Beware of Tainting Graduated Rate Estate Status

Executors and other loved ones of the deceased should be aware of paying for expenses on behalf of the estate

Individuals commonly leave their loved ones, such as their spouse and/or children, as executor of their estate. Their loved ones tend to be the most trusted to carry out the deceased’s last wishes and administer the estate accordingly. However, loved ones who are named as executor should be cautioned about paying for expenses on behalf of the estate as it could taint the estate’s graduated rate estate (GRE) status.

GREs have become an important estate planning tool for many Canadian individuals and provide many post-mortem tax benefits, with the primary benefit being that the estate is subject to graduated tax rates. In contrast, most other trusts are taxed at the highest marginal tax rate for every dollar earned. Additional benefits include flexibility in claiming donation tax credits, the ability to choose a non-calendar year-end, and flexibility for post-mortem tax planning for private corporations.

To access these benefits, the estate must meet several conditions, one of which is that it must be a testamentary trust as defined under subsection 108(1) of the Income Tax Act (ITA). Paragraph (b) of the definition of a testamentary trust will result in the estate losing its testamentary trust status if the property is contributed to the trust otherwise than by an individual on or after the individual’s death and as a consequence thereof. Paragraph (d) of the definition prohibits the estate from incurring a debt or any other obligation owed to, or guaranteed by, a beneficiary, or any other person or partnership with whom the beneficiary of the trust does not deal at arm’s length (“specified party”), with a few exceptions.

These two limitations can result in estates losing their testamentary trust status and, consequently, their GRE status. What are some common ways this can happen? Most executors who are also beneficiaries of the estate (i.e., surviving spouse, children, grandchildren, etc.) may find it easier to pay for estate expenses such as funeral expenses, maintenance costs of the deceased’s home, accounting fees, etc., out of pocket. One may do this for simplicity, as paying for the expense on their credit card is easier than writing a cheque from the estate bank account. If the executor is a beneficiary, most may be indifferent to how the expenses are paid as they either bear the costs personally and immediately or the estate bears the cost reducing their inheritance. In other cases, estates may have illiquid assets, such as a family cottage that the deceased would like to pass on to their children. However, because there are no other liquid assets in the estate, the beneficiaries may have to pay the taxes resulting on death to keep the property within the family.

As noted in the limitations, contributions to the estate can only be made by an individual on or after their death and as a consequence thereof. “Contribution” is not a defined term in the ITA, and as such, we rely on the precedent set by the Greenberg Estate v. R case, ¹ which refers to the plain meaning of “contributed.” Contributed means a voluntary payment made into the estate, made for no consideration, and the payment increases the estate’s capital. Where executors who are also beneficiaries believe that expenses paid by them personally would be indifferent to the estate bearing the cost and subsequently reducing their inheritance, it could ultimately result in the testamentary trust being tainted.² A contribution can be made even if no direct payment is made to the estate. Paying expenses on the estate’s behalf is considered a gift to the estate as it relieves the estate of liability, thereby increasing the estate’s capital.

What happens if an individual decides to pay for an expense on behalf of the estate and treat the payment as a loan? As noted above, loans to the estate by a specified party can also taint testamentary trust status. However, the ITA does provide exceptions where the loan was made within the first 12 months of the individual’s death and was repaid by the estate within 12 months after the payment was made. Often, when a specified party loans money to the estate, individuals do not seek repayment from the estate until the estate is ready to make distributions. However, given the timeframe provided in the legislation, specified parties should be mindful of the timing of estate expenses, and reimbursement from the estate should be sought no later than 12 months after the payment is made. If any payments made on behalf of the estate are considered a loan, the loan must be documented. In the Greenberg Estate case, the appellant attempted to argue that the payment was a loan; however, absent an agreement with specific terms of repayment, the courts denied this argument.

Many estate expenses may be due or paid for well in advance of the completion of the estate settlement. Caution should be taken for any payments on behalf of the estate as it could taint the estate’s GRE status before completing tax planning that requires GRE status to access the tax benefits and planning opportunities. If any expenses are paid on behalf of the estate within the first 12 months of the deceased’s death, care should be taken to document it as a loan and repayment should be sought immediately. While the ITA permits the repayment to be made no later than 12 months after the payment is made, an immediate repayment will ensure the “deadline” is not missed, consequently resulting in the estate being tainted. It’s important for financial, accounting, and legal advisors to stay in touch with estate clients to keep careful watch on when and how expenses are paid to ensure that GRE status is preserved.

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¹ [1997] 3 C.T.C. 2859
² CRA document 9613135