The death of a family member or a close friend, can be a difficult time. Our office is committed to making it as easy as possibly for you during this trying time by providing estate planning prior to death and setting out some tax tips for tax return filing on death.
Does an income tax return need to be filed for a person who has passed away?
Yes. A return must be filed for the year of death of the deceased person. This is known as a person’s terminal return. For the most part, the usual income tax rules apply to prepare the terminal return. However, there are a few exceptions including when the return is required to be filed with the Canada Revenue Agency, and how income is calculated.
Who is responsible for filing the terminal return on behalf of the deceased person?
A deceased person’s legal representative such as their executor/executrix or administrator/administratrix is responsible for filing the terminal tax return. An executor/executrix is the individual(s) appointed by the deceased’s will to administer the person’s estate. In contrast, an administrator/administratrix is an individual(s) appointed by a court to administer a deceased person’s estate when they die without a will (intestate).
When must the terminal return be filed?
Generally, the terminal return is due on April 30 of the year following a person’s death. However, there are certain exceptions. If a person dies after October 1, their legal representative has 6 months from the date of death to file their terminal return. There are also certain situations involving spousal trusts when a legal representative may have up to 18 months to file the terminal return. We suggest that you contact us to seek legal advice if you intend on settling a spousal trust in your will, or if you are administering a will with a spousal trust.
What must be included in a deceased person’s income for the terminal return?
In the terminal return, any income that has been earned and paid up until the date of death must be included in income. This may include income from employment, business, investments, royalties, pensions and employment insurance, to name a few. However, there are certain provisions in the Income Tax Act which have the effect of bringing other amounts into income that would not typically be included in a person’s income. Some of the more common income inclusions in the terminal return are discussed below.
On death, the full market value of the deceased’s RRSPs must be included in their income. However, if the deceased has a spouse, the RRSP may be rolled over into the spouse’s RRSP to achieve tax deferral until the spouse passes away.
Employee Stock Options
If the deceased has unused employee stock options at the time of their death, the full market value must be included in the terminal return.
Immediately before death, the Income Tax Act deems a person to dispose of all of their capital property. This means that for tax purposes, the deceased person is considered to have sold all of their capital property. Capital property may include shares, investments and real property. The advantage of a disposition being classified as capital gain from capital property, is that only ½ of a capital gain is included in income.
Additionally, some capital property is called depreciable capital property, and is treated differently for tax purposes than capital property because it depreciates in value over time. This might include (for example) a photocopier or a piece of farming equipment.
There are several different tax consequences that are possible as a result of the deceased being deemed to have disposed of all of their capital property and depreciable capital property. They may have a capital gain or loss, and they may have recapture (an amount to be included in their income) or a terminal loss(an amount to be deducted from their income) on their depreciable capital property.
If you are unsure of whether an asset is capital property or depreciable capital property, and the consequences of disposing of it, consult your tax expert. Our office would be happy to assist you in making this determination. Additionally, there are certain tax free rollovers for spouses and limited rollovers for children for farm or fishing properties that achieve tax deferral on the disposition of capital property and depreciable capital property of the deceased. Our office can help you determine if you are able to take advantage of these tax savings strategies.
Accrued Income Payments Periodically
There are several situations in which a person may have earned income prior to their death, that they will not receive until after their death. For example, they may receive payments periodically, such as rent, royalties, interest or employment income that is not payable until after death. Payments that are received periodically after the death of a taxpayer are included in their terminal return. Consider the situation when an individual passes away, but will not receive their pay cheque for another 10 days. In this case, their pay cheque is not payable at the time of the person’s death. However, it is still included in income even though it will not be paid until after the person’s death, because it is a periodical payment made to the deceased person.
Rights or Things
The deceased may have certain ‘rights’ or ‘things’ that must be included in income for their terminal return. The benefit of something being classified as a ‘right’ or a ‘thing’, is that the legal representative can elect to file a separate income tax return for the rights and things. Filing a separate return for rights or things provides an opportunity for the deceased taxpayer to have separate deductions and be subject to separate marginal tax rates from the first terminal return. In addition, there are circumstance in which the tax liability of a ‘right’ or ‘thing’ can transferred to the beneficiary rather than the deceased.
The Income Tax Act does not define what a right or a thing is, however, it specifically excludes certain types of property and income. A right or a thing typically catches amounts that are payable before death but have not yet been received such as a declared but unpaid dividend, a retroactive salary payment, or a Professional’s work in progress. In their interpretation bulletin IT-212R3, the Canada Revenue Agency has listed a number of other examples of rights and things. If you are unsure whether something qualifies as a right or a thing and should be included in a person’s terminal return, do not hesitate to consult us.
Introduction – Executor’s Compensation & Estate Planning
Addressing executor’s fee is an important facet of estate planning. When left unaddressed by the will, this fee can negatively impact the number of bequests that a taxpayer intends to leave for his or her loved ones. Many taxpayers include specific clauses in their will that address the issue of executor compensation. Unless the wording in the will is clear on its face, a court may interpret the compensation left for the executor as a gift. This means that the executor has the right to demand compensation from the estate, in addition to the gift the deceased taxpayer has left for the executor. In instances where the executor fee is left unaddressed, either because the will does not address the issue clearly or at all, or the taxpayer does not have a will, the executor can sue the estate for the compensation that he or she is entitled to. This in turn, has the potential to reduce the value of the estate and the beneficiaries’ entitlement.
Executor’s Compensation is Consequential: Impact on Beneficiaries
The executor, the person who administers a will, is legally entitled to compensation. This means that even in instances where family and friends agree to take on the task of estate administration for free, they still have the right to subsequently ask for and receive compensation for their services. The likelihood this scenario materializing increases especially in instances where the estate is complex and the executor is required to invest significant amount of time in its administration.
A well-drafted will should include at least the amount, if not the method for calculating executor’s fees. For example, a will may indicate that the executor is entitled to receive a valuable painting as his or her compensation, or that the executor is to receive $5,000 in fees once the estate is wound up.
In instances where the will does not address the issue of executor’s fees, the statute, and its interpretation by the courts set out the methodology for determining the amount of compensation. The relevant statutes do not set out any fixed fee formula; rather a method for calculating the fees is outlined. The Trustee Act states that the executor’s compensation must be fair and reasonable. Generally, in assessing what fair and reasonable mean in a particular scenario, the courts look at five factors:
- the gross value of the estate;
- the amount of revenue receipts and disbursements;
- the complexity of the work involved and whether any difficult or unusual questions were raised;
- the amount of skill, labour, responsibility, technological support and specialized knowledge required;
- the time expended by the executor;
- the number and complexity of tasks delegated to others;
- the number of personal representatives appointed in the will, if any
Considering these factors, the courts have generally accepted as fair and reasonable an executor’s fee that is about 5% of the estate value, plus the ongoing management fee of 2/5 of 1% of the average annual value of the estate assets during the estate administration process. The executor may be entitled to additional compensation if the estate becomes unduly complicated, requiring quite significant time, knowledge and expertise from the executor in carrying out his responsibilities.
Taxation of Executor Fees: CRA’s Position
The CRA considers the compensation received by an executor to be taxable income. Generally, the CRA classifies these fees as employment income taxable in the year that the fees are paid to the executor. Even if the executor receives a lump sum payment for the services rendered over several years, this income becomes taxable only in the year the executor receives the payment. Thus, the year that the executor receives payment is the year that the he or she is obligated to report this employment income to the CRA.
As the employer, the estate is liable to make the appropriate payroll deductions and T4 filings. Generally, the payroll deductions include the appropriate amount of income tax, Canada Pension Plan (the “CPP”) and Employment Insurance (the “EI”) contributions. The appropriate rate for all three deductions is set out by the relevant statutes. The CRA offers an online tool whereby employers can calculate the appropriate payroll deductions applicable to the executor fee. It is important to note that there are instances where the person or entity acting as the executor can be exempt from the CPP contributions.
Tax Tip: Proper estate planning should address executor fees
Estate litigations pertaining to executor fees can be quite costly, resulting in considerable reduction in the value of the estate available to the beneficiaries A well drafted will, one that appropriately addresses executor fees is an important first step in reducing the expenses, fees and taxes that an estate can incurs. In turn, this has the potential to maximize the value of the estate distributable to the beneficiaries. Contact one of our experienced Canadian accountants and estate planning accountants with your estate planning needs at [email protected] or by phone at 905-448-2241.