Deceased mom’s estate causes tax nightmare

The situation

Kelly Crane*, 63, died unexpectedly last December, and her family is devastated both emotionally and financially.

In October 2017, Crane sold a couponing app and all its rights to a tech giant for $500,000. That’s a relatively low figure by tech standards, but she was thrilled with the windfall. She had started coding as a hobby after her four children flew the nest and hadn’t expected to take to it so easily, never mind to create a marketable app.

Crane, a single mother, quit her factory job upon receiving the cash. Shortly after, she drew up a will that divided her estate equally among her four children and appointed her eldest son, Jeremiah (40), as executor. She paid off the remaining $85,000 on her house in Hamilton, Ont., where she had lived since she purchased it. Aside from the remaining $415,000, Crane had $1,000 in a regular savings account and a piece of vacant land she had bought 15 years ago from an ex-neighbour for $60,000. The land, now zoned for commercial use, is worth $200,000. She had no pension and, having never worked with an advisor, she had no life insurance, RRSP or TFSA.

The Crane children were thrilled when their mom received the money, partly because they were all facing large expenses. Jeremiah asked for a $100,000 loan to buttress his down payment on a Toronto home; Emily (37) asked for a $100,000 loan to fund a renovation; Lori (34) asked for $100,000 to pay for her dream wedding; and Karl (30) just wanted $100,000. Feeling generous but wanting to keep things equal, Crane drew up interest-free, indefinite loans for each child. They gleefully (and gratefully) spent most of the cash.

Crane’s death means all her assets are deemed disposed, and Jeremiah is wondering what to do about her terminal return. Her 2017 factory income was $45,000 gross (with appropriate taxes deducted at source), plus the $500,000 from the app sale (paid to her personally in a lump sum) and the $140,000 capital gain from the land disposal. Her house is worth $450,000, according to the latest assessment, and Jeremiah figures all taxes are covered by the principal residence exemption. Yet Crane’s bank account has a mere $16,000 after dispensing all the loans.

Jeremiah nearly fainted when he calculated his mother’s taxes owed, using an online calculator: more than $250,000.

Is he wrong? What should he do so Crane’s estate can pay all her taxes?

* These are hypothetical clients. Any resemblance to real persons is coincidental.

The experts

Susan Latremoille, director, wealth management, wealth advisor at the Latremoille Group, Richardson GMP, Toronto

Amy MacAlpine, lawyer, wills and estates at Hummingbird Lawyers, Vaughan, Ont.

Adam Morke, partner and tax specialist at Stern Cohen, Toronto

Planning misses

Latremoille: Her first mistake is that she didn’t get professional advice, though that’s not uncommon when you’re a novice investor and you suddenly receive a windfall. Still, she shouldn’t have been making important financial decisions on her own. After any life event, you should consult your wealth advisor.

Had she come to us, I would have done a basic retirement projection for her before she quit her job. At age 63, maybe the $500,000 from the sale of the app sounded like a lot of money, plus having the land. But we would project out to age 100 and there would have been a shortfall in her retirement income. I would have suggested starting an RRSP and TFSA, using life insurance, and putting the proceeds of the sale of the app into a holding company.

She didn’t have any liquidity, so giving her kids these loans was shortsighted. Instead, she could have invested the $415,000 after she paid off her mortgage: [that] was a good idea, but she could have invested the remainder to generate some income. Then she could have said to her children, “I need to keep this lump sum for myself, but I’ll help you by giving you some of the income accruing from this investment.” Or she could have said, “I can’t afford to give you these lump sums right now. I’ll give you a smaller amount each year until I see how my retirement pays out.” Or, “I’ve got to think about my own retirement, so you may have to wait until I’m gone to see if there’s anything left over.”

Did Emily really need that much to renovate her house? Does Lori really need $100,000 for a dream wedding? Jeremiah should have done his own planning for his down payment. So she obviously failed in bringing these kids up to be financially independent. Again, someone that worked with her over the years would have helped her withstand the temptation to bail them out before she thought about herself.

Still, I can’t fault her 100%. She was wise to document these loans, pay off her mortgage, write a will and make an astute investment when she bought the land.

Morke: I agree. If this app—her business—had been transferred into a corporation, she could have sold her corporation, gotten a capital gains exemption and paid practically no tax.

To be eligible for the capital gains exemption, she would have had to create a small business corporation where 90% of assets are used for active business in Canada. If she had marketable securities sitting in her corporation, that would be a passive asset. But the app would be considered an active asset, so she’d qualify.

To get the capital gains exemption, she would have to own the shares for 24 months. But she’s allowed to transfer her app (her business) into the corporation. Then she’d have to issue shares from treasury, and she could immediately sell that corporation and be eligible for the exemption, rather than waiting the 24 months. The lifetime capital gains exemption in 2017 was $835,716. Because she’s below that, there wouldn’t have been any tax on the $500,000 capital gain.

Her only remaining income would have been $45,000 of employment income (which we assume sufficient tax was withheld on) and the deemed disposition on the land triggering a capital gain of $140,000. Based on my 2017 tax software, the taxes owing would be approximately $25,000. The taxes owing in this situation would relate solely to the capital gain on the land.

Incorporating would have helped the estate

MacAlpine: When someone incorporates, you can use either a secondary or corporate will. What this does is separate your personal assets and your shares of the business. Through the secondary will we can transfer the shares without going through probate. So you’re going to save 1.5% estate administration tax. And we could have left the shares or retained earnings to the kids directly through this will and avoided probate.

I would even have suggested having the corporation buy the investment property, or using a holdco for the investment property. Of course, moving the land into a holdco would have caused a deemed disposition triggering capital gains at that time. Further, then we could have used estate planning tools, such as dual wills, that would allow me to separate the corporate assets from her personal assets. This would allow the corporate assets (the fair market value of the investment property at the time of her death) to be transferred without going to probate and [thus] avoiding the estate administration tax.

Since she didn’t do this, everything she owned on the date of death would be included for purposes of determining the value of the estate. So the net value of the investment property, primary home, cash in her bank account and any other personal ownership will be hit with the 1.5% probate tax.

Taxes due now

Morke: An app sale means you’re selling intellectual property, so there’s going to be a capital gain, but only half of it is taxable. So it’ll be similar to the capital gain on the land disposal, which makes a big difference in the tax calculation. When I run the numbers, it comes out to a balance owing of about $153,000, and that assumes that enough tax [was withheld] on the $45,000 of wages she received. Still, it’s not as bad as [we originally thought].

Based on her income, she’s going to be in the top tax bracket, so the marginal tax rate is about 53.53%. Jeremiah can look into the normal tax deductions or credits that could be applied to his mother’s terminal return, like whether she has medical credits or if there were donations made in the year.

Also, it’s not clear when she started developing the app. We’d look to see what stage she was in with her business. Was the app completed and was she generating revenue (not necessarily a profit) from it? We may be able to assess this by looking at old returns. If we can see that it was appropriate to deduct expenses, then we’d deduct against any revenue (not including the sale of the app) earned by her business in 2017.

Again, this is a perfect case of what could happen if you don’t receive professional advice. If we’d had an hour-long conversation with her prior to selling the app, it might have saved her $128,000. The meeting might have cost her $5,000 to $10,000 in professional fees, but that’s still significant savings.

Jeremiah’s duties

MacAlpine: As the executor, Jeremiah is responsible for securing and collecting all of the assets, paying all debts and taxes, and following the disbursements of the will. You’re talking at least a year to properly administer an estate.

Jeremiah should be seeking legal advice to understand steps, like: How do I become officially appointed? How do I sell this property? And how do I transfer this ownership? That’s what probate is—the legal process of being appointed as the executor and granted that legal authority to actually move the money around.

Kelly will owe about $153,000 in taxes, so we need to decide how the estate is going to pay for it. It’s either liquidating the assets or collecting the loans. If they are loans, then the executor would have the fiduciary duty to collect those loans as an asset belonging to the estate. That means every kid owes $100,000 to the estate.

Latremoille: We don’t know if her will forgave the loans. If she’d thought ahead, she might have said to the kids, “Even though I’m not charging interest, they are payable at my death.” Then maybe she wouldn’t have been in this situation and the kids would have had to pay back the money, which would have helped her estate pay the tax liability. And had she taken out life insurance, she would have had something in the way of an inheritance for her kids.

MacAlpine: Since each child already received $100,000, it comes out equally and no child can argue another one was favoured. So we’d advise selling the assets to pay the taxes. Once Jeremiah gets a clearance certificate from CRA saying there are no other taxes owed, then he can equally distribute any money left.

When are terminal taxes due?

If a person dies between Jan. 1 and Oct. 31, the taxes owing are due April 30 of the following year, explains Adam Morke, tax partner at Stern Cohen. Anyone who dies between Nov. 1 and Dec. 31 has six months from the date of death to pay their taxes. Since Kelly died in December, the taxes owing are due the following June.

“If they don’t have the funds to make the tax payment by June, then CRA will charge them interest and will likely get a bit aggressive to collect the $153,000,” he says. “The interest is an annual rate of 6%” (as of the second calendar quarter of 2018).