Dealing with the taxation of income earned by an estate can be complex. It has become even more complex since January 1, 2016. It was on this date that all estates, other than those that qualify as a “graduated rate estate” (GRE), were no longer able to benefit from graduated rates of taxation on their taxable income. Rather, to the extent an estate that is not a GRE earns and retains taxable income, that taxable income will be subject to tax at a flat rate equal to the top marginal rate applicable to individuals. An exception to this rule applies for those estates that qualify as a GRE.
When these tax changes were introduced many professionals turned their attention to drafting their wills to ensure maximum tax advantage could be taken of the new tax entity called a GRE (for an estate to qualify as a GRE a number of conditions must be met). In doing so, they may have inadvertently closed the door on the ability of an estate that is not a GRE to distribute taxable income it earned to the residuary beneficiaries and thereby have the amount taxed in the hands of the residuary beneficiaries at their marginal tax rates.
An issue that sometimes arises in the context of an estate that has earned taxable income is whether it can distribute that taxable income, to the beneficiaries entitled to the residue. Typically this issue arises once all debts, legacies, and other liabilities have been paid such that the executors are in a position to distribute the residue. Assuming the executors can distribute taxable income that is not needed to satisfy debts, legacies and other liabilities, a related issue is whether the estate can claim a deduction under ss. 104(6) of the Income Tax Act for taxable income that is then distributed to the residuary beneficiaries.
This issue was recently considered at the CTF Annual Conference, CRA Roundtable held in November 29, 2016.
Not surprisingly, CRA’s response confirmed that the tax outcome is driven by the legal outcome. In particular, the terms of the will and the powers available to the executors. If the will does not include directions as to which assets must satisfy the debts, legacies and other liabilities, the executors can satisfy such financial requirements as they wish so long as they act impartially, follow the classification of the gifts in terms of determining what gifts may be available to satisfy debts, legacies and other liabilities and ultimately pay all liabilities of the estate. In addition, the wording of the will must support a conclusion that the executors have the power to distribute taxable income to the residual beneficiaries. This latter point typically is not an issue in most wills.
Assuming the context is as described above, a distribution of the residue of the estate, which includes taxable income earned by the estate during a year, can be made to the residual beneficiaries, with the estate claiming a deduction under ss. 104(6) of the Income Tax Act. This may be important. In particular, if the estate no longer qualifies as the GRE, then any taxable income that is taxed in the estate will be taxed at a flat rate equal to the top marginal tax rate applicable to individuals.
If, however, there is wording in the will that suggests the obligation of the executor is to pay income taxes owing on taxable income earned by the estate, then such a deduction could not be taken. Rather, the taxable income would be taxed in the estate and the executors would be required to make an after-tax distribution of capital to the residual beneficiaries. Again, if the estate no longer qualifies as the GRE, the upshot may be more income tax is payable, leaving less available for the residuary beneficiaries. Ultimately the goal is to ensure the executors have the power to distribute taxable income to the residuary beneficiaries and to avoid directing the executors to tax income earned by the estate in the estate.