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Estate planning is often thought of as an exercise in generosity, deciding who gets what, and making sure assets pass to the right people with as little friction as possible. But sometimes, even the most carefully constructed plan contains the seeds of a problem that only becomes visible after death.
The story of a fictional family, let’s call them the Martins, illustrates how quickly those seeds can grow.
The Martin Family
Margaret Martin passed away leaving a Last Will and Testament, and an Alter Ego Trust holding her several properties, shares of a few companies and other assets equal to worth $6 million. She also had a Registered Retirement Income Fund (RRIF) worth about $800,000, to which she had designated her eldest son, David, as the beneficiary. She had also named David as one of two co-executors of her Estate, and as a co-trustee of the Alter Ego Trust.
On the surface, this looked like a sensible arrangement. The properties, shares of the companies and other assets were within the trust, thereby reducing the probate fees payable by her Estate. The RRIF passed directly to David, outside the estate, quickly and without probate. Since the estate itself had only a modest bank account, it did not require probate to access it. Margaret had made careful plans to reduce the burden of probate fees on her Estate and desired beneficiaries; however, the problem emerged when it came time to pay Margaret’s final tax bill.
The Estate Has a Tax Problem It Cannot Solve
Under Canadian tax law, when a person dies holding a RRIF, the full value of that RRIF is included as income on their terminal tax return. In Margaret’s case, that meant $800,000 of income hitting her final return, generating a potential tax liability in the range of $350,000 to $400,000.
However, there was no money to pay that bill in Margaret’s Estate since the RRIF proceeds had already passed to David, and the assets held in the Alter Ego trust did not form part of Margaret’s Estate.
This is a situation that surprises many families. The assumption is often that if an asset passes outside the estate, it takes its tax consequences with it. However, in the case of an RRSP or RRIF, the tax liability is a liability of the deceased and, subject to what we explain below, it stays with the Estate, even when the assets or money have gone elsewhere.
The CRA’s Long Reach
Here is where the situation becomes more complicated. The Canada Revenue Agency is not without recourse simply because the estate is insolvent. Under subsection 160.2(1) of the Income Tax Act, where an RRSP or RRIF amount is included in a deceased’s income but paid out to a named beneficiary, if the taxes do not get paid, CRA can assess the RRSP or RRIF beneficiary directly for the unpaid tax, up to the amount they received.
In plain terms: David received $800,000 from the RRIF. If Margaret’s Estate cannot pay the tax arising from the RRIF, CRA can come after David personally for it, up to the amount of $800,000.
This is not a technicality buried in fine print. It is a deliberate mechanism in the legislation, designed precisely for situations like Margaret’s, where assets and tax liabilities have been separated by the structure of an estate plan.
Can’t the Trust just Pay the Taxes?
This is a natural question, especially as the Trust has so many assets, AND the beneficiaries of the Trust are the same as the Estate. However, a trust is a separate legal arrangement, and its trustees are bound by the terms of the Trust Deed. Unless the Trust Deed expressly authorizes the trustees to pay the taxes and debts of the deceased or of the Estate, the trustees have no authority to do so. Using trust assets for that purpose without proper authority could itself expose the trustees to liability from the Trust’s beneficiaries.
It is not uncommon for inter vivos trusts, these kinds of trusts that are created during a person’s lifetime, to include language specifically directing the trustees to pay the deceased’s taxes and other debts from trust assets after death. That kind of provision, drafted thoughtfully at the outset, can resolve exactly the problem the Martin family now faces. Unfortunately, Margaret’s Alter Ego Trust Deed contained no such language. What looked like an oversight at the drafting stage has become a significant obstacle in the administration of her Estate.
For anyone drafting a trust deed, this is an important lesson. The question of what happens to the deceased’s tax obligations after death is foreseeable, and the trust deed is the right place to address it. A simple provision, included at the time of drafting, can prevent a great deal of difficulty later.
The Conflict at the Heart of the Matter
This is where the Martin family’s situation becomes more complicated, and where the lesson for anyone involved in estate planning becomes most important.
David is not just a beneficiary. He is a co-executor of the estate, with a legal duty to ensure the estate’s obligations, including its tax obligations, are met. He is also a co-trustee of the Alter Ego Trust, with fiduciary duties to all of the Trust’s beneficiaries. And, most importantly, he is the person who received the RRIF proceeds that generated the very tax liability he is now, in his capacity as executor, obliged to address.
Every decision about how to resolve the estate’s insolvency affects David differently depending on which hat he wears. As executor, he should want the tax paid and has a duty to do so to the extent the Estate has assets. He and all the other trust beneficiaries would likely prefer trust assets not be used to cover the shortfall. As the RRIF recipient, he has a personal financial stake in whether CRA pursues him directly. These interests do not point in the same direction, and they cannot be neatly reconciled.
This is the definition of a conflict of interest, by no means a personal failing on David’s part, but a structural problem created by the overlapping roles he was asked to fill.
The Planning Lesson
Margaret’s situation was not the result of bad intentions. It was the result of a plan that optimized for simplicity and efficiency in how assets passed, without fully accounting for what the Estate would need to meet its obligations.
A few questions, asked earlier in the planning process, might have changed the outcome significantly. Was there sufficient liquidity in the estate to cover the terminal tax liability? If not, was there a mechanism in the trust deed to address a shortfall? And was it wise to place the same person in the roles of executor, trustee, and primary beneficiary of an asset that would generate the estate’s largest tax liability?
Estate planning is not just about where assets go. It is about ensuring that when obligations arise, and tax obligations always arise, that there generally is a clear and workable path to meeting them. When that path is unclear, or when the people responsible for finding it have competing personal interests, the administration of even a modest estate can become unexpectedly complicated and costly.
If you have questions about how your estate plan addresses your eventual liabilities, or about the roles and responsibilities of executors and trustees, please reach out to any member of the LK Law Estate Planning and Litigation Group. We would be pleased to speak with you.
This article is intended to be an overview of the law and is for informational purposes only. Readers are cautioned that this article does not constitute legal or professional advice and should not be relied on as such. Rather, readers should obtain specific legal advice in relation to the issues they are facing.
