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Solutions to Questions on Income Tax Planning - Post #10 - FPSC Level 1 Examination - December 2017

Posted by John Gobeil on

The FPSC Level 1 Examination is the first of two exams that must be passed to obtain CFP® certification. We have posted this entry to assist you in your preparation for the FPSC Level 1 Examination (FPE1) on Friday December 1, 2017.

In our last Post, we provided looked at the Competency Profile distinguishing between collection, analysis and recommendation.

In this Post, we will provide the solutions to two questions on income tax planning.

Collection versus Recommendation

The following question included in our previous Post, addresses Competency 1.110.

At the time of his death in January, the fair market value of John's RRSP was $185,000. John was single at the time of his death with no financial dependants. After his death, the value of the RRSP declined and the trustee paid John's estate $175,000 in final settlement of the RRSP.

What should his personal representative do?

(A) Deduct a loss of $5,000 on John's final return.
(B) Deduct a loss of $5,000 on the income tax return of John's estate.
(C) Deduct a loss of $10,000 on John's final return.
(D) Deduct a loss of $10,000 on the income tax return of John's estate.

(Concepts)   The fair market value of investments held in a Registered Retirement Savings Plan (RRSP) at the time of an RRSP annuitant's death is generally included in the income of the deceased for the year of death.

A subsequent increase in the value of the RRSP investments is generally included in the income of the beneficiaries of the RRSP upon distribution. Similar rules apply in the case of Registered Retirement Income Funds (RRIFs).

Upon the final distribution of property from a deceased annuitant's RRSP or RRIF, the amount of post-death decreases in value of the RRSP or RRIF may be carried back and deducted against the year-of-death RRSP/RRIF income inclusion.

The amount that may be carried back will generally be calculated as:

  • ((the amount in respect of the RRSP or RRIF included in the income of the annuitant as a result of the death of the annuitant) - (the total of all amounts paid out of the RRSP or RRIF after the death of the annuitant)).

This measure applies in respect of deceased annuitants' RRSPs or RRIFs where the final distribution from the RRSP or RRIF occurs after 2008.

(Choice C is correct.) Because there was no spouse, common-law partner or dependent children, the fair market value of investments held in the RRSP at the time of John's death would be included in his income for the year of death.

The amount that may be carried back is $10,000, calculated as:

  • ((the amount in respect of the RRSP or RRIF included in the income of the annuitant as a result of the death of the annuitant) - (the total of all amounts paid out of the RRSP or RRIF after the death of the annuitant)); or
  • ($185,000 - $175,000).

Upon the final distribution of property from a deceased annuitant's RRSP or RRIF, the amount of post-death decreases in value of the RRSP or RRIF may be carried back and deducted against the year-of-death RRSP/RRIF income inclusion.

So, his personal representative should deduct a loss of $10,000 on John's final return. 

The following question involves Competency 3.113, developing tax planning strategies.

Art is a widower who has just turned 80 years of age. He is in good health and owns his home. Art has four children. He would like to leave the cottage to his son, Bert. Art wants to leave each of his children an equal amount of his estate. Art's will includes a bequest of the cottage to Bert and an equal division of his estate to his four children.

Art should:

(A) Do an installment sale.
(B) Transfer the cottage to an inter vivos trust.
(C) Change the ownership to joint tenancy.
(D) Use his principal residence exemption.

(Concepts)   An instalment sale is a sale where the vendor owner will receive the proceeds in instalments over a number of years. The vendor may claim a capital gains reserve that allows him to defer, within limits, reporting a portion of the capital gain to the year in which he receives the proceeds.

The maximum reserve period is generally limited to five years. However, the maximum reserve period is 10 years for transfers of farming property and fishing property to a child/grandchild (ITA 40(1)(a)(iii)).

An inter vivos trust is a trust that the settlor established while still alive. A settlor normally creates an inter vivos trust by a trust deed. Once an inter vivos trust is established, it continues to be an inter vivos trust for tax purposes even after the death of the settlor.

Any income attributed to an inter vivos trust is taxed at the top, combined federal and provincial marginal rate. This tax rate varies from province to province (ITA 122.1). This severely limits the usefulness of inter vivos trusts as an income-splitting tool.

An alter ego trust is an inter vivos trust where the trust deed specifies that:

  • the settlor of the trust must be entitled to receive all of the income that the trust earns prior to her death;
  • the settlor must be at least 65 years of age at the time that he creates the trust; and
  • the only individual who has any access to the trust capital during the settlor's lifetime is the settlor (ITA 104(4) (ii.1) and (iv)); ITA 248(1)).

An individual can transfer capital property to an alter ego trust without the transfer being considered a disposition for tax purposes.

A joint tenancy is a form of ownership in which all co-owners have an equal right to possess and use the whole property, along with the right to dispose of their ownership interests in any way that they see fit during their lifetimes.

A right of survivorship is a right of joint tenants, such that if one of the joint tenants dies, her ownership interest automatically passes to her surviving co-tenants in equal shares. She is not able to bequeath her interest to anyone else through her will.

To avoid a deemed disposition, the registration of joint tenancy must be accompanied by an agreement that denies the new co-tenant a beneficial interest in the property. If such an agreement is included, Canada Revenue Agency (CRA) should consider that no disposition has taken place for tax purposes. 

The principal residence exemption is a deduction permitted from a capital gain on a principal residence that the owner designated for a particular year of ownership.

To determine which property to designate for a particular year, a taxpayer would designate the property with the highest present value of the annualized deferred income tax.

(Client situation) In Art's situation, you would have to make certain assumptions:

  • there must be significant capital appreciation on the cottage, otherwise it would not matter how Art transferred the cottage to his son;
  • if it was appropriate and possible to use the principal residence exemption to avoid the tax on the all of the cottage's capital appreciation, rather than his home's capital appreciation, it would not matter what Art did, so we will assume that is not the case; and
  • Art must normally have a taxable income less than that of the top income tax bracket, otherwise, the capital appreciation would be taxed at the top effective income tax and clawback rate regardless of when it is realized.

(Choice A) Art could sell the cottage to Bert as an instalment sale over five years. He would have Bert sign five promissory notes, one due each year for five years. Art would forgive the notes as they come due by effectively gifting the notes to Bert.

By doing so, Art would only have to report one-fifth of the capital appreciation as a capital gain for each of the five years. This would assumedly result in less income tax and clawback than having to report the entire amount of capital appreciation as a capital gain in the year of death.

So, Art could benefit from an installment sale.

(Choice B) If Art transferred the cottage to an ordinary inter vivos trust, he would have a deemed disposition upon the transfer. This would result in the capital appreciation being realized immediately. He might as well wait until he dies.

If Art transferred the cottage to an alter ego trust, he would not have a deemed disposition upon the transfer. This would result in the capital appreciation being realized upon death. From a tax and clawback point of view, this would be no better than waiting until he dies and bequeathing the cottage to his son.

The instalment sale offers better advantage than the transfer to an inter vivos trust. So, Art should not transfer the cottage to an inter vivos trust.

(Choice C) Art could register a change of ownership as a joint tenancy.

If he made the transfer effective immediately for income tax purposes, half of the capital appreciation would be a realized capital gain upon the change of ownership and half upon his death. If he did not make the transfer effective immediately for income tax purposes, the capital appreciation would be realized upon his death.

Neither arrangement would offer any particular advantage.

The instalment sale offers better advantage than the joint tenancy. So, Art should not change the ownership to joint tenancy.

(Choice D) This is a tough one. Art owns his home, as well as the cottage.

Of course, Art should use his principal residence exemption to the extent that the annualized deferred income tax on the cottage is higher than that of any other property that he could designate for the years in which he owned the cottage.

If it was appropriate and possible to use the principal residence exemption to avoid the tax on the all of the cottage's capital appreciation, rather than his home's capital appreciation, it would not matter what Art did, so we will assume that is not the case.

The instalment sale plus any principal residence exemption offers better advantage than just the principal residence exemption. So, Art should not just use his principal residence exemption.

(Choice A is correct.) So, Art should do an installment sale and use the principal residence exemption as appropriate.

The solution to this question is a lot to expect for one mark in 2 minutes.

If you selected D as the solution, you were partly right. If you were not sure about making assumptions, you are not alone.

Next Post

In our next Post, we will look further into Income Tax Planning Recommendations.

John Gobeil, BSc, CFP®
David Gobeil, CPA, CA, CFP® 

Certified Financial Planner® and CFP® are certification marks owned outside the U.S. by the Financial Planning Standards Board Ltd. The Financial Planners Standards Council is the marks licensing authority for the CFP marks in Canada, through agreement with FPSB.


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