not using the 40% rate because of the prospect of a capital gain rate inclusion increase, but as a dividend rate if a pipeline cannot be undertaken or is partially blocked).
If your private company shares qualify for the lifetime capital gains exemption because they are Qualified Small Business Corporation shares, you will need to factor in the fact that $971,190 (as of 2023) of the capital gain will not be taxable.
Finally, the tax rate on a private corporation share can also be impacted by corporate attributes such as the Capital Dividend Account and refundable income taxes on hand (NERDTOH and ERDTOH), which again makes it more difficult to determine the appropriate income tax rate. Where your corporation has these tax preference items, your accountant needs to undertake more detailed calculations.
The question of which tax rates should be used for an estate tax liability estimate is somewhat complicated as discussed above and subject to future taxation legislation and government policy. Thus, as noted above, I personally provide clients with two estimates: (1) Using the highest marginal rate for income items and a 30% capital gains rate and (2) a second more conservative estimate using the highest marginal rate for income items and a 40% capital gains rate. This at least provides a range of their potential future estate tax liability.
For purpose of this blog, I am hoping/ignoring the possibility that a future government implements an Estate Tax like that in the United States (the estate tax can go as high as 40% Federally subject to exemptions) as that would significantly affect any future tax liability planning.
Finally, as the above discussion is premised on estimates, please ensure you consult your accountant or estate planning specialist for specific estate planning advice and the determination of your estate tax liability. This advice should be obtained earlier rather than later and then reviewed every few years thereafter as personal circumstances change and new legislation is introduced.
(1) The first is known as a subsection 164(6) loss carryback. In simple terms a loss is created on a share redemption by the estate that reduces or eliminates the capital gain that arose as result of the deemed disposition on death.
(2) The second, known as the pipeline strategy allows the estate to remove the corporate funds generally tax-free. This is achieved by transferring the deceased owner’s shares to a new corporation and using share redemptions and a netting of promissory notes to remove those funds tax-free.
However, a pipeline strategy can be problematic in certain circumstances and the strategy relies upon the CRA allowing such a strategy in the future. This makes determining a future capital gains rate potentially problematic. So, when I prepare my estate tax liability, for private corporations I use a 30% rate as a low-end and a 40% rate as a high-end estimate (Note: unlike above, I am not using the 40% rate because of the prospect of a capital gain rate inclusion increase, but as a dividend rate if a pipeline cannot be undertaken or is partially blocked).
If your private company shares qualify for the lifetime capital gains exemption because they are Qualified Small Business Corporation shares, you will need to factor in the fact that $971,190 (as of 2023) of the capital gain will not be taxable.
Finally, the tax rate on a private corporation share can also be impacted by corporate attributes such as the Capital Dividend Account and refundable income taxes on hand (NERDTOH and ERDTOH), which again makes it more difficult to determine the appropriate income tax rate. Where your corporation has these tax preference items, your accountant needs to undertake more detailed calculations.
The question of which tax rates should be used for an estate tax liability estimate is somewhat complicated as discussed above and subject to future taxation legislation and government policy. Thus, as noted above, I personally provide clients with two estimates: (1) Using the highest marginal rate for income items and a 30% capital gains rate and (2) a second more conservative estimate using the highest marginal rate for income items and a 40% capital gains rate. This at least provides a range of their potential future estate tax liability.
For purpose of this blog, I am hoping/ignoring the possibility that a future government implements an Estate Tax like that in the United States (the estate tax can go as high as 40% Federally subject to exemptions) as that would significantly affect any future tax liability planning.
Finally, as the above discussion is premised on estimates, please ensure you consult your accountant or estate planning specialist for specific estate planning advice and the determination of your estate tax liability. This advice should be obtained earlier rather than later and then reviewed every few years thereafter as personal circumstances change and new legislation is introduced.
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Thank you so much for the insight. I had not thought about this. We are going to depart for an extended trip (6-months) and have, for the most part, put together information on our assets in the event something were to happen to us. I’m going to go back and thumbnail the potential tax liability…never a pleasant task.
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