What Income Tax Rate(s) Should You Use in Estimating Your Estate Tax Liability?

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.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Sacred Tax Cows

We are all aware that almost every level of government is strapped for funds and consequently, they often look at how they can raise additional monies through taxation. As funding needs become more desperate, a couple of my clients have asked me if they think any of the “sacred tax cows” will be sacrificed. Today I consider the political and tax risks a government would take if they attacked these “sacred tax cows”.

What tax cows am I talking about? I would suggest in Canada we have two “sacred tax cows” and one “tax cow” which is important but has been sacrificed in the past and will likely be in the future.

In my opinion, these tax cows are as follows:

The sacrificial tax cow:

1. The 50% tax inclusion rate for capital gains

The two sacred cows are:

1. The tax-free nature of your principal residence

2. No estate tax on death

The Capital Gains Rate

The capital gains rate prior to January 1, 1972 was nil. Aw, the good old days! From 1972 to 1988, the government only taxed 50% of any capital gains. For 1989 and 1990 the inclusion rate was changed to 2/3 of your capital gains. For the years 1990-1999, 3/4 of your capital gain was taxed. From 2000 onward, we have been at the current 50% inclusion rate (except for 8 months in 2000).

The above clearly reflects various governments do not see a 50% inclusion rate as a sacred tax cow. In fact, in 2017 I had a few clients sell stocks to lock in the 50% rate because there were rumours the Federal Liberals would increase the inclusion rate to 3/4. However, the inclusion rate was not changed.

I think no one would be surprised if the capital gains inclusion rate is increased in the future and I don’t think there is huge political risk in doing so, since most people paying capital gains have already been hit with higher personal and corporate taxes and are numb to various tax hits. In addition, a change in inclusion rates has been floated multiple times by different governments, so the shock component would not be high.

Tax-Free Sale of Your Principal Residence

Currently, when you sell your principal residence (“PR”) it is tax-free. Each family unit is only entitled to one PR exemption. In 2017, the Liberal government issued legislation that requires you to report the sale of your PR, even if it is exempt (see the second paragraph of this post). This measure was implemented to prevent some of the abuse in respect to the non-reporting related to PR (especially house flips) and situations where taxpayers thought the sale was exempt and in fact it was not exempt.

I would suggest the tax-free nature of a home is clearly a sacred cow to most Canadians and the political risk in making your home taxable would be immense. However, I can envision a government trying to move to a U.S model. In the U.S. the first $250,000 gain on the sale of a house is exempt from tax for U.S. citizens or $500,000 for spouses who are both U.S. citizens. The exemption mentioned is applicable when the following two conditions are met:

Ownership test: the taxpayer owned the property as his/her main home for a period aggregating at least two years out of the five years prior to its date of sale.

Use test: the property was used by the taxpayer as his/her main home for a period aggregating at least two years out of the five years prior to its date of sale.

These two tests can be met during different two- year periods. Also, for married couples filing joint returns, each spouse needs to meet the ownership and use tests individually in order to qualify for the $500,000 exemption jointly. The taxpayer would not be eligible for the exclusion if he or she excluded the gain from the sale of another home during the two-year period prior to the sale of his/her home.

Ignoring the technicalities of the U.S. rule, one ponders whether such a measure could possibly work in Canada if say the numbers increased to $500k and $1mill respectively, since that would likely eliminate the gains for most provinces other than maybe B.C and Ontario. Although, losing a significant number of voters in those two provinces would probably still not be smart politics. But if the exemptions moved to $1,000,000 and $2,000,000 the blow-back would likely be more muted. However, IMHO, I think in the end, a government would risk re-election if they put forth such legislation.

Estate Tax

The United States has levied estate tax for many years. The tax has been a political football with the exclusion amount from estate tax varying from $675,000 to $11,180,000. The tax was even repealed for one year in 2010, known as the year to die in the U.S. The estate tax has varied from 35% to 55%.

In most U.S. states, the annual personal income tax burden is substantially less than in most provinces. In addition, the U.S. has many more significant tax deductions such as mortgage interest; so, for U.S. taxpayers, they typically pay far less than Canadians in yearly tax but will typically pay substantially more on death. So the U.S. model is pay me less now and possible a whole bunch later.

In Canada, an estate tax would be pay me now and pay me later and the effective tax rate could end up being a ridiculous amount. For example, if you made a million dollars at the highest marginal rate in Canada you would have $460,000 left. Imagine a 40% estate tax on your $460,000 estate if you died. Your net estate would be only $276,000; so a total tax burden of 75% if the estate tax was 40%. Of course, this is simplistic and not necessarily realistic, but I use the example to demonstrate how massive the tax burden could be with a Canadian estate tax. In my opinion, I can see a government taking a huge political risk and imposing an estate tax with a large basic exemption; since they seem to feel, mid to high earning Canadians are a never ending source of tax dollars. 

In summary, I think we will see an increase in the capital gains inclusion rate at some point in the next five years. As for the two other sacred cows, I really hope no government is willing to eliminate the PR exemption or quantify the amount of the PR exemption and definitely not impose an estate tax. Let’s hope such taxes never see the light of day.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.