Author: Peter Weissman, FCPA, FCA, TEP, CEA
Estate litigation can be a complex and emotional process, often involving significant assets, costs, and stress. Unexpected tax issues can turn the relief of a negotiated settlement into further anguish. Without proactive and timely tax advice during the litigation process, a good faith settlement may create an additional and undesired beneficiary, the CRA. These surprises are problematic for all parties involved and hard to change once the settlement is signed.
Consulting an experienced tax advisor during the estate litigation process (before any settlement is approved) will increase the chances of a successful settlement by providing guidance on tax planning strategies that can increase the size of the pie to be divided amongst the beneficiaries.
Enlarging the settlement pie can be the difference between closure and a lengthy or costly court battle. But how do you increase the size of the pie when there is only so much to go around? You make sure the tax departments don’t eat too much!
Reason #1: Surrendering Entitlement to Achieve a Settlement
There are many factors in the estate litigation process that can impact the amount of tax required to be paid. Often, beneficiaries forego a portion of their entitlement, to facilitate settlement. Surrenders of property[1] or an interest in the estate can be treated as dispositions by the surrendering person. Surrenders or releases of interests in the underlying property are not taxable because of specific provisions in the Income Tax Act. Although not yet addressed by the CRA, it appears a surrender or release of an interest in an Estate, rather than specific property can create a gain that will be taxable to the person surrendering their interest.
For example, if one sibling agrees to give up $200,000 to settle but the settlement is not clear as to whether the sibling is surrendering a portion of the property they were entitled to or surrendering part of their interest in the estate the surrender could be taxable to the sibling surrendering the $200,000. Structuring the settlement clearly as a surrender of the right to property can avoid the uncertainty of this issue.
Reason #2: “Mistrust”
Settlements often include the creation of one or more new trusts. If the trust is not considered to have arisen “on and as a consequence of the death”, income in the trust may be taxed at the top tax rate, rather than being able to utilize lower tax brackets. Furthermore, it may not qualify for the preferred treatment available to trusts created for someone with a disability.
Reason #3: Breaking Up is Hard to Do
Breaking up an investment company between its various shareholders is often an objective of a settlement. While this can be done, the rules are complex and easily applied incorrectly. For instance, splitting up an investment company amongst siblings without creating tax is complicated and specific steps must be followed carefully to avoid making the separation of the company taxable.
For example, if two siblings equally split an investment company tax-free and one of them had decided to sell investments worth more than 10% of value of the assets they receive, that tax free split, could become taxable to both siblings. This is one of several esoteric rules that can raise their heads after a settlement has been completed. As such, it is important to seek the guidance of a tax advisor who can provide expert advice to avoid triggering any unexpected tax liabilities and potential penalties.
Reason #4: Avoiding IRS Penalties
Working with a tax advisor during the estate litigation process can help you avoid potential IRS penalties. For example, if a beneficiary lives in Canada but is a US citizen or green card holder, US tax rules will apply in addition to Canadian rules. Not properly coordinating the Canadian and US rules can create complications and potentially make annual income and future distributions very expensive. To avoid IRS penalties and ensure compliance with US tax laws, it is crucial to work with a tax advisor who has cross-border expertise to navigate the complexities of cross-border tax rules and ensure that all necessary reporting and documentation requirements are met. With proper planning and guidance, individuals can minimize their exposure to potential IRS penalties and reduce potential legal or financial consequences during the estate litigation process.
Reason #5: Unexpected Taxable Amounts
People often assume certain items can be dealt with tax-free when that is not always the case. Two common examples of false assumptions are that pensions can be transferred tax free and that any gain realized by the estate on the sale of the deceased’s home will be tax free. Various rollovers are available to defer tax on retirement assets distributed to beneficiaries, but these options are only available if the facts allow, and specific rules and deadlines are complied with. Unfortunately, these rules are often misunderstood or easily overlooked, which can result in significant tax liabilities for beneficiaries. For example, pension plans can only be rolled over to certain beneficiaries, and only if the funds are directed to the right place (ie. the beneficiary directly, rather than to the estate).
An estate’s gain on the sale of the deceased’s principal residence for more than the date of death value is usually not tax free. In some cases, having the estate distribute the home to a beneficiary who had and has still been living in the home, can result in access to the full principal residence exemption.
There are many additional examples of tax problems that can arise when settling an estate litigation matter. Consulting with a tax advisor who is familiar with these issues during the estate litigation process is critical. With the guidance of a tax advisor, individuals can better understand tax implications, maximize tax savings, handle complex tax situations, avoid CRA penalties, and avoid inadvertently making certain settlement components taxable.
In future blogs, we will discuss more tax traps to be aware of before finalizing any settlement.
[1] If the property had been owned by the deceased.
