^Blog Importance of Estate Liquidity Planning

Many times in estate planning we come across “estate liquidity” issues that need to be planned for. Estate liquidity issues will arise where the deceased’s estate has more liabilities than liquid cash to satisfy these liabilities.

This could happen, for example, where the deceased has a mortgage on a property that they would like to pass on to their children, or where the deceased wishes to transfer their business interest, such as shares in a private corporation, to the next generation, triggering tax liabilities. Before either of these gifts can be made, the respective debt and taxes would need to be paid.

When a person dies property can roll tax-free from one spouse to the other, however, where property passes from a parent to a child, or a trust for that child, a deemed disposition of that property takes place, and this may create a tax liability. If these tax liabilities are not planned for, and there is not enough liquidity within the estate to satisfy them, a sale of these assets may need to take place.

Failure to plan for this could result in the deceased person’s gifting intentions being defeated. When the residue (the amount remaining after all gifts and bequests) of an estate is insufficient to satisfy all the liabilities of the estate, the gifts must be reduced to satisfy the payment of debts and liabilities – this is called “abatement” (gifts under the Will must be reduced to raise the funds necessary for meeting the shortfall to pay debts and liabilities of the estate).

Where abatement is required, gifts are abated according to the type of category of gift and are abated in the following order:

1. the residue of the estate is reduced first until it is exhausted,
2. general gifts are abated second (such as gifts of money),
3. specific and demonstrative gifts, other than real estate, abate next and for the purposes of abatement they are reduced pro rata together as one category of gift, and
4. specific gifts of real property abate last.

The gifts in each category abate at the same rate. For example, suppose that the entire residue of the estate must be used to pay liabilities but there still remains $60,000 of debt. If the Will contains two general gifts, one of $30,000 to Bert, and one of $90,000 to Ernie, each gift will be reduced by 50% since the total of all general gifts is $120,000 and the amount of the outstanding debt is $60,000, or 50% of this amount. So Bert would receive $15,000 and Ernie would receive $45,000 after the debt of $60,000 is paid.

Now suppose, in the same example above, that the amount of debt after exhausting the residue of the estate was $500,000, and there was a further gift of valuable private corporation shares to the children. The general gifts to Bert and Ernie would be exhausted completely, and the remaining $380,000 of unpaid liability would then be satisfied from the specific gift of the private corporation shares. Before these shares can be passed to the children the remaining estate liability of $380,000 would have to be paid. In order to create the liquidity to pay this liability, the shares in the company may have to be sold, or the company liquidated, thus defeating the intentions of the deceased. As the above example illustrates, planning for estate liquidity is very important in estate planning, and the ultimate distribution of your estate depends on it.

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Authored by: Jason Nagel, Director of Advanced Planning at Three60 Wealth & Estate Solutions Inc.